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BW Businessworld

Far From Over

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The August of 2011 will be remembered as one of the most turbulent and chaotic months in recent history with the western world coming under grips of social, economic and political turbulence. The nervousness around Euro and fear of contagion of bad European debts, riots and social unrest  in England,  the government debt gridlock in the US and the downgrading of her debt for the first time since 1941 were too much for investors around the world to bear and their flight towards  safety fuelled a downward spiral in equity indices. The FTSE 100 index dropped by 14 per cent, the Dow-Jones index fell by 13.5 per cent and Germany's DAX lost more than 23 per cent in less than a month.
Ever since the financial crisis of 2008, such volatilities of financial market indices over and above the normal bands, partly reflecting the sombre outlook of investors about the future prospect of global economy, have become a part of the international financial market. So, a worrisome question is: when will the sharp edges of volatilities turn smooth and a normal pattern of movements of indices within a reasonable range come back for a longer duration?  To answer these questions, all one needs to do is to introspect into the chain of events that took place in recent months.
The recent downgrading of US debt certainly had an impact on all of these partly due to revised estimate of risk factors and its consequent impact on market liquidity, volume of trading and reallocation of portfolio but their combined effects on the world financial indices will be minor and transitory. The downgrading of US Government debt does not even remotely resemble similar changes in rating accorded to Greece or even to Japan.  It is true that that US pays $250 billion as annual interest rate to her creditors and has a debt of $14 trillion, but the overall wealth and assets of the country far exceed the total liabilities. Hence, it is not a question of capability of repayment that is a relevant concern when rating agencies downgrade the quality of debt. In fact, after a temporary selling, investors again came back to US treasuries which is, paradoxically, still treated as one of the safest sanctuaries, leading to fall in its yield.  

The problem lies elsewhere. Though credibility of S&P is itself in doubt but its statement "More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011'' is hardly questionable.
The main structural problem facing US currently is her rigid political system which prevents the government from financing the stimulus package either via raising current taxes paid by the rich or through extra borrowing. Inability to reach a political consensus on the method of financing government expenditure is adding uncertainties to the process and speed of full recovery which is even harder this time primarily due to forces of globalisations. In all earlier downturns, recovery was relatively easier because all US had to do was to regain the lost ground (in terms of lost jobs and GDP) from herself. The emergence of China as an industrial giant has been made possible due to irreversible relocations of erstwhile US factories to that country and these job losses are permanent. At the top of it, rigidity of both democrats and republicans on agreeing upon the debt-tax deal had certainly added salt to the wounds.

Second, financial markets are tumbling but this time it is very much different from 2008. Unlike then, the banks' balance sheets do not look disrespectful and they do not need a rescue programme. Banks have cash but they are not lending. The corporations are also sitting on piles of idle money but not investing. Both are holding back because of the aggregate demand uncertainty, thanks to the imposition of a forced cut in aggregate demand boosting aggregate expenditure and a temporary truce in reaching a debt deal.
However discredited among academic (primarily Minnesota Chicago), regulatory and conservative political circles, the Keynesian economics still remains the best palliative in a depression stricken economy. The country has a choice between borrowing money now to fund stimulus and raise overall taxes after economy completes a recovery to pay back debt or to cut expenditure to balance its budget now. The former achieves balance in Government budget over time without hurting the economy at present and the latter balances budget immediately at the expense of recovery. Apparently, by cutting $2.4 trillion over a next decade in exchange for a marginal increase in debt ceiling, the US Government has signalled that it has opted for the latter. Not surprisingly, the forecast for growth of the country in the next quarter was revised down sharply from 1.9 per cent to 0.4 per cent and in the last quarter the economy grew at an annualized rate of 1.3 per cent which is much lower than expectations. It is also reported that in July, employers in US had added only 1,17,000 jobs and will be adding less than 100,000 net jobs in rest of the year.
 The news is perhaps worse in the other side of Atlantic. The Europe's structural problems lie elsewhere. In the zeal of making a unified Europe, it has made monetary union faster without fiscal reunions leading to profligacy of Governments of constituent countries which had indulged in expenditure far beyond its capacity. The debt to GDP ratio of Greece is 140 per cent; for Ireland it is 95 per cent. These countries cannot have their currency devalued because they do not have any on their own and the value of Euro depends on the average performance of disparate countries. With some in deep and bad debt, the spill over effects are felt all over. Worse, the monetary union even did not have any contingent plans for crisis of individual countries. Hence, the recovery of Europe is not in sight either.   All these bad news hit the markets at the same time making investors jittery and nervous and fled from the equity market which tripped immediately.
China, on the other hand, apparently looks good internally due to a projected growth rate of 9 per cent but her future is at stake as well. The country via export led growth and a manipulated exchange rate regime is running a current account surplus of $3 trillion and had invested almost $1.1 trillion in US dollars. The US, in order to reduce the burden of foreign debt and to ease her own budget constraint will certainly monetise its debt by devaluing its currency via printing money. This will partially shift the burden to her lenders in the form of both devaluation of US dollar and inflationary pressure. A weak dollar and inflation will mitigate the cost of servicing interest payment of US to her creditors. China with her huge exposure to US dollars will suffer more in the future and this will certainly heighten the tension between these two giants. At this point, China has no escape route because there is nowhere it can stash the dollars that she had accumulated almost in a fit of absent mindedness.
The process of global recovery requires co-ordination of fiscal, monetary and exchange rate policies under the supervision of an undisputed leader. With her eroding manufacturing bases, persistence of high unemployment, falling value of dollar and a political gridlock within the country weakened the position of US considerably. Bad debts and fear of their contagion have gripped Europe. China has a long way to go before it can make Yuan world's hard currency.
Investors across the world market thus realize that not only will the downturn be prolonged but the vacuum in the global leadership created by weakness of US will not be filled up by anyone else very soon. Hence, any crisis and its propagation across borders, big or small, in the future will not be addressed in a coherent manner. Such realisations will show up again in the form of statistics, estimates and figures of key indicators that financial markets routinely churn out. The world market will tumble again.

The write is a Professor of Finance at Nottingham University and can be reached at Sanjay dot Banerji at nottingham dot ac dot uk