Will Someone Break The Chain Of Crises Please?

Preventing another global financial crisis by ensuring coordination in policy-making between states. 

The industrial world is under tremendous political pressure to restore high economic growth rates observed prior to the global financial crisis. This has led policymakers to adopt policies that try to ‘steal growth’ from other countries. History has shown that such policies can be disastrous, leading to one crisis after another. This was the theme of a recent lecture by the RBI Governor, Raghuram Rajan, who called for global coordination to put an end to policies that are inimical to global economic health. Given Rajan’s track-record of being prescient, it would only be wise to take a deep-dive into some of his observations and analyse them critically in context of the global economy.

The global financial crisis in 2007 saw a considerable decline in the economic growth of several countries from the highs of pre-crisis years. While the policymakers avoided a repeat of the Great Depression in the 1930s, the financial crisis nonetheless resulted in a long recession that lingers on even today. Even though governments pursued several stimulus policies, ranging from aggressive fiscal expansion to ultra-loose monetary policies, one wonders why growth did not rebound.

The potential growth mystery

As highlighted by Rajan, one plausible reason could be that the potential growth, defined as the rate of growth in GDP which is attainable at a constant and low inflation rate, in the industrial countries has declined. Rajan highlighted both demand and supply side factors that could have contributed to lower potential growth. On the demand side, an ageing population and greater concentration of wealth in the hands of the rich, whose marginal propensity to consume is small, have resulted in lower aggregate demand. On the supply side, productivity has declined in industrial countries as the low hanging fruits of infrastructure like roads, railways, flyovers, electricity, telephone have already been exploited. Rajan argued that the potential growth for the industrial world could remain low and unless countries take cognizance of this, policies that aim at increasing growth could be unsustainable.

But has the potential growth really fallen? To understand this better, let’s take a slight detour from Rajan’s lecture and look at evidence that supports or dismisses the lower potential growth hypothesis.

The hypothesis of a fall in potential growth does find evidence in a recent cross-country study by the IMF titled “Lower Potential Growth: A New Reality”. The study points to a fall in potential growth and concludes that industrial countries need to adjust to this new reality. Several prominent economists have also spoken in a similar vein. Larry Summers uses the term ‘secular stagnation’ to describe the fall in growth rates post the global financial crisis.  While Summers focuses on shortfall in demand to explain lower potential growth, Tyler Cowen has talked about supply-side challenges as reflected in the slow pace of innovation.

However, not everybody is convinced. Kenneth Rogoff has argued that the persistent fall in growth rates post the global financial crisis is due to the end of a ‘debt supercycle’ rather than secular stagnation. This basically means that the high pre-crisis growth rate was built on rapid increases in debt levels, and growth will rebound once the process of normalization in debt levels is complete. Thus, industrial countries are not stuck forever with lower potential growth.

Irrespective of what we attribute the slow growth of industrial nations to, it has unfortunately come at a time when it is politically inexpedient to commit to low growth. Unemployment rates have remained high post crisis, and some countries like Spain and Greece have been hit hard with half of their youth currently unemployed. To add fuel to fire, the crisis has brought to the forefront increasing wealth inequality and unfulfilled aspirations of many who have been left behind in the path to growth.

While the political need to revive growth is evident, the real question is how?

Let’s ‘steal growth’ from other countries

Most industrial nations have ramped up huge debt which leaves them with limited room for further fiscal expansion. Domestic demand is expected to be weak, irrespective of whether you would want to go with Larry’s lower potential growth hypothesis or Rogoff’s debt supercycle. Structural reforms could address supply-side issues to give a fillip to innovation, but such reforms are difficult to undertake and are politically infeasible given their long gestation periods. This leaves industrial countries with only one other channel to stimulate growth – through exports. And herein lies Rajan’s concerns on countries adopting policies to ‘steal growth.’

So what happens when a country has only the exports channel to boost economic growth? To make its exports more competitive in the global market, it adopts policies that apply depreciation pressure on its currency. Such currency depreciation will give a boost to its exports and shift demand away from other countries to its own, or effectively, ‘steal growth’ from other countries.

Given this, it is not surprising that the industrial countries have embarked on a strategy of unprecedented monetary easing- what is termed as ‘unconventional monetary policies.’ These policies consist of a commitment to hold interest rates close to zero for a long period and aggressive bond buyback programs to dampen interest rates on debt securities. While the impact of such monetary policies on reviving domestic investment has been limited, they have been successful in engineering a massive outflow of capital from industrial countries as investors seek yield elsewhere. In 2013, for instance, emerging markets saw capital inflow of USD 550 bn as compared to USD 120 bn in 2006. Such capital flows have exerted pressure on the currencies of the industrial nations to depreciate and, barring a few exceptions, have broadly led to appreciation pressure on currencies of emerging markets.

Will we learn from our past or continue the dangerous game of musical crisis?

Rajan’s concerns were reminiscent of the European mercantilist era from the 16th to the 18th century when countries adopted the ‘beggar-thy-neighbour’ policy to accumulate bullion through capturing a larger share of the world trade. While such policies took the form of colonization and monopolizing trade during the mercantilist era, it now appears that strategies to ‘steal growth’ have made a comeback in the form of unconventional monetary policies that influence capital flows and exchange rates.

History is testimony to the dangerous consequences that such policies can have – during the mercantilist era, they lead to military aggression between empires like that of Great Britain, France and Spain. In recent decades, capital sloshing across the globe in search for yield has ended in one crisis or the other. For instance, the capital flow from industrial countries for infrastructure financing in Asian economies during the 1990s ended with the Asian Financial Crisis in 1997. Subsequently, the decade of the 2000s witnessed a role reversal – with emerging markets routing capital to the industrial nations that ended with the global financial crisis starting in 2007.

Post the global financial crisis, the industrial nations reverted back to financing the current account deficits of emerging markets. As a result, we find ourselves again in a precarious situation today where normalization of interest rates in the developed countries can lead to a sudden outflow of capital from the emerging markets. This is a dangerous situation to be in and unless countries stop repeating the mistakes from the past, we are looking at a world that will be beleaguered by musical crises.

According to Rajan, the only way to rein in policies that may help one country but are inimical to the health of the global economy is greater global coordination in policy-making. However, given the immense political pressures that industrial countries face to restore pre-crisis growth rates, is the chain of musical crises inevitable?