When a government’s expenditure exceeds its income, it resorts to borrowing from the public. The US economy has been playing a similar role for a few decades now. A single piece of information would suffice to illustrate the fact. Americans tend to spend around 95 per cent of their disposable income on consumption, devoting a meagre 5 per cent to saving. By comparison, a country such as India saves around 24 per cent of its disposable income. Savings, in turn, constitute a major source of investment funding and economic growth. The massive investment spending by the US economy ($ 2,200 billion in 2006) therefore cannot be financed by its own savings. The US economy borrows from other countries to supplement its inadequate savings the same way governments borrow from the public. Indeed, 36.7 per cent of American investment was financed by foreign savings in 2006.

This has a two-pronged implication. First, American imports from the rest of the world far exceed its exports. Consequently, Americans boost world demand for commodities by borrowing from the world itself, an arrangement that is comparable to automobile producers offering soft loans to potential buyers of their cars. The car loans need to be repaid on time. The US economy, on the other hand, need not pay off its debts since the rest of the world is normally happy to hold American IOUs — the way commercial banks do not object to holding government-issued safe treasury bills.

American debts are attractive assets to hold since they are normally acceptable almost anywhere in the world as a means of payment. However, the flip side of the story is that as the size of the American debt keeps increasing, the value of the dollar continues to fall since dollars are chasing other currencies to support imports.

Despite the fall in the value of the dollar, however, most economies would not shirk away from dollar holdings since, in the world market, the prices of the two most important commodities — petroleum and gold — are quoted in US dollars. Petroleum, in particular, is a vital input into the production process of almost all commodities, and dollars happen to be the accepted medium for purchasing this input. As far as gold is concerned, it is a traditional store of value and traders often use it as a means to preserve their purchasing power vis-à-vis the dollar.

An important impact of rising dollar holdings across the world is the rise in the dollar price of petroleum. From the point of view of petroleum producers, the falling value of the US dollar against a variety of currencies reduces their ability to purchase essential commodities from other countries. Hence, the falling dollar value is a far more potent cause underlying the rapid rise in oil prices than falling oil reserves.

Demand for consumption goods constitutes the lion’s share of the American GDP. Hence a slow down of the US GDP has a sobering effect on the American demand for imports and this, in turn, decelerates the output growth of major exporters to America. They include China, the United Kingdom, a large part of Europe and so on. In this sense, growth in the American economy, even if financed by debts, keeps the world growing. The sheer size of the US economy guarantees this. Going back to where we started, this is comparable to economic growth brought about by the government spending more than its income.

Over the last two years or so, however, the American economy has faced the so-called sub-prime crisis. The crisis arose from the fact that the unlimited availability of US dollars was accompanied by the US Federal Reserve Bank’s low interest policy. Low interest rates helped aggravate demand and keep industrial activity and growth alive. Most importantly, housing demand increased as house-building loans were available at low interest rates. The rise in demand led to a rise in the prices of houses. Hence, existing house-owners too mortgaged their homes and used the proceeds to keep consumer demand growing. This gave rise to an upturn in the rest of the US economy, too.

As it turned out, many of these house-owners were not financially strong borrowers and they failed to pay off their debts to the mortgagees. The situation was particularly severe since house prices had increased substantially on account of unbridled availability of mortgage-based loans. Well-known banking institutions were affected in the process and sustained severe losses connected to sub-prime loans.

At the same time, spiralling house prices led the economy into an inflationary phase. To correct these errors, the American policy-planners decided to raise lending rates in the economy, thereby curtailing demand. Any reduction of American demand, however, leads to a fall in demand elsewhere in the world, for reasons already explained. Hence, not only did the American economy begin to slow down, it produced recessionary signals in the rest of the world also, particularly in economies where a significant fraction of the GDP was explained by exports to the United States of America.

With increasing globalization, accompanied as it has been by the mounting sophistication of financial markets, the American recession had implications for the bourses too. While rallying stock markets do not necessarily reflect a robust underlying economy — as well documented by the period immediately preceding the Great Depression of the Thirties — recognized economic recession almost invariably leads to a gloomy stock market scenario. Most of these economies, therefore, began to experience stock market jitters. This was reinforced by the fact that American liquidity was substantially reduced by the losses suffered in the US by the financial sector as well as by high interest rates. The foreign institutional investors had to withdraw from these markets to resuscitate the American financial sector itself.

The world economy has thus been struggling with three well-known diseases. First, the price of petroleum has skyrocketed. Second, important economies are in a recessionary mode. Finally, the stock markets are showing signs of crisis. Where will this lead us? The question breaks up into two parts. What would be the implication of these developments for economies across the world? Are we back to the Thirties, as some have us believe? The second question is, how will India be affected?

In reply to the first question, it would appear to be an acute overreaction to believe that we are back in the Thirties. Despite the rejection of Keynesian economics in recent times, the Keynesian message is well-understood and Keynesian policies are available ready at hand. These would be ineffective if they were implemented simultaneously with non-Keynesian policies in different but integrated economies, as was the case when the Far Eastern financial crisis broke out in the Nineties. However, now that the world’s largest economy is faltering, such contradictions are unlikely.

Regarding India, there should be no major impact of the rise in oil prices since the dollar has been steadily sliding against the rupee. If prices of petroleum products rise nevertheless, the phenomenon would have little economic rationale. Second, even if recessionary signals show up, they will be far less than in countries which are major exporters to the US. India’s exports to the US are negligible by comparison. Finally, will the bourses take a nosedive? This too is unlikely. There was a panic reaction to start with when the FIIs were hit by the reality of their losses. First, interest rates were relatively high in the US and parking funds there could have looked like a safer option compared to investing in stock markets not only in India but elsewhere too. The uncertainty was too high. But interest rates have now been slashed in the US. Soon calculations are likely to produce a clearer picture about the Indian stock market, which is currently less vulnerable to economic recession than others. Once this happens, the funds will flow back. The first signs are already evident. The Sensex or Nifty may fall, but not to devastatingly low levels.