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Global recession from West to East

03 December 2013 [10:53] - TODAY.AZ

By Pr.Kamran Dadkhah, Senior Economist - Trend:

There seems to be pessimism in the air regarding the economic prospects of the West and by extension the world. In its recent report, the Organization for Economic Co-operation and Development (OECD) revised downward its estimates of growth for many countries. It lowered the overall growth rate forecast of the Euro Zone for 2013 and 2014 each by 0.5 per cent. For the entire OECD, the forecast has been lowered by 0.6 per cent for 2013 and 0.2 per cent for 2014.

We hear the same pessimism from economists and experts. In his talk at a conference honoring Stanley Fischer at the International Monetary Fund, Larry Summers noted that in order to achieve full employment, the interest rate has to be at a "natural level". However at present, he contended, that rate is negative. But the Federal Reserve cannot possibly set the nominal interest rate below zero. Similar sentiment was shown by two Nobel laureates, Joseph Stiglitz and Paul Krugman, in a recent interview with the BBC.

Needless to say, we are living in a globalized world and if the United States and the Euro Zone experience economic stagnation, it will affect other countries around the world. Many economies including China, South Korea, and Japan would be affected by the sluggish demand for their exports. Similarly, many developing countries have to rely on export promotion at the first stage of economic growth.

New round of recessions more complicated than ever

So, we might ask, what is happening? According to official data and expert pronouncements, the recessions in the United States and Europe are over.

According to the National Bureau of Economic Research (NBER), which dates business cycles in the United States, the recent recession that started in December 2007, ended in June 2009. According to Eurostat, the recession in Europe started in the second quarter of 2008 and ended in the third quarter of 2009. But then another recession started in the fourth quarter of 2011. This later recession came to an end in the second quarter of 2013 when both German and French economies posted growth.

Thus, as far as Europe is concerned, there has been a double-dip recession and many fear that if fundamental changes are not adapted, then there could be another recession. It is true that the United States has not experienced a double-dip recession, but the recovery has been anaemic. The average annual growth rate of the economy since the end of the recession has been slightly more than 2.2 per cent. In comparison, during the last recovery, that is from November 2001 to December 2007 the average annual rate of growth was more than 2.8 per cent. If we go further back the contrast is stronger. During the recovery period from March 1991 to March 2001 the average annual growth rate was more than 3.6 per cent.

The employment data is also not encouraging. The unemployment rate is still above 7 per cent. But more importantly, the labor force participation rate has fallen and many have claimed disability.

Another possible recession

Of course, not all news is bad. The stock market has recovered and recently there has been a strong showing in the housing market.

But overall the feeling in the United States and around the world is that there may be another recession. More importantly, many believe that there will be long term stagnation; slow growth and high unemployment in the West, which will be transmitted to emerging markets.

The basic diagnosis is that the European and American economies are beset by fundamental problems, which can only be fixed by structural changes. Different economists have a variety of ideas about these structural problems. For instance, Stiglitz believes that a main problem is the increasing income inequality. As mentioned before, Summers points to the fact the natural rate of interest (the rate that is consistent with full employment) is now negative. Some also claim that the natural rate of unemployment now is far above 4 per cent-5 per cent that it used to be.

U.S. policy

The policy followed so far by the U.S. Federal Reserve has been to keep the interest rate low and buy financial assets to inject liquidity into the market (quantitative easing or QE). But this is demand side stimulus. It has been in effect since the start of recession and has not been as effective as advertised.

Some have noted that this policy has only benefited rich investors and large banks. On the other hand, median income of households (in constant 2012 prices) that had reached $55,627 in 2007 went down to $51,017 in 2012. On February 1, 2014 Janet Yellen will become the first chairwoman of the Board of Governors of the Federal Reserve System. It is expected that she will continue the same policy. John Taylor, a prominent economist from Stanford University notes that such low interest rates reduce banks incentive to extend loans and assume credit risk.

What Summers, Stiglitz, Krugman, and some other economists suggest are also demand based policies. For instance, Stiglitz believes that if the low income people get more money they will spend all of it, while the rich would not do the same.

But if we agree that we need a structural change, then stimulating demand or even redistribution of income by taxing the rich and increasing welfare payments will not succeed. The structural changes should be aimed at removing barriers to investment and innovation. Recoveries and booms in the economy will happen when there is innovation. Indeed this is essence of Schumpeter's theory of business cycles. Barriers to investment should be removed and innovation and competition encouraged. These were the essence of policies followed by President Kennedy, who reduced tax rates and President Regan, and Margaret Thatcher.

Towards the East

In Europe, welfare programs should be reined in. Furthermore, the European Union was not meant to stop at monetary unification. It is time to take further steps. Finally, countries like Greece have to seriously address corruption. If people can live off welfare or through graft and embezzlement, why would they think about working?

But what about countries such as China, Korea and others which rely on exports? Particularly China needs to shift a good deal of its reliance on exports to domestic demand. There are many who have everything and there are more people who have not shared the fruits of economic growth. Here again there is a need for structural change to shift to domestic consumption and also opening work and investment opportunities for those left behind.

Oil and gas producing countries need not worry in the short run. But in the long run, the energy map of the world will be changing. The United States and other countries are using innovative technologies to get more oil and gas from untapped sources. The warning for oil and gas producing countries is: "diversify while there is time."

Finally, developing countries have no choice but to rely on export promotion if they want to break out of a cycle of poverty and underdevelopment. Their markets at the beginning are too small to solely rely on domestic demand. Therefore, long term stagnation in developed countries is bad news for developing countries.

So if the United States and Europe experience another recession, long term stagnation, or even slow growth, it is bad news for the rest of the world. So let us hope that these countries opt for fundamental changes in their economies and stimulate supply.

--

Kamran M. Dadkhah is Associate Professor in the Department of Economics at Northeastern University, Boston, where his areas of interest are econometrics, macroeconomics, international economics, and Middle Eastern economies. Previous positions have included Senior Economist, Abt Associates, Inc., Cambridge, Mass.; Senior Economist, Development and Investment Bank of Iran; and Director of Planometrics and General Economy Bureau, Plan and Budget Organization of Iran. He is the author of Foundations of Mathematical and Computational Economics, 2nd ed. (Springer 2011) and The Evolution of Macroeconomic Theory and Policy (Springer 2009).

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