The European scare

Indian Express, 9 Dec 2010

The Indian economy has grown rapidly while the US and Europe continue to face serious problems. Many observers suggest that emerging economies and advanced countries may continue to witness different growth rates. However, this may be a short run phenomenon, and in the longer run, unless deeper problems of industrial countries are not solved, they may pull the whole world, including emerging economies, down with them.

India is now deeply integrated into the world economy, much more than most of us think. Sustained high growth in India requires sustained world GDP growth. In this sense, we have a stake in the success of economic policy worldwide, in breaking away from the slow growth that is found today, for getting world GDP growth back up to 5% as was found before the crisis.

The US and Europe are witnessing a gradual economic recovery but the situation is fraught with risk. There is still signficant uncertainly about the recovery as deeper problems have yet to be solved. The dollar has to depreciate and the US has to reduce its net imports. Private demand in the US has to rise. Many governments in the Eurozone have to do fiscal consolidation. Until now the recovery has come more from short term stimuli and the inventory rebound, rather than from structural change the leads to a new stable equilibrium. The rescue of Greece and Ireland may have addressed an immediate problem, but it has not helped set the stage for strong sustained world GDP growth.

In the US, fiscal and monetary stimuli have pushed up GDP growth, but a high marginal propensity to import means that a lot of it has spilled over into higher imports. As unemployment rose, transfers from the government rose, but sustained growth requires broadening growth away from transfers. The housing market remains depressed. The scale of dollar depreciation that is required for the US current account deficit to contract has yet to come about. Sustaining growth in the US requires wage income to grow, and demand for domestic goods and services to rise. The Chinese exchange rate policy and the response of many emerging economies in the form of currency trading and capital controls is keeping the dollar strong. Unless global exchange rate adjustments come about, the US could be in for a prolonged recession.

Turning to Europe, the soverign debt crisis in the PIGS has worsened. Ireland has received a financing package to recapitalise its banking system and overcome its immediate public debt obligations from the IMF and Eurpean Union. Earlier Greece had obtained a loan and promised to undertake fiscal consolidation. The soverign debt crisis is however not over, as Portugal and Spain are seen to be the next trouble spots. While the magnidute of the financial assistance needed for Portugal may be smaller, that for Spain may be too large to come from the EU or IMF after Greece, Ireland and Portugal have been bailed out.

While the massive interventions of the global community in Greece and Ireland have staved off the immediate problems of both countries, the fiscal situation is daunting. Fairly small countries have been burdened with very large indebtedness. It may take 20 to 30 years for the fiscal consequences of these programs to be digested. The citizens of these countries will face elevated taxes through these years.

In both countries, political constraints interfere with scaling back of government welfare programs. But the task of repaying on the debt, coupled with paying for welfare programs, will require high tax rates. If 5 lakh high income individuals choose to leave the country when faced with high tax rates, this could have a substantial adverse impact on fiscal dynamics and GDP growth. Politicians in both countries are trapped in a bind, and a future government could choose to default on debt or renege on the promises made about policy reform. Such scenarios would trigger off fresh crises.

This raises questions about why Greece and Ireland were rescued in the way that they were rescued. One clear motivation for the rescue was the extent to which banks across Europe had an exposure to Greece and Ireland. But this immediately suggests an alternative strategy: Perhaps the right strategy was to have Greece and Ireland go into default, and then design a recapitalisation strategy for European banks. If this strategy had been adopted, it would have given Greece and Ireland a clean slate in terms of the fiscal burden, albeit at the cost of being locked out of borrowing on the international market for 20 years. It would also have put European banks on a sound footing. Given the German focus on prudent and responsible behaviour by all economic agents, the design of the recent packages is puzzling.

These events have also raised fresh questions about the usefulness of currency unions such as the Eurozone. To some extent, the case of the critics is overstated: Greece was likely to have headed into a crisis anyway, given the combination of West European style welfare programs without the underlying economic strength that is required to pay for these. But it is also true that in places like Ireland or Greece, if there had been a floating exchange rate, then in the crisis a large currency depreciation would have come about, and this would have been a powerful tool for stabilisation. By participating in the Euro, both countries lost this lever for stability.

In summary, the world economy is facing unexpected difficulties. After the crisis subsided in early 2009, financial markets expected a rapid reversion to normal macroeconomic conditions. This rapid return to normalcy has not materialised. The three great economic blocks of the world -- US, Europe, Japan -- are all facing sluggish growth with no immediate sign of a return to normal GDP growth. These problems matter more to India than meets the eye. It is not a coincidence that India's years of unprecedented GDP growth were also years where world GDP was at unprecedented levels.

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