THE BEAR'S LAIR Drowning in the soup of recovery
By Martin Hutchinson
The alphabet soup of possible shapes for this recession is now clarifying
somewhat. The recent strength in several US and global indicators, before
fiscal stimulus has had time to kick in, indicates that the panic among
governments after September's financial crisis was overblown. Indeed, the
strength in economic indicators, combined with the global stock market rise and
the impending kick-in of "stimulus," suggests that the initial trough may be
short-lived, with apparent recovery swift and robust.
Unfortunately, the imbalances produced by panicky fiscal policy and in some
countries monetary policy are considerably larger than the original imbalances
that led to recession, so the recovery will be short-lived. A year from now, we
will probably be diving into
a second global "dip" of recession that may well be deeper than the first, and
is certainly likely to be much more prolonged.
There are some countries for which this is not true; those which, for one
reason or another, did not adopt the prevalent global pattern of monetary
laxity and fiscal hysteria. Poland, for example, was always likely to get in
trouble from this recession, because it ran a balance of payments deficit, and
over 5% of its gross domestic product (GDP) came in through foreign direct
investment, which has dropped sharply. However, instead of engaging in massive
stimulus, Poland allowed the zloty to depreciate by about 30% against the euro
since July 2008, while its M3 money supply, up 17% in zloty terms, declined in
euro terms by over 10%.
Poland also benefited from two other favorable factors: its economic structure
is relatively free-market and its government relatively small, spending only
25% of GDP. Consequently, Poland's exports have held up well in zloty terms,
while its balance of payments is improving rapidly and it appears likely to
avoid outright recession. Once global economic recovery arrives, Poland will
have no imbalances to correct and so should return quite quickly to its
trajectory of around 4% to 5% annual growth.
Because of its large international debts, Brazil has since 2002 run a fairly
tight fiscal policy and an extremely tight monetary policy, with short-term
interest rates of 13.5% going into this recession, against domestic inflation
around 6%. Brazil shares with Poland the benefit of a relatively small
government, but its economic structure is bedeviled by inefficiencies put in
place by past governments, particularly the dead weight of the public sector,
irremovable by the 1988 constitution.
Like Poland, it did not have the option of vigorous fiscal and monetary
stimulus, which would have caused the Brazilian real to collapse and produced a
debt default. Instead, the real has declined by about 27% against the dollar,
while domestic interest rates have remained in double digits, allowing only
modest domestic reflation. Consequently, Brazil is projected by the Economist
to suffer only a 1.5% decline in GDP in 2009, with 2.7% growth in 2010 - a
forecast that may well be too pessimistic.
South Korea, also, has been affected by the Western banking system collapse and
by the sharp fall in Asian exports. However, through allowing the Korean won to
decline by 23% against the dollar, it has limited the decline in its exports
and caused its balance of payments to swing into sharp surplus. Like Poland and
Brazil, Korea has implemented only limited stimulus; the Economist forecasts a
budget deficit of only 3.5% of GDP in 2009. Unlike its view of Poland and
Brazil, the Economist forecast a sharp recession for Korea, with GDP declining
more than 5% in 2009. Given Korea's relatively small public sector and open
economy, that looks much too pessimistic. In any case, also like Poland and
Brazil, there will be no reason for Korea's economic recovery to be delayed
once its economy has bottomed out.
All three of these countries have survived the downturn through what in the
1930s were called "beggar my neighbor" devaluations, the policy followed by
1930s Britain under Neville Chamberlain to great success. By definition, not
all countries can follow such policies, and indeed even these three moderately
substantial countries - by following these policies - have made the position of
their neighbors more difficult.
For most other poor and middle-income countries, the constraints against
uncontrolled monetary and fiscal stimulus are strong because of the danger of
financial collapse due to their fragile credit positions.
In the context, the expansion of International Monetary Fund (IMF) lending
facilities, if it takes place, will be thoroughly unhelpful. In IMF-favored
cases, such as Mexico, unconditional IMF facilities will allow the countries to
purse more expansionary fiscal policies than would otherwise be possible (this
danger also exists in Poland, but the Polish government is pretty sensible).
In other cases, the prospect of IMF conditionality is so unpleasant that
countries such as Indonesia will seek to avoid it at all costs. Thus, most IMF
help will go to such countries as Pakistan, Ukraine, Hungary and Latvia where
past profligacy has been so great that no non-IMF solution is possible. In
other words, as has been the case for so much of recent stimulus programs, the
extra IMF aid will go predominantly to the least-productive countries.
