Will the lessons from the recession help to prevent another one?

(The write-up below is a review of three articles from The Economist. The three articles are:

1. Briefing: The danger of the bounce, Once again cheap money is driving up asset prices, January 9^th 2010

2. Curb your enthusiasm, A welcome recovery-but an uneven one, with dangers both for sluggish Europe and bubbly economics, 24^th April 2010

3. Unemployment benefits, A titanic struggle to decide whether the jobless should get the money for longer, July 22^nd 2010)

The global recession that engulfed almost the entire world is over now. The world economy is on a recovery path. But is the recovery sustainable? An unsustainable recovery will lead the globe to another burst. The recession essentially provides a scope to learn new lessons. But whether the lessons are being incorporated in policy decisions needs to be analyzed. This review is an attempt to connect three distinct articles of the Economist to focus on the drivers of current recovery, its distinct patterns and the direction this recovery heading to.

The article “The danger of the bounce” provides empirical evidence that the cost of borrowing money has fallen in the US in last three decades. As a result the firms and the consumers have been borrowing the cheaply available money. Understanding of FMGD reveals that firms employ this money to generate more income for future cycles. Hence, they employ this money on opportunities where they expect a positive return on investment. In absence of suitable investible opportunities firms as well as rich individuals start buying newer assets in financial markets to increase their profit. This leads to increase in asset demand and price. This increase is demand and price is because of the availability of cheap money exaggerated by the inherent design of the stock markets and do not reflect the true economy. Eventually the investors withdraw money from assets to pay off the debts. Suddenly there comes a credit crunch in the market. The market bursts.

Central banks have deliberately kept the interest rates low during this recovery. They aim to increase consumer spending by providing money at lower rates. Consumer spending power is essential in a private enterprise based market economy (PEBME) to ease resilient constraint. However, low interest rates don’t ensure easing out of resilient constraint. First, though the cheap money may provide purchasing power to the consumer, it also increases the pumping of money for the firms and puts pressure on firms to generate higher profit out of the cheap money available. Second, the possibility of hoarding of the cheap money can’t be ruled out. Third, the borrowed money eventually has to be paid off. Hence, too much reliance on low interest rate to fight out the issue is not tenable. Had it been the problem of lack of money, it would have worked. But the problem here is imprudent application of the surplus money. In the problem of surplus of money, low interest rate to pump more money is like paving the way for another bubble. The Economist believes that there is a need to raise the interest rates. However, the authorities concerned with the fragility of recovery are unlike to do so. As a result the low interest rate triggered cheap money will keep pumping into the market. The problem of surplus and pressure of higher profit will force the companies as well as rich individuals to invest in risky assets.

The article tries to fit the current market situation to the model of market madness proposed by Hyman Minsky. As per the model bubbles occur through some distinct stages. It starts with a shock in financial system because of new assets like new technology, internet etc. which attracts the faith of investors. The second stage is characterized by growth of credit that inflates the bubble. Investors borrow money to fiancé their assets. In the next stage, investors move away from the fundamentals. Assets are bought because the price has been growing. In the process the financial economy gets disjuncted with the real economy. Eventually due to excessive high price the asset runs out of new buyers. Price slumps.

Due to the low interest rates, the economies of developed nations (PEBMEs) are witnessing a shock to financial system as the investments in riskier assets are growing. The low interest rate is encouraging investors to take their money out of cash to risky assets. At the same time the small businesses in PEBMEs are facing difficulties to find bank loans. It is crucial to realize that the small businesses are employment generators. Despite the low interest unavailability of money for small business indicates lack of growth in employment.

To drive the point further the Economist reveals that the Wall Street is offering a dividend yield lower than the long term average. This indicates that firms in their relentless pursuit of higher profits are not distributing the profit adequately. This distribution in turn could have increased the consumption power. Hence, the chances of resilient constraint to choke the system are going up.

After dealing with the recovery of the PEBMEs, the article shifts its focus to emerging economies. Emerging economies are more plausible candidates for bubble status. The emerging economies survived the crisis better than the PEBMEs. These economies enjoy two advantages over the PEBMEs: first, higher potential rates of growth; second, stronger fiscal positions. But the credit growth in emerging market, increasing investment by westerner investors of PEBMEs in financial market of emerging economies increase the chances of bubbles in emerging economies. The pegging of currency in such economies ties them with the economies of PEBMEs. But what is right in the PEBME context may not be right for emerging economies. The article here may be referring to inherent difference in the two economies like state of charging, extent of capitalism, nature FDI, export orientation etc. Due these difference the right action for PEBMEs can’t be followed blindly in emerging economies.

