Wait till 2011 for economic bounce

Governments across the globe are using Keynesian stimuli to revive drooping economies. Even George Bush has presided over the greatest stimuli in US history, with a projected fiscal deficit of $1.2 trillion and monetary injection of almost $2 trillion by the Fed.

But is the recession Keynesian? Trillions of dollars of stimuli have failed to end the downswing. Keynesians argue that even trillions are not enough. Really?

The current recession looks more Hayekian than Keynesian. A Keynesian recession represents a sudden fall in demand, and can be remedied within six months by pumping enough purchasing power into the economy. A Hayekian recession, however, is caused by misallocation of resources over a long period, driven by unrealistic interest rates, ending in a bust that requires years of structural adjustment. Such a recession can last a decade (as in Japan in the 1990s).

The many recessions between World War II and the oil shock of 1973 proved amenable to Keynesian remedies. But 1973-80 witnessed a Hayekian recession, caused by excess pumping of money into economies in an attempt to stimulate them. Rising trade union demands meant that the stimuli translated into higher wages and inflation, not higher production.

After this era of stagflation, economists could hardly utterly the word ‘Keynesian’ without a snigger — it had become a joke.

However, the recessions of 1991 and 2001 were mild affairs remediable by Keynesian stimuli. Keynes was back in fashion. So, when the subprime mortgage crisis hit the US in 2007, it responded with Keynesian nostrums. But to no avail.

Politicians want to be seen as quick and effective. They love Keynesianism, which puts them in the driver’s seat, allowing them to portray recessions as caused by greedy business villains, and paint themselves as rescuers.

But Hayekian recessions occur when politicians themselves distort the economy for years, creating misallocations of resources that ultimately prove unsustainable. The consequent bust cannot be ended by pumping in more money. Rather, the entire economic structure must change to correct the historical misallocations, and make future growth sustainable. This involves wrenching changes in individual, corporate and political behaviour. Neither the public nor politicians are quick to acknowledge a Hayekian recession.

They would rather hope it is Keynesian, remediable by pumping in more money. Yet at some point somebody will surely declare that Emperor Keynes has no clothes.

The current recession is deeply structural. For a decade, the US has run the biggest trade deficits in history, matched by corresponding trade surpluses of China, Opec, and other Asian countries. After the financial crisis of 1997-99, many Asian countries swore to build large forex reserves to avoid another debacle. So they deliberately undervalued their exchange rates, ran large current account surpluses, and so generated large forex reserves. This had to be mirrored in correspondingly large current account deficits in some other countries. The biggest turned out to be the US.

This defied conventional economic logic. Normally, rich countries run trade surpluses, and send their excess savings to poor countries with scarce capital that are running trade deficits. This normality was turned on its head by Asian countries determined to build large forex reserves after the trauma of 1997-99. These forex reserves went mainly into US gilts.

Suddenly the world was flooded with money. The US trade deficit sent a flood of dollars into Asia and Opec, which then flooded back into US financial markets, mainly through forex reserves. Bernanke called this the Asian savings glut. The flood of dollars drove down long-term interest rates, especially in the US, and drove up asset prices. It became highly profitable for Americans to borrow cheaply to invest in houses, stocks and commodities. Even when the Fed raised short-term interest rates in 2006, long-term rates remained low because of the flood of money from Asia. Innovations in the US financial system, some productive and some mere con-games, encouraged leverage by everybody — individuals, corporations, banks, speculators. This was classical Hayekian misallocation.

This misallocation yielded mouth-watering short-term gains. It proved a huge stimulus for the global economy, which grew at its fastest rate in history in 2003-08. Record US trade deficits sucked in record imports of manufactures from Asia and oil from Opec. Asia in turn bought record quantities of commodities from Africa and Latin America to be converted into manufactures for export. Thus the whole world economy boomed as never before, and so did asset prices.


Yet the boom was patently unsustainable. American households, who historically saved 6% of disposable income, started saving nothing at all, and dipped into their wealth to spend as never before. Today, this seems terribly irresponsible. Yet the boom had hugely increased the wealth of Americans, and it was logical for them to spend part of this wealth. The spending spree was subsidised by artificially low interest rates, which also generated bubbles in the markets for houses, stocks and commodities.

These bubbles have now burst. A Keynesian stimulus amounts to an attempt to re-inflate those bubbles. That is neither practical nor wise. The US government in 2008 mailed $80 billion to households to stimulate spending, but households spent only $12 billion of that and saved the rest — they knew, even if politicians did not, that the old spending spree had to stop.

The world — and India — must accept that the global boom of 2003-08 was based on an unsustainable economic structure. In future, Americans will have to save much more (and export more), and Asians will have to consume much more (and export much less) to end existing global imbalances. This Hayekian adjustment, which started in 2007, may take years to complete.

So, the global — and Indian — economy may not revive in mid-2009. Even if it does, the recovery may be so weak as to count for little. Hayekian theory suggests that we may have to wait till 2010 or 2011 for a sustained economic bounce. One ray of hope: the current recession may be partly Keynesian, even if mainly Hayekian. That may diminish its travails.