In the rich world, the Polish solution has not been tried, as memories of the
1930s make competitive devaluation unacceptable even if, in a closed planet, it
were possible. Instead, most governments, with the partial exception of Germany
and France, have indulged in expansionary fiscal policies, many of them running
budget deficits up to unprecedented (in peacetime) levels of around 10% of GDP.
In monetary policy, there is a difference between the US and Britain, which
have both been highly expansionary to counteract the effect of their banking
collapses, and the eurozone and Japan, which have cut interest rates but
maintained monetary growth at moderate rates - 7% in euro M3 in the 12 months
to February 2009, for example.
It now seems likely that the next few quarters will see an economic bounce. The
rate of decline of economic indicators has slowed sharply in almost all
countries. Confidence indicators such as the University of Michigan sentiment
indicator have ticked up, albeit from very low levels. The worrying collapse in
Asian trade has turned around, showing itself to have been a largely a matter
of inventory correction in the supply pipeline to the US consumer. In countries
such as Britain and the United States, where monetary policy has been
exceptionally expansive, this expansion has doubtless played a part also - and
even in the EU and Japan, monetary policy has been far from contractionary.
Now the fiscal stimuli are about to kick in - in the US, for example, the
modest Obama tax cuts are appearing in April pay packets. While the economy is
so far below full capacity, these stimuli will have the expected Keynesian
effect in boosting demand further. If you asked me to guess, I would expect
that the third and probably fourth quarters of 2009 would show quite robust
global growth.
Then what? In only a few countries, like Poland, Brazil and Korea, one could in
isolation expect growth to continue, producing a normal-strength business-cycle
upswing. China and India are both special cases.
In China, infrastructure investment should also produce an upswing, but with
the caveat that the problems in the Chinese banking system have not gone away
and may be getting worse - thus the future trajectory is more or less
unknowable. In India, the fiscal deficit is so large, and the prospects for
reform if a Congress-led government wins the current election so poor, that,
absent an unexpected BJP triumph, it seems likely that growth even if it
resumes will be sluggish and interrupted over the medium term.
In the rich West, there will be two factors tending to impede growth. In some
countries, such as the US and Britain, rapidly rising inflation will pose the
authorities with a problem they will need to deal with urgently. In most other
countries (but only marginally in France and Germany), large fiscal deficits
will produce a "crowding out" effect by which private investment is stunted by
the excessive demands on credit from the public sector deficit. Both these
imbalances will be larger than previous imbalances that the recession has
corrected, notably the US payments and savings deficits, which were 6% and 8%
of GDP, respectively, compared to the 2009 budget deficit's 12% of GDP.
Countries with both large budget deficits and inflation will pay a pretty
obvious price: higher interest rates, which will impose costs across the
economy. Federal Reserve chairman Ben Bernanke's claim that the Fed will remove
liquidity when it needs to is pure hogwash.
The Fed will be slow in reacting, as it almost always has been with inflation,
because it will be politically much easier to deny that inflation has become a
problem. Hence, inflation will get a major hold on the economy, and the
combination of inflation and excessive budget deficits (which were not a
problem in 1979-82 - the federal budget deficit peaked at 6.6% of GDP in 1983,
after inflation had been broken) will prove exceptionally intractable.
The recession will not be W-shaped because there will not for several years be
a final upward swing from the W. Instead, after a sharp middle upswing, which
is now beginning, the US economy will relapse into inflationary stagnation, the
right-hand side of the W becoming an L or even declining further.
In countries without inflation, such as Japan, India and the Eurozone countries
with excessive budget deficits, there will be no inflationary signal of
trouble. Instead, the recovery will much be weaker than in the US and the UK
because it will lack the exceptional monetary stimulus and will be retarded by
excessive public sector deficits. The pattern will be that of Japan in the late
1990s, with the bottoming-out process exceptionally prolonged - a very sluggish
U-shaped recession. In these countries, particularly in Japan, Bernanke's
favorite demon of deflation, prolonged price declines, is also possible. The
correct solution will be a combination of moderate monetary laxity and severe
fiscal tightness, similar to Poland's current policy, which will both remove
government's drag on the economy and allow prices to resume a gentle rise.
The reversal of recovery in the inflationary countries and the lack of recovery
in the deflationary ones will make economic recovery in even the paragons of
Poland, Brazil and Korea sluggish because of the lack of buoyancy in their
export markets. Nevertheless, over the next five years, I'd rather be Polish,
Brazilian or Korean than Japanese, Indian or Anglo-American.
As in 1929-41, government bungling has in most countries made the recessionary
experience much more unpleasant and prolonged than it needed to be. Governments
never learn.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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