Davos is a small, and for much of the year, an ordinary Swiss ski resort. But, for about a week every year, limousines and helicopters converge in Davos as the world’s rich and mighty congregate to attend the World Economic Forum. It is not clear exactly what role this forum plays in world affairs — or whether it plays any role at all. But what is certain is that every year, many heads of state, and an even larger number of chief executives from some of the world’s largest companies, congregate here. For instance, Bill Gates is said to be a regular participant almost every year.
Perhaps, most years, the CEOs discuss how they are going to make their next billion. But this year’s meeting, in the last week of January, was very different. It was held against a backdrop of apprehensions that the American economy is teetering on the brink of a recession, and stock markets plunging across the world. The Federal Reserve Bank in the United States of America had just announced the largest ever one-time cut in interest rates, but this did not seem to provide much solace either to the leaders congregated in Davos or to international stock-market prices.
Newspaper reports suggest that the mood was so pessimistic that it even transformed into growing fears that a change in the international economic order was imminent. Some people also asked whether this was the end of neo-classical economics, since economists clearly had no answers or solutions to get the international economy out of the mess.
But perhaps a sensible jury will be more sympathetic to neo-classical economists and to their discipline. After all, most level-headed economists have never claimed that they have a magic potion which can cure all ills. On the contrary, they will point out that their subject has evolved over the years, with new theories typically evolving in response to major crises.
Undoubtedly, the best example of this is the birth of Keynesian economics following the Great Depression of the Thirties. John Maynard Keynes, often called the father of modern economics, had a simple but effective cure for the depression. His key observation was that the depression was caused by a deficiency of aggregate demand — people were simply not spending enough.
This observation suggested that government policy should be directed towards stimulation of aggregate demand in time of slumps. An important instrument is expansionary monetary policy in order to provide easier access to credit for firms so that they can invest more. Similar initiatives were proposed on the fiscal front. For instance, governments were advised to increase spending as a direct supplement to aggregate spending. An indirect tool was to lower taxes so that households would have more disposable incomes for increased spending.
Conversely, when the economy is overheated, the Keynesian prescription is to follow contractionary public policies — high interest rates and more generally a so-called “tight” monetary policy and reduced public spending. These policy prescriptions seem very elementary today. In fact, the basic or underlying theoretical justifications for these policy prescriptions can be found in any first- year undergraduate macroeconomics textbook today.
Naïve Keynesianism has had its critics, including the Nobel laureates, Milton Friedman and Robert Lucas. Nevertheless, these policy prescriptions have had a very profound influence throughout the world after the Great Depression. Its success can be gauged from the fact that while the advanced economies have experienced several periods of recession after World War II, none of these has actually turned into a major depression. This is in marked contrast to the international experience in the pre-war era.
Keynesianism, and economic theory in general, faced the biggest challenge during the oil shock of the Seventies. The rising oil prices resulted in a huge increase in price level. At the same time, production became less profitable and so the economies also slowed down. Thus was born a new phenomenon — rising prices being accompanied by recessionary tendencies in the economy. A new term was coined to describe this situation — stagflation.
Simple Keynesian prescriptions are useless to combat stagflation. In its initial stages, policymakers did not seem to understand this. For instance, some central banks actually used expansionary monetary policies in an attempt to stimulate the economy. Unfortunately, this proved to be counterproductive, because the increase in money supply typically exacerbated the situation by causing a runaway wage-price spiral.
It soon dawned on economists that stagflation poses a dilemma for public policy. While the control of inflation requires contractionary policies, economic recovery can only be stimulated by increased public spending, lower rates of interest and easier access to credit. In other words, policies which help to contain inflation are exactly the ones which can strengthen recessionary tendencies in the economy.
Faced with this dilemma, central banks and finance ministries have to trade off one evil against the other. Can we tolerate a one per cent higher rate of inflation in order to gain half a per cent additional rate of growth in gross domestic product? This is always a “judgment call” — there is no theoretical answer to this question.
During the last decade, the spread of globalization has brought about new challenges for economists. The process of greater economic interdependence amongst countries has resulted in larger flows of cross-border movement of goods and services, and in international capital flows. (Of course, there has been relatively little movement of labour across countries.) This has had obvious benefits. For instance, citizens typically have more choice about what goods to buy, greater competition has resulted in better prices.
Unfortunately, the profit-and-loss account has entries in both columns. Globalization has also caused a lot of headaches. A major problem is that economic turmoil in one part of the globe quickly moves across country borders to the rest of the world. An obvious example of this has been the recent chaos in international financial markets caused by the sub-prime crisis in the US. Apprehensions about a recession in the US economy have also resulted in share prices sinking lower and lower in stock exchanges across the world.
The fears of “contagion” have thrown orthodox economic theory into disarray. Old prescriptions such as “free trade is the best medicine” or “remove all controls on international capital flows” no longer seem completely appropriate. For instance, the two Asian countries which came out relatively unscathed from the east Asian meltdown were China and India. These are both countries which had several controls on foreign exchange transactions. In fact, even as conservative a body as the International Monetary Fund is no longer such a strident advocate of openness.
The problem of course is to know how much to insulate the domestic economy from the rest of the world. If there are too many controls, then all the benefits of globalization would be lost. If there are too few, then shocks from outside can create havoc in the domestic economy. So, what is the golden mean? Clearly, globalization of the sort prevailing today is too new a phenomenon for any clear-cut replies. But experience will help economists to come up with better answers.