Is There A Short Cut For Solving Global Economic Problems?

While the global economic managers are struggling to find a solution to the impending double dip recession, it may be time to have a relook from where the problems began, why they did so and given the long experience that we have got now, what might be the best solution for it.

Since 2007 end, when the subprime crisis first surfaced in the United States, and rapidly spread to all parts of the globe, the governments of the world have been struggling with different measures to control the damage and bring the economy back on track. Unfortunately, every stimulus since

then has proved to be an illusion that only postpones the solution. The moment there are signs of stimulus withdrawal, the crisis reappears. It is like a patient suffering from a severe disease being given a lot of pain killers, where as soon as the effect of medication begins to fade, the pain returns, reminding us that pain killers are not enough. We also need to treat the ailment.

What is the Root Cause of the Economic Problems?

The root cause of 2007-08 crisis lied in the formation of a massive global asset bubble that had been brewing since 2002. It was primarily a result of two events, the combination of which created the asset bubble and the bust of this bubble lead to the global crisis in 2007, from which we are still trying to recover.

The Global Trade Imbalance

The first factor responsible for this global asset bubble was the global trade imbalance that resulted largely from the US trade deficits with China and Oil exporting countries. The large US deficit crossed $ 750 billion in 2007 becoming grossly unsustainable, as were the large surplus of China and its accumulation of unprecedented foreign reserves. Every economist worth his salt would have told you that it was unsustainable, that it was extremely dangerous, that it was going to lead to instability, and yet up to 2007 end, there were no signs of any impending crisis. The global economy was growing in a healthy manner. Inflation was very manageable and dollar held its ground. Developed world continued to prosper, while the emerging states made their presence noticed with extraordinary rates of economic growth, lead by China at the forefront. The US trade deficit ensured a huge consumer surplus there by bringing prices down through cheap imports. Interestingly, a major factor behind these cheap imports was the undervalued Chinese currency that ensured demand for Chinese goods in US, even if it meant that the returns to Chinese enterprises were compromised.

The reason why China allowed its enterprises to lose returns was based on a very simple economic principle. With a huge labor surplus, the opportunity cost of surplus labor for China was close to zero. Maximizing production through its deliberate policy of attracting investment at all terms allowed China to employ its surplus labor and produce at very low costs. The fact that most of the capital in China is controlled by State enterprises allowed the Chinese government to make it happen. The net result was an extraordinary miracle achieved by a combination of monetary, trade and labor policy measures. Its GDP kept scaling new peaks, and its labor also got employment, even if the wages they earned were very low.

Chinese and OPEC Investments Fuelled the Global Asset Bubble

The reason why US trade deficit was not creating problems all this time is due to the second factor that lead to the bubble. The trade surplus of China and Oil exporting countries, mostly at the cost of United States, was largely invested back into US securities. Primarily it was invested in treasuries, but that brought the yields down, and important cascading effects followed. It strengthened the hands of US Federal Reserve in keeping interest rates artificially low, by supporting the dollar. Simultaneously, the low yields led to shifting of capital out from treasuries in to riskier assets like stocks, commodities and housing, leading to asset bubbles therein.

Most important of these bubbles in the United States was the housing bubble, which had been building up since a long time. Typically, real estate bubbles take around a decade and a half to build up. This one was fuelled initially by a liberalization of capital gains tax regime in the late nineties and from 2002 onwards, it was fuelled by a wide margin between the Fed rate and the prevalent market rate for mortgage interest. This gap meant huge profits for the mortgage financiers, and that is what lead to their excessive risk taking in the form of subprime lending through innovative instruments. Shift of capital from more conservative assets and additional demand from subprime lenders aggravated the housing bubble in the United States between 2004 and 2007.

Asset bubbles have a very positive impact on demand. People who believe they have become rich do not mind spending more. People who believe their assets like stocks or real estate have grown in value are ready to consume more on borrowed money. The feel good factor generally boosts the economy as a whole, and that is what happened not only to United Stated, but to the rest of the global economy, which was highly dependent upon the US demand for its growth and survival. As a result, there were

asset bubbles growing all over the globe, though many of them did not get busted in 2007.

