Policy response to the Great Recession
By Shahid Javed Burki
Monday, Oct 12, 2009
THE “decoupling” hypothesis that the emerging world of which Pakistan is a part is no longer so closely tied to the old industrial world – that whatever happens in the latter would affect the former – became popular before the global economy went into what economists have begun to call, the “Great Recession.” The down turn began in the United States in the summer of 2007. Initially there was a consensus among economists that the downturn’s effect would not be felt by the emerging countries to the extent it would influence the more linked economies of the industrial world. That didn’t happen.
We know from Pakistan’s experience that even in an economy that was not an integral part of the global production system, there were many negative consequences from the economic crisis in the United States and Europe. Pakistan’s exports were affected by the contraction in the global markets. The Karachi stock market, shaken by the rapid deterioration in the security situation, suffered as foreign capital flew out and joined the exit from a number of other emerging markets.
It is important, therefore, for Pakistan’s policymakers to stay abreast of the developing situation in the global economy.Today I will explore some of the current expert thinking on the subject of the Great Recession. I do this in the belief that there are lessons to be learned for the governments in the emerging markets.
How close was the Great Recession to the Great Depression of the 1930s? One answer to the question was provided by Christiana Romer, the head of President Barack Obama’s Council of Economic Advisers. She is one of the two senior officials in the new administration who have a good understanding of the Great Depression. The other, of course, is Ben Bernanke, the Chairman of the Federal Reserve, America’s central bank. Bernanke studied the subject as a graduate student and then published a book about it. He is generally credited with pulling the American economy back from the brink of a depression.
What is an economic depression? What distinguishes it from a deep recession is the paralysing fear of the unknown. That fear leads consumers, investors and business managers to pull back from the market. They begin to hoard cash by sharply cutting expenditure.
According to the students of economic depression, “a devastating loss of confidence inspires behaviour that overwhelms the normal self-correcting mechanisms (lower interest rates, inventory re-supply, cheap prices) that usually prevent a recession from becoming deep and prolonged: a depression.” In other words, economic managers have to try to address the situation by using new tools. As the US economy got close to a depression, Bernanke, having lowered interest rates to near zero, went for what is called the “quantitative easing” of money. This he did by printing enormous amounts of money and gave it to the credit starved sectors of the economy. This was done while hundreds of billion dollars worth of stimulus was being provided to the economy through the budget by way of President Barack Obama’s large stimulus package.
Did the state of the US economy justify these extraordinary moves? A report issued recently by Ms Romer finds that the initial impact on the levels of confidence for all categories of eco nomic actors was much more severe than was the case at the beginning and during the Great Depression.
While it is correct that stock prices fell by one-third from September to December 1929, the beginning of the downturn, it has to be recognised that far fewer people owned stocks then than is the case now. The effect on the economy, therefore, was not as severe as was the case now when the fall in stock prices affected the levels of wealth for many more people. At this time, home prices barely dropped then but fell sharply now. From December 1928 to December 1929, households lost three per cent of their accumulated wealth. This time they lost a much larger proportion – as much as 17 per cent.
There were some policy missteps that accelerated the pace of economic deterioration. Among them was the decision not to support Lehman Brothers, the fourth largest US investment bank. The anniversary of the bank’s collapse inspired much commentary. While there was disagreement about the wisdom of the decision – some argued that even if the bank had not been allowed to fail, some other would have become the victim of the economic malaise. There is a consensus that the decision accelerated the deterioration. As Robert J. Samuelson of Newsweek puts it, by “allowing Lehman to fail almost certainly made the crisis worse. By creating more unknowns – which companies would be rescued, how much were ‘toxic’ securities worth? It converted normal anxieties into abnormal fears that triggered panic.” The economy, in other words, was brought near the state of depression not only by the economy’s own internal dynamics, but by public policy.
The Lehman decision froze credit markets and resulted in the collapse of the stock markets. By year end, the Dow Jones industrial average was down 23 per cent from the level reached before the bank’s collapse and 34 per cent from a year earlier. There was panic in the financial markets which affected general confidence.
In September, the Conference Board’s Consumer Confidence Index was 61.4. By February 2009, it fell to 25.3. Spending on consumer durables fell at the annual rate of 12 per cent in the first three quarters of 2008, accelerating to a decline of 20 per cent in the fourth. Investment by businesses fell by 39 per cent in the last quarter of 2008. This is when the Obama administration decided to act.
The most important lesson to be drawn from this episode in recent American economic history is that public policy plays an important role in the way economies develop and how they should be steered out of the crises into which they can find themselves as they move forward.
This lesson is particularly important for a country such as Pakistan that has allowed economic institutions in the public sector to weaken greatly, has lost the capacity to do serious analytical work on the state of the economy in both the public and the private sectors, and has not developed linkages between the private and the public sectors to develop. The last is particularly important since it provides the policymakers advice from analysts who don’t have political axes to grind. One important step the government could take is to put in place a strategy for undertaking analytical work in economic management in both public and private sectors.