The Great Stabilization

Opinion

Hey there, time traveller!
This article was published 19/12/2009 (5774 days ago), so information in it may no longer be current.

It has become known as the “Great Recession,” the year in which the global economy suffered its deepest slump since Second World War. But an equally apt name would be the “Great Stabilization.” For 2009 was extraordinary not just for how output fell, but for how a catastrophe was averted.

Twelve months ago, the panic sown by the bankruptcy of Lehman Brothers had pushed financial markets close to collapse. Global economic activity, from industrial production to foreign trade, was falling faster than in the early 1930s. This time, though, the decline was stemmed within months. Big emerging economies accelerated first and fastest. China’s output, which stalled but never fell, was growing by an annualized rate of some 17 per cent in the second quarter. By mid-year the world’s big, rich economies (with the exception of Britain and Spain) had started to expand again. Only a few laggards, such as Latvia and Ireland, are now likely still to be in recession.

There has been a lot of collateral damage. Average unemployment across the Organization for Economic Cooperation and Development is almost nine per cent. In the United States, where the recession began much earlier, the jobless rate has doubled to 10 per cent. In some places years of progress in poverty reduction have been undone as the poorest have been hit by the double whammy of weak economies and still-high food prices. But thanks to the resilience of big, populous economies such as China, India and Indonesia, the emerging world overall fared no worse in this downturn than in the 1991 recession. For many people on the planet, the Great Recession was not all that great.

That outcome was not inevitable. It was the result of the biggest, broadest and fastest government response in history. Teetering banks were wrapped in a multi-trillion-dollar cocoon of public cash and guarantees. Central banks slashed interest rates; the big ones dramatically expanded their balance sheets. Governments worldwide embraced fiscal stimulus with gusto. This extraordinary activism helped to stem panic, prop up the financial system and counter the collapse in private demand. Despite claims to the contrary, the Great Recession could have been a Depression without it.

So much for the good news. The bad news is that today’s stability, however welcome, is worryingly fragile, both because global demand is still dependent on government support and because public largesse has papered over old problems while creating new sources of volatility. Property prices are still falling in more places than they are rising, and, as this week’s nationalization of Austria’s Hypo Group shows, banking stresses still persist. Apparent signs of success, such as American megabanks repaying public capital early, make it easy to forget that the recovery still depends on government support.

Strip out the temporary effects of firms’ restocking, and much of the rebound in global demand is thanks to the public purse, from the officially induced investment surge in China to stimulus-prompted spending in the U.S. That is revving recovery in big emerging economies, while only staving off a relapse into recession in much of the rich world.

This divergence will persist. Demand in the rich world will remain weak, especially in countries with over-indebted households and broken banking systems. For all the talk of de-leveraging, U.S. households’ debt, relative to their income, is only slightly below its peak and some 30 per cent above its level a decade ago. British and Spanish households have adjusted even less, so the odds of prolonged weakness in private spending are even greater.

And as their public debt burden rises, rich-world governments will find it increasingly difficult to borrow even more to compensate. The contrast with better-run emerging economies will sharpen. Investors are already worried about Greece defaulting, but other members of the Euro zone are also at risk. Even Britain and the U.S. could face sharply higher borrowing costs.

Big emerging economies face the opposite problem: the shadow of asset bubbles and other distortions as governments choose, or are forced, to keep financial conditions too loose for too long. China is a worry, thanks to the scale and composition of its stimulus. Liquidity is alarmingly abundant and the government’s refusal to allow the yuan to appreciate is hampering the economy’s shift toward consumption. But loose monetary policy in the rich world makes it hard for emerging economies to tighten even if they want to, since that would suck in even more speculative foreign capital.

Whether the world economy moves smoothly from the Great Stabilization to a sustainable recovery depends on how well these divergent challenges are met. Some of the remedies are obvious. A stronger yuan would accelerate the rebalancing of China’s economy while reducing the pressure on other emerging markets. Credible plans for medium-term fiscal cuts would reduce the risk of rising long-term interest rates in the rich world. But there are genuine trade-offs. Fiscal tightening now could kill the rich world’s recovery. And the monetary stance that makes sense for the U.S.’s domestic economy will add to the problems facing the emerging world.

That is why policy makers face huge technical difficulties in getting the exit strategies right. Worse, they must do so against a darkening political backdrop. As Britain’s tax on bank bonuses shows, fiscal policy in the rich world risks being driven by rising public fury at bankers and bailouts. In the U.S., the independence of the Federal Reserve is under threat from Congress. And the politics of high unemployment means trade spats are becoming a bigger risk, especially with China.