Global Trends by Martin Khor

Monday 5 September 2011

Policy conflicts as major economies weaken

The United States and Europe are both mired in growing economic crises, and caught up as well in policy conflicts on how to get out of the mess.  Meanwhile developing countries should review the evolving situation and prepare better to deal with the effects.

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Last week saw more signs of weakening of the major industrial economies, raising the prospects of global slowdown or recession.

Another problem is that there is also a kind of policy paralysis in these major countries that hinder them from taking the kind of policy measures that helped them and the world recover from recession in 2009.

The world economy is entering a “new danger zone” this autumn, said the World Bank president Robert Zoellick, in Beijing over the weekend. He warned that what Europe faced is a sovereign debt crisis with serious implications for the European monetary union, banks and the competitiveness of some countries.

His own country, the United States, announced there was no growth in jobs in August, a depressing performance that caused the Dow Jones stock market index to fall 253 points or by 2.2% last Friday.

It was the first time in 11 months that there was a standstill in jobs, and contrasted with 85,000 new jobs in July.  Unemployment remained at 9.1% and the White House said this high level is likely to remain in 2012.

Can the US do something to counter this trend?  President Obama will address Congress this Thursday on the jobs situation.  He is expected to announce some measures such as government spending on infrastructure, tax incentives for job creation and an extension of unemployment benefits and payroll tax cuts.

But these are unlikely to be adequate to the task of reviving an economy on the verge of a new recession. Even then, it is uncertain the Republicans will allow him to take the inadequate measures.

The situation has changed drastically since the Obama administration introduced a US$800 billion fiscal stimulus package, implemented over two years, that Congress approved in February 2009. 

This fiscal stimulus is credited by Keynesian economists with a having major role in getting the economy out of recession, and its ending a few months ago is thought to have contributed to the economy’s weakening.

But this line of thinking is now challenged by many Republicans which saw the fiscal expansion as getting the US further into debt.  Since the Republicans won a majority in the House of Representatives last November, they have made cutting government spending and the budget deficit the top priority.

By linking the needed increase in the government debt limit to spending cuts, they forced Obama to shift from a recession-busting to a deficit-busting mode.  

Obama is thus now hampered from taking significant stimulus measures like before.  He will however argue before Congress that job creation and economic revival is now the top priority and that he needs to take short-term job creation policies immediately, even if that means an increase in spending.

The spending cuts and deficit reduction would have to wait till the economy recovers, and even then there must be an increase on taxes on the rich to help reduce the deficit.

This argument makes immense sense to Keynesian economists, but will be resisted by a core of Republican Congress members who will try to tie up the President’s proposals in ideology-laden knots.

Thus, there will be severe limits to the President’s strategy of recession-busting in the short term and deficit-busting in the medium term.

In the United States, the problem is more with policy paralysis due to the conflict in ideologies.  In Europe, the situation is even more complicated and probably deeper, as the region has moved into the zone of sovereign debt crisis, with contagion spreading to more countries in the Euro-zone.

The chosen policy model of getting the worst-affected country out of the mess is not working.  Greece was given two bail-out loan packages, in exchange for taking drastic austerity measures.

But last week, a team of European Union, European Central Bank and IMF officials broke off bail-out talks with the Greek government, indicating that all is not well.

Meanwhile, a Greek state budget office report said that the debt problem is out of control, and that there has been no primary budget surplus despite the stern austerity and privatization policies.  The deficit is in fact increasing, due to the shrinking economy.

Keynesian economists will point out the failure of the bail-out model is to be expected, since big budget cut-backs are bound to squeeze the economy, which in turn will reduce government revenue and increase the deficit.  While the economy spirals down, the debt crisis worsens rather than reduces.

Many analysts concluded a while back that Greece and probably some of the other affected countries need a partial debt write-off.  The sooner this is done the better, as part of a permanent solution to the crisis.

Of course, debt default brings its own problems, and so this measure is being resisted.  It will take place only when nothing else works, and by then the damage will be extensive.

The US and European economies are thus going to be caught in a deteriorating condition as well as in fierce policy conflicts for some time.  As the situation evolves, developing countries will be affected one way or the other, since most of them are still tightly linked to the developed countries.   It is important for them to continuously review the situation and devise their own policies to respond better to this crisis.