Dated: January 28, 2009
Governments across the globe are using Keynesian stimuli to revive drooping
economies. Even George Bush has presided over the greatest stimuli in US history,
with a projected fiscal deficit of $ 1.2 trillion and monetary injection of
almost $ 2 trillion by the Fed.
But is the recession Keynesian? Trillions of dollars of stimuli have failed
to end the downswing. Keynesians argue that even trillions are not enough. Really?
The current recession looks more Hayekian than Keynesian. A Keynesian recession
represents a sudden fall in demand, and can be remedied within six months by
pumping enough purchasing power into the economy. A Hayekian recession, however,
is caused by misallocation of resources over a long period, driven by unrealistic
interest rates, ending in a bust that requires years of structural adjustment.
Such a recession can last a decade (as in Japan in the 1990s).
The many recessions between World War II and the oil shock of 1973 proved amenable
to Keynesian remedies. But 1973-80 witnessed a Hayekian recession, caused by
excess pumping of money into economies in an attempt to stimulate them. Rising
trade union demands meant that the stimuli translated into higher wages and
inflation, not higher production. After this era of stagflation, economists
could hardly utterly the word “Keynesian” without a snigger—it
had become a joke.
However, the recessions of 1991 and 2001 were mild affairs remediable by Keynesian
stimuli. Keynes was back in fashion. So, when the subprime mortgage crisis hit
the US in 2007, it responded with Keynesian nostrums. But to no avail.
Politicians want to be seen as quick and effective. They love Keynesianism,
which puts them in the driver’s seat, allowing them to portray recessions
as caused by greedy business villains, and paint themselves as rescuers.
But Hayekian recessions occur when politicians themselves distort the economy
for years, creating misallocations of resources that ultimately prove unsustainable.
The consequent bust cannot be ended by pumping in more money. Rather, the entire
economic structure must change to correct the historical misallocations, and
make future growth sustainable. This involves wrenching changes in individual,
corporate and political behaviour. Neither the public nor politicians are quick
to acknowledge a Hayekian recession. They would rather hope it is Keynesian,
remediable by pumping in more money. Yet at some point somebody will surely
declare that Emperor Keynes has no clothes.
The current recession is deeply structural. For a decade, the US has run the
biggest trade deficits in history, matched by corresponding trade surpluses
of China, OPEC, and other Asian countries. After the financial crisis of 1997-99,
many Asian countries swore to build large forex reserves to avoid another debacle.
So they deliberately undervalued their exchange rates, ran large current account
surpluses, and so generated large forex reserves. This had to be mirrored in
correspondingly large current account deficits in some other countries. The
biggest turned out to be the US.
This defied conventional economic logic. Normally, rich countries run trade
surpluses, and send their excess savings to poor countries with scarce capital
that are running trade deficits. This normality was turned on its head by Asian
countries determined to build large forex reserves after the trauma of 1997-99.
These forex reserves went mainly into US gilts.
Suddenly the world was flooded with money. The US trade deficit sent a flood
of dollars into Asia and OPEC, which then flooded back into US financial markets,
mainly through forex reserves. Bernanke called this the Asian savings glut.
The flood of dollars drove down long-term interest rates, especially in the
US, and drove up asset prices. It became highly profitable for Americans to
borrow cheaply to invest in houses, stocks and commodities. Even when the Fed
raised short-term interest rates in 2006, long-term rates remained low because
of the flood of money from Asia. Innovations in the US financial system, some
productive and some mere con-games, encouraged leverage by everybody—individuals,
corporations, banks, speculators. This was classical Hayekian misallocation.
This misallocation yielded mouth-watering short-term gains. It proved a huge
stimulus for the global economy, which grew at its fastest rate in history in
2003-08. Record US trade deficits sucked in record imports of manufactures from
Asia and oil from OPEC. Asia in turn bought record quantities of commodities
from Africa and Latin America to be converted into manufactures for export.
Thus the whole world economy boomed as never before, and so did asset prices.
Yet the boom was patently unsustainable. American households, who historically
saved 6% of disposable income, started saving nothing at all, and dipped into
their wealth to spend as never before. Today, this seems terribly irresponsible.
Yet the boom had hugely increased the wealth of Americans, and it was logical
for them to spend part of this wealth. The spending spree was subsidized by
artificially low interest rates, which also generated bubbles in the markets
for houses, stocks and commodities.
These bubbles have now burst. A Keynesian stimulus amounts to an attempt to
re-inflate those bubbles. That is neither practical nor wise. The US government
in 2008 mailed $ 80 billion to households to stimulate spending, but households
spent only $ 12 billion of that and saved the rest—they knew, even if
politicians did not, that the old spending spree had to stop.
The world—and India-- must accept that the global boom of 2003-08 was
based on an unsustainable economic structure. In future, Americans will have
to save much more (and export more), and Asians will have to consume much more
(and export much less) to end existing global imbalances. This Hayekian adjustment,
which started in 2007, may take years to complete.
So, the global—and Indian—economy may not revive in mid-2009. Even
if it does, the recovery may be so weak as to count for little. Hayekian theory
suggests that we may have to wait till 2010 or 2011 for a sustained economic
bounce. One ray of hope: the current recession may be partly Keynesian, even
if mainly Hayekian. That may diminish its travails.