Employment-spending cycle
By Shahid Javed Burki
Monday, 12 Sep, 2011
CONFIDENCE plays an important part in the health of an economy. When people are optimistic they spend more and save less. This increases the demand for goods and services. That leads businesses to hire more in order to meet the greater demand.
Increase in employment raises spending even more and that leads to another investment-employment-spending cycle. The reverse happens when people lose confidence which is the case now in both the developed and the developing parts of the global economy.
Employment is not increasing in most parts of the world economy. In the United States it is stuck at a bit more than nine per cent of the work force. Experts believe that there is a fifty-fifty per cent chance of another dip in economic activity. How should policymakers respond to this developing situation?
One important legacy of the Great Depression of the 1930s was the development of policy tools that could be used to take care of economic downturns. Such downturns are inevitable. They are part of the way capitalist economies function and develop. These business cycles could be tamed by the use of monetary and fiscal instruments. Which of these two was used depended upon the taste and ideologies of the policymakers.
Those of Keynesian disposition were inclined to use the budget to reduce the adverse consequences of the cycle. The government could pump money into the economy and create jobs for the unemployed which would increase aggregate demand and provide incentives to the private sector to start investing again.
The monetarists — or Friedmanites, after the economist Milton Friedman — preferred to use money supply to tune the economy. The central bank lowered interest rates by printing money and money’s lower cost provided the needed incentive for private entrepreneurs. Those in favour of this approach argue that the use of monetary instruments acted quickly whereas increasing public expenditure had longer time lag between policy action and desired results.
In either event, the cycles were short; mostly of “V” type. In most of the cases after the Second World War, the down turns were sharp but so was the recovery. Plotted on a chart, economic activity had a “V” shape. The economies quickly returned to the level of activity they were at before the downturn.
This has not happened with what was called the Great Recession of 2008-09. It was great because of the severity of the collapse of economic activity in all industrial countries. The sharpest decline in real GDP occurred in Japan with a fall of 10 per cent from the first quarter of 2008 to first quarter of the following year.The gentlest fall was in France with a decline of four per cent. The United States with five per cent and Germany with seven per cent came in between these two extremes.
Policy response to this event was a mixture of fiscal and monetary instruments. The governments acted together to provide fiscal stimulus to the economies.The central banks brought interest rates to near zero. The result was mild recovery in all Western economies. However, none of the economies regained the levels achieved before the downturn began. The United States was at the nearest point in the first quarter of the current calendar year while Japan, having recovered to four per cent below the start of the recession, dipped again to about six per cent decline. The GDP growth estimates for the United States in the second quarter of 2011 indicated a slowdown in recovery.
This led some to talk about a “W” shaped recession — a drop in activity followed by a mild rise, followed again by a decline, followed once again by mild recovery. However, some economists believe that it was premature to declare that the Great Recession had ended in the first quarter of 2009. A more accurate way of describing it would be to call it a “U” shaped recession, with a long and flat bottom. If this is the correct interpretation, what are the options available to those who make policy? This is where politics enters the picture.
With interest rates set near zero and with the Federal Reserve, the United States central bank, having declared that they will stay there for at least a couple of years, the only monetary instrument left is something called “quantitative easing”. The Fed has undertaken two of these — QE1 and QE2 — but there is political pressure on it not to go that route a third time.
In fact, Rick Perry, the leading Republican contender for President Barack Obama’s job in the elections of 2012 has warned that he would regard QE3 as a treasonous activity. While toning down his rhetoric a bit in the first Republican candidates’ debate on September 7 at the Ronald Regan Centre, he stuck to his basic position.
The ugly wrangling over the decision to raise the level of public debt in the United States means that another fiscal stimulation is not an option either. The Europeans have severe problems of their own with a number of weaker economies in the Union close to bankruptcy.This helplessness in the West has turned the attention of some analysts towards emerging markets. The European banks are under great stress having acquired significant amount of government debt issued by weak economies.
Much of this debt has been classified as “junk” by the rating agencies.
Since the downturn began, but especially after the weak recovery from it, the shift in economic power from the developed to the developing world is quite apparent. The International Monetary Fund has estimated that the output of developing Asia — which means all of Asia not including Japan — was seven per cent higher in the first half of 2011 compared to the level at the beginning of the recession.
The estimate for Latin America is two per cent higher. This has obvious implication for the share of developing countries in world output.The emerging markets are expected to account for 38 of global output by 2016 compared with just 25 per cent in 2007.This means that these economies are likely to increase their share in world product by 13 percentage points within one decade. Could they be relied upon to stimulate global economic activity?
The answer is not for the simple reason that together emerging markets have a current account surplus with the rest of the world. For them to stimulate global economy they need to run deficits. This is not likely to happen especially with China in the lead. A major adjustment in the Chinese exchange rate would act as a major stimulant for the global economy. If that were to happen, China will buy more from the West rather than run large trade surpluses with it.
But the Chinese have resisted the pressure on them — which was intense at times — to increase the value of their currency. The IMF’s projection is that China will go in the opposite direction with the current account surplus rising from 5.7 per cent in 2011 to 7.8 per cent in 2016. South Asia is also weakening because of the palpable decline in India which makes up 80 per cent of the region’s output.The Pakistani economy remains weak mostly because of security concerns and unsettled politics.
The conclusion is obvious but disturbing: it is politics that is keeping the West and the emerging world from responding to the economic challenges it faces. To paraphrase James Carville, an advisor to President Clinton, “It is politics, stupid rather than economics".
Employment-spending cycle