Many economists love peering into the future, predicting the rate of growth of the economy whether the central bank will raise interest rates, or what will happen to foreign exchange rates or equity prices. Ask any question about the future levels of economic variables and you will get some answers typically several, if you consult more than one economist. These answers are often wide off the mark. But this has never deterred economists from forecasting. And why should it? After all, astrologers and meteorologists have made prediction their profession. And when was the last time they got it right?
The favourite topic of such economists today is whether a global recession will plague us in 2008. This is not altogether surprising. In this globalized world, the state of the world economy affects all countries, big and small. Geographical distances have ceased to matter. What happens in one country has ripple effects in countries on the other side of the world, the larger the country the bigger the effects.
The Chinese economy has been growing at remarkably rapid rates for about two decades very soon development economics may have to be rewritten to incorporate or explain the unprecedented growth rates achieved by China. Our own experience has also been admirable. Despite all this, the American economy still remains almost a barometer for the world economy as a whole because it remains the largest economy in the world. A sharp fall in aggregate demand in the United States of America can cause sleepless nights for ministers in charge of economic ministries all over the world and hypertension to exporters to the US. The experience of Indian software companies is an example of how the US economy can cast its shadow across the globe.
Unfortunately, the American economy has been flashing danger signals for quite some time now. The flashpoint came when the crisis in the US sub-prime mortgage market erupted. Much has been written about the sub-prime market in recent months, and so only a few words will suffice to refresh the memories of readers about the nature of the crisis.
Sub-prime mortgages are loans given to borrowers who are perceived to have high credit risk. That is, these are borrowers who are more likely to default on their loans. Sub-prime mortgages have been very useful to US borrowers who would otherwise not have had access to credit and these have helped them to own houses. All was well as long as financial institutions exercised some minimal caution in underwriting standards. Unfortunately, sheer greed for higher profits caused some institutions to relax standards, to push loans to borrowers who were in no position to pay back. Once loan delinquencies crossed a certain threshold, several financial institutions had to incur huge losses.
All this has resulted in a severe turmoil in financial markets all over the world. While there has been a sharp cutback in the supply of credit in all countries whose banking systems are closely linked to the US financial sector, the effect has naturally been particularly severe in the US. This is expected to have adverse effects throughout the US economy as businesses strive to find credit to finance their operations.
The negative effects have already emerged in the US housing sector. Average house prices have started falling because new buyers find it hard to access credit. Of course, expectations have also started casting a shadow. Even buyers who do have access to credit are not buying houses because they expect house prices to fall even further in the near future. So, there has been a large fall in the construction of new houses. Since the housing sector is a major source of demand for the construction industry, the latter has also started feeling the effects of the crisis in the sub-prime mortgage market. Everyone is now scared that there will be multiplier effects in other sectors of the US economy.
The after-effects have started appearing on the other side of the Atlantic. The boom in the United Kingdoms housing sector has come to an end, and UK house prices have fallen for the third month in a row. Forecasts of the rate of growth of the UK economy have become quite pessimistic. The Bank of England, which oversees monetary policy in the country, has intervened and reduced the bank rate by 0.25 per cent. The bank believes that this will improve liquidity in the economy and so stem any recessionary tendencies. The Japanese economy has also slowed down.
While these are certainly worrying signs, it is premature to think that a global recession is inevitable in the near future. Although growth rates in the US, UK and Japan have slowed down, they are still positive. US labour market data show that new jobs have been created in both October and November. Consumer demand in the UK shows no signs of having lost steam. Moreover, other countries in western Europe do not seem unduly perturbed at this stage.
Much depends on government policy, and in particular how strongly governments intervene in the credit markets to liberalize credit. Unfortunately, a more liberalized credit regime requires an expansionary monetary policy in the form of lower structure of interest rates and increased supply of money. The downside risk of expansionary monetary policies is that they may lead to an increase in inflationary pressures.
So, there is a trade-off between inflation and growth. Most Western countries typically have very low tolerance to inflation, and so they follow conservative policies that are often biased in favour of controlling inflation. For instance, despite the threat of recession, the UK government still has a target of an annual rate of inflation of just two per cent. It does not help matters that many commodity prices have been rising, while crude oil prices remain close to historically high levels. When prices of inputs and intermediate goods remain high, it becomes difficult to control inflation even without the added burden of having to maintain a liberalized credit regime.
How will a recession in the West affect emerging economies like China and India? Much depends of course on the intensity of the recessionary tendencies. It is also very likely that the effects in the two countries will be very different. The export sector in the Chinese economy is much larger than that in India. If the slowdown in the US economy is very pronounced, then Chinese manufacturers will find that their markets have shrunk and they will have to find alternative markets. Given the size of the export sector in China, this will have a non-negligible impact on the rest of the economy.
In contrast, the relatively low size of the export sector will mean that the Indian economy is better insulated against shocks elsewhere in the world. Of course, sectors like the software industry will suffer, but these will be more localized. So, our inability to match the Chinese success in breaching foreign markets may actually prove a blessing in disguise.