Global Trends by Martin Khor

Monday 7 July 2008

Gloomy times ahead for world economy

In recent weeks inflation has worsened, complicating the already difficult problems caused by financial turmoil, the onset of recession and the decline in stock markets.  The world economy and developing countries are in for a bumpy ride.

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Those who had harboured some hopes that the global financial crisis is over and that the world economy would suffer a mere hiccup had these hopes dashed last week.

The news is bad.  The financial problems besetting banks and investment institutions are still expressing themselves with no end in sight.

Added to this is a decline of stock markets to official “bear” status.   The real economy of jobs and growth is being hit harder. 

And on top of all these is the rise of inflation, spurred by the oil price which has hit a high of US$145 per barrel, and the onward march of food prices.

The inflation factor affects ordinary people more widely than anything else. Only the rich and middle classes can afford to invest in shares.  But rising prices of food, petrol and bus fares hit everyone, especially the poorer people since they spend more of their income than the well-to-do.

Inflation is also most inconvenient to policy makers.  Inflation deprives them of the ability to use their most powerful weapon (changes in interest rates) to counter the other two problems -- recession and financial market chaos.

Until recently, American central bankers were lowering interest rates in many steps to boost the economy.  Lower interest rates make it cheaper for borrowers to service their loans, for consumers to buy things and for companies to invest.

Each time the interest rate was cut by the U.S. Federal Reserve, this would be treated as good news, and the stock market in the US and elsewhere would rise, at least for a few days, before more bad news about a bank in trouble or more job losses led to more market decline.

But the lowering of interest rates also had adverse effects.  It had fuelled the credit boom and the asset price bubbles (in houses and equities) that had been a major part of the build up to the crisis.

It also helped spur on speculators in search of higher yield to find more lucrative profits in the oil and commodity markets, which in turn contributed to the recent fast rise in oil and food prices.

Now, with interest rates already so low, there is only a little more of lowering that the US Fed Reserve can do.

But even that may not be possible.  This is because inflation is once again taking over as a priority problem. The usual way to fight inflation is to raise the interest rate.

Last Thursday, the European Central Bank raised the main interest rate by 0.25% to 4.25%, the highest level in seven years.  This was a few days after data showed European inflation had hit 4 per cent, the highest since the euro was launched in 1999.

Up to a few weeks ago, there was expectation that as recession deepens, governments would counter this by reducing interest rates.  Now they are discouraged from doing this because of inflation.  And instead we can expect interest rates to go up to keep in step with the rising prices.

This puts policy makers in a bind, because a rise in interest rates is about the worst thing that can happen during a recession, as it dampens consumer spending and makes it more costly to repay loans and finance new investments, thus adding to the gloom.

The recession is biting and will bite even more.  Last week’s news included the loss of another 62,000 jobs in the U.S. in June, with wages stagnating.  Britain’s economy is also sinking, with the price of houses falling for 8 months (in June, to 6% below a year ago on average), and the big retail chain Marks & Spencer announcing a sharp drop in sales.

The series of bad news hit the stock markets last week.  The U.S. had its worst month in June since 2002 and the stock indices had fallen by more than 20% off its peak, thus meeting the definition of a “bear market.” 

On Friday, “UK and equities shuddered to their lowest levels since 2005, a bleak end to a torrid week as record oil prices fuelled inflation fears and sent investors fleeing to safety,” in the colorful words of the Financial Times.

The effects on developing countries have become serious.  The value of stock markets in emerging markets fell by 10% in June, contributing most to a US$3 trillion decline in the value of global stock markets in that month.

Last week, stock prices in developing countries fell for the fourth week in a row.  By last Friday, stock market indices had fallen by 6.3% in South Korea, 4% in Thailand and 3.2% in Pakistan.  Malaysia also saw a downturn, as well as a day of non-trading due to a computer glitch.

It was also reported that a quarter of countries in the world now have double-digit inflation, all of them developing countries.

With all the negative news, it is easy to conclude that the woes that began with the sub-prime mortgage crisis in the United States is far from over. 

Instead, the problems have migrated from the finance and housing sectors to other areas (such as retail business) while inflation is now rivaling recession.

It is the most complex and difficult economic crisis the world has seen in decades, and possibly since the Great Depression, according to a growing number of well known analysts.