The article unequivocally opines that due the surplus of credit and western investments in financial markets the emerging economies will develop bubbles as long as a combination of low interest rates and pegged currencies continue. But the bigger question unaddressed by the article is whether the emerging economies can come out this combination. The excessive foreign reserve of the emerging economies indicates that they are aware of their vulnerability. They intend to interfere in the foreign exchange market to keep the pegged exchange rate pegged to avoid adverse effect on export. Despite better growths they will not allow their currency to appreciate. As a result they are trapped in a non-charging loop. There is no sign of coming out of this loop in near future. This combined with the article’s stand indicates that emerging economies will continue to develop bubbles time and again.

The logic discussed in the previous article “The danger of the bounce” is taken further by another article of the Economist - “Curb your enthusiasm”. The article deals with the justified and not so justified aspects of the optimisms of the current recovery. It brings in new dimensions like difference in recovery path of the PEBMEs and the emerging economies, possible measures to tackle the budding bubble.

The healthier financial market is facilitating the recovery. Consumer spending is getting propped up due to the rising asset prices. IMF’s reduction of the banks’ total estimated loss due from the crisis by $500b indicated the justification of the enthusiasm associated with the recovery.

The article details the unequal sharing of the good fortune. Emerging economies which were least affected by the recession are demonstrating a faster recovery. The worst-hit PEBMEs have a sluggish rate of recovery. In case of the emerging economies the fast recovery is not just because of the low impact of the recession. The effective use of the fiscal and monetary policies in emerging economies paved the way for fast recovery. The article reasons structure of bank dependence, economic flexibility and effectiveness of policy stimulus as for such differences. The same reasons also hold for slow recovery in Europe than America. Productivity has increased in the US and slumped in Europe. This could be because of the difference in flexibility in the US caused by the structure of finance. Europe is more bank-driven. Banks lack flexibility and are conservative in nature. The US is more stock-market driven. Stock market has the ability to speculate and respond quickly to the future of economy where as banks are more conservative by nature. In comparison to Europe, America enjoyed better fiscal latitudes due to dollars currency reserve status.

The gap between the growth rate of the PEBMEs and emerging economies will definitely hamper the future growth of emerging economies.

The article is positive with the capability of the economies, both PEBMEs and emerging ones to deal the unstable, unsynchronized recovery rate of the globe. The PEBMEs could aim at deficit reduction, tax reforms, and freer job markets. The emerging economies could aim at control on foreign inflow, flexible exchange rates etc.

But the practical implementations of the measures suggested by the articles are questionable. The PEBMEs could reduce their fiscal deficit by increasing the tax rates. However, from the patterns of decision making of the US reveals that the economy has deliberately reduced tax from 1970s and has increased debt since then. Reduction of tax has provided greater surplus with the firms and rich section. In the charged stage, in lack of suitable investible option this money has always gone to the financial market upto such an extent that the financial market disjuncts from the real economy leading to crash. The boom-slump cycle caused by tax reduction in the US indicates its orientation to force the market for a controlled crashing. It is not expected that US in short run will change its orientation and increase the tax rate.

The third article “Unemployment benefits” provides insights on how America instead of moving its charged economy to an ever more maturely charged economy, steering it to an economy with controlled recession.

Recession in the US is over, but unemployment figures have not improved. Millions of unemployed are losing employment benefits. In some cases Congress has been able to extend the unemployment benefits. But the long-term help for unemployed workers is still an issue. The article mentions two reasons proposed by the Republicans against the benefits: lack of affordability and benefits act as an incentive to stay out of work. It is notable that unless the consumption power of population increases the US will find it difficult to recover from indebtedness. FMGD suggests that the Republican arguments that unemployment benefits act as an incentive not to work is not tenable. The example of benefits provided by Denmark to the unemployed section to make the nation ever more maturely charged state worked in favour of both the public and the firms. The Economist also suggests in line with FMGD citing one recent study at San Francisco Federal Reserve Bank that confirmed that long-term benefits do not keep unemployment high. America is not moving towards the ever more maturely charged state may be because it knows such a move will be sustainable only if entire world follows similar mechanism.

Lack of job creation despite the recovery could create structural unemployment. However, America’s labour market policies are not addressing the issue. America has the option to tax the corporates and rich section to extend the benefits of the recovery to the poor section. America is not willing to take this decision to increase tax rate and moving the economy to the ever more matured state. On one hand firms and the wealthy people have excess of money, on the other, unemployment is killing the consumtion power of millions of Americans.

The article suggest job search and matching assistance would typically be the quickest way to handle unemployment. Retraining worker with obsolete skills can be effective in long-term. The problem has no quick fix solution. But the failure to deal the problem of unemployment would have long-term repercussions. The frustrated unemployed section of the so called developed USA may chose paths that may cause social unrest. The cost of keeping its own citizens underprivileged might prove costly to the US.

From the review of the three articles of the Economist, it is evident that the lessons from the recession are not being considered to prevent a future recession. Rather the cheap money and unsustainable recovery is leading towards another recession. The pattern of recovery provides good base to conjecture the coming recession. The PEBMEs despite being aware of this future are not taking measures to avoid it. The recovery path has actually turned into the path of another recession.