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Unwarranted optimism by Jayati Ghosh

Without policy efforts to deal specifically with issues such as reduced incomes and unemployment, the global economic crisis will be far from over.

FOR most economic commentators, 2010 begins on an optimistic note. Just a year ago, there was much gloom about the world economy. The worst financial crisis since the Great Depression had broken out in full fury; asset markets in the United States, Europe and then most developing and emerging markets had crashed and were exhibiting extreme volatility; world trade collapsed; volatile capital flows made things much worse even for developing countries, which had been fiscally and externally “disciplined”, as they were affected by a crisis that was not of their creation.

Compared with that bleak scenario, the current situation seems to be a sea change. Developing countries (particularly those in Asia) were the first to come out of the crisis; indeed, many of them had experienced a deceleration of still positive growth rather than negative growth. The U.S., the United Kingdom and the Euro Area have all been recently declared to be out of recession, as income has recovered, especially from the second quarter of 2009. Stock markets are upbeat once again, and lending has resumed to some developing countries (though not all). There is renewed optimism that the world economy will grow again in 2010 with especially rapid recovery in the developing world.

Much of this is related to the apparently uncoordinated but nonetheless synchronised recovery packages that were introduced in the wake of the crisis. Across the world, governments – even the ones like Germany which openly disdain the so-called Keynesian policies – responded not only with huge bailouts of troubled financial institutions but also with large fiscal stimulus packages that were effective in staving off depression, at least in the short term.

Is the optimism warranted? Is the global economy out of the woods and can we now proceed with business as usual after this somewhat unfortunate blip? This seems to be the response of most commentators, not only in India but everywhere.

Unfortunately, such a conclusion would be premature at best, and in all probability absolutely wrong. Certainly output growth in the world economy is recovering after the extreme lows a year ago. But there are two sets of reasons for this not to continue. On a more structural level, the basic imbalances that caused the most recent crisis of international capitalism have still not been resolved: the imbalance between finance and the real economy; the macroeconomic imbalances between major players in the international economy; and the ecological imbalance that will necessarily become a constraint on future growth because of not only climate change but also other environmental problems and the demand for energy.

These structural features are in turn reflected in a number of more conjunctural issues that characterise the current situation. These imply that the only complete reliable prediction for the immediate future is uncertainty and continued volatility.

First, the problems in finance remain just below the surface. They have not been adequately addressed or dealt with, and are therefore likely to strike again quite soon. This is partly because the underlying problem of stagnating real estate markets continues to fester in the U.S. and in other major countries, and will sooner or later once again become a problem for financial institutions that are implicated in them. The near-default of Dubai World was just one example of the problems that continue to fester in the real estate sector. Meanwhile, sovereign debt issues have emerged as the next new thing to worry about for financial markets, and as the examples of Greece and Ireland indicate, these concerns are no longer confined to developing countries in the global periphery.

But financial problems may even have increased because the crisis response has been faulty. Enormous financial bailouts may have saved the economies from collapse but they created disincentives for “efficient” behaviour in financial markets in the form of moral hazard that is greater than ever before. Banks that were “too big to fail” have become “too bigger to fail”, and incentives are still skewed towards excessive and unsustainable risk-taking. Appropriate regulation to control the incentives and activities of various financial players – banks, hedge funds, private equity firms, index traders and so on – has still not been enacted.

Food and oil prices

So the problems in finance are far from over, and are likely to return with even greater ferocity in the foreseeable future. Second, this has direct implications for some global markets for food and fuel that directly affect people’s lives. It is now an open secret that the huge price volatility in food and oil prices, which has created so much havoc, especially in the developing world, was significantly related to the involvement of financial players in such markets. This was particularly so because futures contracts allowed the emergence of “index investors” who simply betted on changing prices and thus drove up prices far beyond any real changes in demand and supply.

Such forces are on the prowl once again, and there has been no regulation of commodity futures markets. As the economic recovery gains ground, it is more than likely that commodity prices will once again rise, overshooting any real demand-supply imbalances. Many people in developing countries are still reeling under the impact of rising food prices, and if their global prices rise once again, the effect on real incomes, hunger and undernutrition is likely to be devastating.

Third, the response in many countries, notwithstanding the large fiscal packages that have been implemented in some countries, has generally been to somehow stimulate another bubble. This is even true of developing countries such as China and India, where the recovery has been based on providing fiscal incentives to particular sectors like automobiles and other consumer durables and encouraging another housing market bubble through the provision of easy housing finance. Bubbles, as we now know, eventually burst.

Fourth, the unwinding of global macroeconomic balances – which must necessarily occur – means that the U.S. cannot continue to be the engine of growth for the world economy. So other countries must find other sources of growth, in domestic demand (which should ideally be through wage-led growth) or by diversifying exports. There is some evidence that this is occurring, but thus far this is nowhere near the extent required. Stimulating more bubbles in non-tradeable sectors like real estate and stock markets in the hope that this will once again generate more real economic growth is not a sustainable alternative to this, yet this is the direction that most policy measures have taken.

Without significant restructuring of global demand in favour of the large segments of the world’s population that still has to meet basic needs, world growth will not just be more unequal: it will simply run out of steam.

Fifth, unfortunately, such reorientation of economic growth in the world economy has been made more difficult by the pro-cyclicality of adjustment measures being imposed on developing and transition economies that have been hit hardest by the crisis. Despite all the pious talk to the contrary, the International Monetary Fund is still imposing stringent pro-cyclical conditionality on countries that seek emergency assistance, and others are being forced into deflationary measures by the combination of falling exports and capital flow reversals. This reduces current and future growth potential in these economies.

Sixth, the real economy impact of the crisis has mostly been felt in employment, and this is where the effects of the crisis are still widespread and serious. Of course, it is well known that over the standard business cycle, employment tends to recover more slowly and less sharply than unemployment. To that extent, the delayed recovery of employment would seem to be only normal and not cause for excessive concern.

But this current crisis has followed a boom in which, despite rapid increases in economic activity, employment – especially in the formal sector – had simply not kept pace. So labour markets across the world were increasingly characterised by more casual non-formal contracts and the growth of precarious forms of self-employment rather than “decent work”. In other words, the boom did not generate enough productive employment, yet the crisis has already had severe effects in reducing even those inadequate levels of employment across the world.

Despite some recent indicators of recovery in total employment, paid employment in non-agricultural activities has continued to plummet over the course of the past year. So the apparent recovery of employment in developing countries is likely to have been largely in self-employment in various forms, which reflects the lack of social security and unemployment protection in most developing countries.

Where there is no real social option to continue in open unemployment, underemployment expressed in self-employed activities is much more likely to be the norm. So the most significant aspects of the crisis for most people in the world – the worsening of labour market conditions, greater risk of unemployment and reduced incomes from employment – still remain as strong as ever.

Without serious policy efforts to deal specifically with these pressing issues and address other structural aspects such as those concerning the relationship between economic growth and nature, this global crisis will be far from over.

But these policy efforts imply significant changes in economic trajectories, which means a very different political landscape in which the voices of ordinary people around the world are heard louder than those of financial interests and corporate industry lobbies. It remains to be seen whether 2010 will deliver such much-needed change.