The Crisis and the Remedial Global Measures

Once the US housing bubble deflated, the global economy went in to a spiralling crisis, with prices of all assets crashing down. Commodities and equity were the worst sufferers, as these respond most sharply to changing market sentiment. In housing bubble busts, usually the prices do not fall as fast as they do in case of stocks, but in this case, it was different, because a large number of mortgages went in to default, leaving the financing agencies with no other option except panic sale, which sent the housing market crashing in an almost unprecedented way. Soon, the US economy and with it the rest of the world was in turmoil.

As the contagion spread globally, all states came together, and in a remarkable display of solidarity that must be considered one of the greatest achievements of globalization, jointly adopted large scale expansionary policies, both monetary and fiscal, to fight the global recession. Immediately after the crisis, the US trade deficit with China had fallen on a year to year basis, for the first time in over a decade. Thanks to the expansionary stimulus, within a year, it was back to its usual ways. Asset markets including equity, commodities and housing also picked up significantly since then.

The Problems with Stimulus and Expansions

While the global stimulus resolved the problem in the short term and prevented the global economy from worsening further in 2008, it also expanded the burden on future years. Since there are no free lunches, the cost of these packages was to be borne largely by the tax payers in future. Today, it is this very future that stares at us. A retraction of the stimulus would again constrict the economy, while another expansion will only delay the pain, and make the problem more complex.

The expectations of the market created by the moral hazard of government stimuli means that it is fast becoming a vicious cycle of expectations that will cause frequent bubbles and busts in various asset markets.

The Optimum Solution

In such a scenario, the best solution may be to break this moral hazard among asset market investors, who expect the government to dole them out again. It has created a situation, where a QE3 will also lead to a crash, and so will a lack of QE3. Going for QE3 will not only lead to a worsening sentiment in anticipation of deteriorating future, but also sustain this moral hazard.

It may be better to go for an end to the expansionary policies since they are beginning to lose their ability to boost the sentiment anymore. One must understand here that in today’s markets, it is the expectations that govern the market. Once the expectation of QE3 disappears, there will probably be a crash, but its extent may be limited by the expectation of future stability.

There are several other reasons for not opting for QE3. Such expansionary policies also amount to interference in the market process and lead to its failures from distortion of resource allocation. We must remember that market efficiency is all about efficient production and consumption, and not about GDP figures and growth. The sooner we regain market efficiency, the better it will be for the economy, and the best way for doing it is by leaving markets to manage themselves.

It is true that there will be some pain, but such pain may also bring in a lot of impacts that are not possible otherwise. It will bring down the US trade deficit which continues to be the root cause of all ills, putting breaks on the insatiable American thirst for gas and Chinese imports. The dollar may fall with respect to other major currencies and in the process, bring a halt to US consumerism and give a boost to its exports. It may also stimulate further appreciation of Yuan, something that American diplomats have not been able to achieve in the last ten years. There will be raised inflation in the short run that will be widely detested, but the pain may still be worth, as it will lead to fall in wages, rise in profitability and creation of jobs. All in all it will restore the competitiveness of American industry and set right the distortions that plague it today.

The fear that can prevent Governments from taking this path is the lurking possibility of recession. This recession has too components. Correction brought about by market forces and the overcorrection brought about by gloomy expectations, particularly in asset markets. The only solution to that lies in managing expectations by dialogue, projection and reassurance. In simple words, we need to find a better way of managing market expectation than use of expansionary policies, which are about to lose their potency anyway.

Article Written By V Kumar

I am a freelance writer. I write for the passion of writing. Life has blessed me an opportunity to be a witness to many interesting aspects of life and people around the world. Indeed, these are very interesting times and we who live in this era are privileged to experience it. You can find my articles at

Last updated on 12-07-2016 92 0

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