Business Times - 27 May 2009

Global fixes needed for global crisis

The adjustment process requires more than just stimulating the economy and involves a
worldwide rebalancing

By JOERGEN OERSTROEM MOELLER

THE current financial and economic crisis seems to be moving into a phase where the
deceleration is losing steam. But we are still in unknown territory, wondering how long it will take
before a flat economy caught by stagnation will gain sufficient momentum to accelerate.

The global economy has encountered more serious problems than originally envisaged because
deep and strong imbalances - especially in the US - have been allowed to persist. Therefore an
adjustment process is not just about stimulating the economy, but the need to tackle the more
agonising issue of rebalancing the global economy.

There are four basic challenges requiring the policymaker's attention.

The first one is the frightening similarity between this crisis and the start of the Great Depression
in 1929. In both cases, the calamities began with a collapse of the financial system in the US
spreading to the financial systems in other countries, triggering a decline in the real economy
through rising unemployment and economic contraction.

All other recessions seen between these two events have started with a fall in demand, steering
the economy into recession with the result that the financial sector ran into problems later
because the lower growth or outright contraction pushed enterprises into lower profits or losses,
turning normal bank loans into bad debt.

In 1929 and 2007, the financial sector dragged the economy into crisis, contrary to the normal
pattern characterising recessions.

Is the worst over?

When people judge the performance of the financial sector in the current crisis and the policy
measures applied by central banks and finance ministers, they - quite rightly - find it reassuring
that the worst seems to be over.

That disregards the unhappy phenomenon waiting in the wings that over the next six to 12
months, financial institutions will report heavy losses as many enterprises cannot service their
debts. Or in other words: what we have seen so far in the financial sector is the consequences of
the original financial crisis emanating from sub-prime and related exuberance, but not yet the
consequences from the economic downturn coming in with a time lag.

Unless we realise this, observers may be disappointed. They may be more than that when 2009
does not bring along improving but deteriorating profits for the financial institutions.

The second challenge is that the financial cycles have gone global. Work by the International
Monetary Fund (IMF) shows unequivocally that the world is steered by a congruous financial
cycle among industrialised countries and emerging economies. The curves reveal that as soon as
one of these groups get into difficulties, another one is dragged into the quagmire immediately.
There is no possibility of finding a refuge or opting out.

This also explains why global policymakers are so focused upon global or international steering
instruments for the financial systems. If the cycles were national or regional, they might be dealt
with in a national or regional context. But the plain fact is that as they are global, measures on a
global scale are required. The other plain fact is that even if all political goodwill is taken into
account, the world is far away from such measures.

The third point is that there is no global business cycle. There are two business cycles - one
dominating the economies of the industrialised countries and another one for the economies of
the emerging economies and developing countries. As the figures published by the IMF show,
emerging Asia stopped fluctuating with the US business cycle around 1980 and emerging Latin
America did the same around 1990 to follow the business cycle in emerging Asia instead of the
US.

That makes global economic policy more difficult than if there was a global business cycle. When
the major countries do not follow the same or congruous business cycle, measures required to
turn the economy around differ and countries tend to diverge in their policy options instead of
converging them.

The fourth point is that the US follows a course of strong stimulatory policies disregarding the
deficits and imbalances. China is adopting a similar policy, but can better afford to do so, as the
Chinese deficits and debts are manageable. The figures for the US are frightening, disclosing a
deficit for the federal budget running close to 15 per cent of gross domestic product (GDP) plus a
high debt, and deficits on the balance of payments despite a reduction of the growth differential
between the US and several other industrialised nations including Europe. The main worry is that
there are no signs that these deficits and imbalances gripping US economy are going away.

Japan is mired in a severe recession with a contraction of about 6 per cent this year. Britain falls
more or less in the same category as the US, while continental Europe is reluctant to run up
heavy deficits to stimulate their economies.

The discrepancy is illustrated by a closer look at the figures for G-20 countries. From 2008 to
2010, the budget deficit among industrialised G-20 countries is expected to grow from 4 per cent
of GDP to about 7 per cent. For emerging G-20 countries, the corresponding figures are nil for
2008 and only 2 per cent expected for 2010. Government debt among industrialised G-20
countries is expected to rise from 80 per cent to 100 per cent, but at an almost stable fluctuation
of around 35 per cent of GDP for emerging G-20 countries.

Politically, it reverberates around the globe that unsound and irresponsible policies are pursued
by the industrialised world with the US in the forefront, while prudent policies have become the
pride of emerging G-20 countries.

The inevitable repercussion of this is an unbalanced effect on the global economy of national
stimulatory measures. Some of the US stimulatory measures will benefit Europe or Japan or
China, which will give rise to questions in the US on why such countries do not adopt similar
stimulatory policies instead of getting a free ride on the US measures.

So far, these voices have been kept under control, but unless the US economy starts to reflate in
early autumn, there is considerable risk that the US discontent about the lack of coordination will
spill over into strong words and maybe even policy actions to preserve the positive effects of
stimulatory measures for the US economy.
Time is running out for the global economy to mastermind a better coordinated global response
addressing the underlying imbalances. We know that the crisis is deeper than we thought. Unless
we introduce global measures to address the imbalances, it will also be longer.

The writer is a visiting senior research fellow at the Institute of Southeast Asian Studies,
Singapore and an adjunct professor at Copenhagen Business School and Singapore
Management University