Return of the Crisis

Are we on the brink of another Recession?

Tethering on the Brink: Why? European Debt Crisis Uncertainties and negative outlook in major

economies of the world Non-viability of current economic structure

and trajectory of the European Union How and whether Greece might exit is the

biggest and fattest uncertainty of all (Article in The Economist)

Is austerity the right way to go? No, the drive for fiscal austerity is completely

misplaced Fiscal tightening, in this context, is self-

defeating It reduces gross domestic product (GDP)

growth and fiscal revenues It makes fiscal consolidation targets even

harder to reach

Struggling Economies Greece's national income is nearly 30% lower than what it was

four years ago The current strategy that is making the output fall further,

reducing the hope to recover (and therefore be in a position to repay debts)

The austerity strategy is being imposed on all the “peripheral” countries in the euro-zone that have debt problems.

Ireland and Portugal which had rigorously fulfilled all the draconian austerity measures, are still struggling to grow.

Spain's huge economy is being pushed into a downward spiral as the asset deflation of the collapse of the construction boom combines with reductions in public spending to throw more people out of employment and cause incomes to fall further.

Italy is set to join that group, with massive implications for all of Europe.

What’s next? Break-up of the currency union in the dearth

of significant structural and policy changes Given the situation, it is only a matter of time

before one or more of these countries defaults on at least a part of its debt and then leaves the currency union.

What if the currency union breaks? “Weaker” economies will immediately face the pressure on their domestic

banking systems, as investors begin to doubt whether their deposits will really continue to be denominated in euros in future.

Bank runs will start. Indeed, bank runs in Europe have already started. So far they have been slow, but such processes can very quickly

accelerate and precipitate a crisis. (All financial crises are usually associated with bank runs.)

Deposits in Greek banks have fallen by more than one-third since the beginning of the crisis, and €1.2 billion was withdrawn in just two days after the inconclusive election.

Even banking systems in other countries that do not have such political instability are experiencing similar slow runs. Deposits held in Spanish and Italian banks have also fallen by more than €300 billion since the start of 2012.

The “flight to safety” of Europeans has led to increases in German bank deposits of approximately an equivalent amount.

But since the banks of north European countries are also deeply implicated in lending to the peripheral countries, they are not really safe either. (Incidentally, United States banks will also be affected.)

What if the currency union breaks? (contd.)

The doomsday scenario has been summarised by Martin Wolf of Financial Times (May 17, 2012):

“The mechanisms at work would be powerful: runs; the imposition of (illegal) exchange controls; legal uncertainties; asset price collapses; unpredictable shifts in balance sheets; freezing of the financial system; disruption of central banking; collapse in spending and trade; and enormous shifts in the exchange rates of new currencies.

What if Greece Leaves the Euro?

Can this be averted? The only way to prevent havoc is to create a common deposit

insurance and bank resolution regime that covers the entire euro-zone, issue of jointly held euro-zone bonds and and fiscal transfers to assist regions in distress.

These are now seen as more acceptable: France under Francois Hollande has already declared its support.

• But Germany and some other north European countries oppose such reforms. German Chancellor Angela Merkel keeps insisting on ‘Budget Discipline’. There is lack of recognition in surplus countries that they have been huge

beneficiaries of the monetary union. They have been able to preserve employment through export surpluses and

then use these to finance investments (mostly in private non-tradable activities like real estate and some public spending like arms purchases in Greece) that provided their banks high returns for a while and also further benefited their own industries.

In such a context, non-symmetric adjustment, by making only the debtors suffer and pay, is grossly unfair.

German business newspaper Handelsblatt takes a swipe at the latest cover of The Economist

Implications for Rest of the World In the last recession (2008-09), emerging

economies (China, India, Brazil, Argentina, etc.) experienced less severe downswings and recovered faster and more strongly to exhibit GDP growth rates similar to those of the previous decade.

However, this time internal trends within regions and closer integration between regions may interfere in the ‘de-coupling’ with a global recession.

USA At G-8 summit 2012, U.S. President Barack Obama outlined

that there was “emerging consensus that more must be done to promote economic growth and job creation, right now”.

However, Obama had the U.S. economy in mind, not the Greek people, when he promoted growth in Europe.

The U.S. was worried that a second collapse of the European banking system would adversely threaten U.S. banking institutions. U.S. banks have already reduced their exposure to the Greek financial system by 40%.

A Greek exit from the euro-zone might infect the rest of southern Europe (Italy and Spain), in whose financial markets the U.S. banks are more heavily leveraged both directly and indirectly.

A Europe-wide collapse would devastate the U.S. financial firms.

China In China, the authorities had sought to slow growth because

of fears of “overheating” as evidenced by high inflation rates. However, slowdown has been sharper than expected, already

leading to calls for renewed state stimulation of the economy. There are problems in trying to recreate the real estate and

construction boom that has already spiralled out of control. Falls in real estate prices continue to have unpleasant

implications for bad loans of the banking sector and for employment in construction, which had been an important part of the increased employment since 2008.

There are growing fears that further slowdown in exports can create a “hard landing” for China's economy.

The political instability generated by the power struggle within the elite after the fall of Bo Xilai is also likely to have economic implications, though these can still only be guessed at.

India India is dealing with its own unique problems of political lethargy

in introducing economic reforms in addition to rupee depreciation, capital flight, high fiscal deficit, low foreign exchange reserves and falling GDP growth rate.

International ratings agency Standard and Poor’s (S&P) has warned that India could be the first BRIC nation to lose its investment-grade rating, scaring away foreign investors even further.

There are talks of the need for austerity and harsh decisions amidst a slowdown in growth. Austerity would only convert falling growth into a recession. “Harsh decisions” involve measures such as cutting subsidies to reduce

expenditure and raising oil prices. Combined with the increase in the prices of imports as a result of the

rupee's depreciation, these administered price hikes will only fuel inflation and further aggravate the tendency towards stagflation (prices keep rising but output stays stagnant).

Conclusion There is no doubt that the world must brace

itself for another recession, possibly greater than the recent one.

The performance of individual countries in this will depend on the extent to which they are able to insulate themselves by boosting domestic demand in sustainable ways.