The Two Steps still needed for World Recovery

Andrew Smithers
Nikkei Veritas - Market Eye column, 26th February 2009

Two changes are needed before the world economy will recover. Banks must be refinanced so that they can afford to lend more, and demand must be stabilised. At the moment banks canít expand their loans as they have too little equity capital. To get around this problem they must either raise new equity or be nationalised. As it is difficult for them to raise new equity from investors, governments must provide the capital. While this is not the same as outright nationalisation, it is not so very different. Either way it requires decisive government action, which is currently lacking. Delay means further deterioration in the world economy with more bankruptcies, so that government indecision postpones recovery and increases the ultimate cost of bank bail-outs.

Demand is declining nearly everywhere and, as it falls, bankruptcies rise. While this continues, banks will be unwilling to lend even if they are able to do so. As interest rates are near zero, monetary policy on its own is unlikely to be able to stabilise demand and reduced taxes or increased government spending are also needed. But such fiscal stimulus is being resisted for a variety of reasons.

Private sector debt is already extremely high, particularly in the UK and US. Increasing public sector debt is often misunderstood as simply increasing the total debt burden and this seems to make no sense when the need is so clearly to reduce debt. But expanding government deficits tends to replace private with public sector debt, rather than increase the total. In Japan, for example, the fall in non-financial corporate debt was equal to three-quarters of the rise in net government debt from 1999 to 2006. A switch from private to public debt reduces bankruptcies and the damaging fears that go with them. It means replacing debts which may not get repaid, with those that will be. The process creates future problems, as it increases the risk of future inflation and adds to the tax burdens of future generations, but it is better than allowing the economy to slump today.

Individual people and companies can reduce their debts by repaying them out of cash flow. However, in aggregate this process tends to be self-defeating, as it involves increased plans to save and reduced plans to invest. But since savings and investment must be equal, such plans often cause demand to fall.

The need for fiscal stimulus is often misunderstood, particularly in countries which have had large current account surpluses, such as China, Germany and Japan. After World War II, the US accounted for half world output and had no current account deficit. It was thus able to use fiscal policy to stimulate its economy without worrying about its external deficit. Whenever world demand weakened, the US stimulated its economy, and exporting nations benefitted without needing to take any action themselves. Those days are gone. The major exporters now need to take a major role in boosting demand by fiscal stimulus and must not leave the burden to fall solely on the US. But politicians and voters in the exporting nations, which have been high savers, are even more resistant to fiscal stimuli than those in the UK and US. They see their past success as the reward for virtue, unconnected with the knock-on benefits from othersí fiscal policies.

Governments are in the process of dealing with the problems of the banks and with inadequate demand. They are working to improve bank balance sheets and to introduce fiscal stimuli. They have not, however, as yet done enough in either respect. They continue to meet resistance to the necessary refinancing of banks from those who mistakenly see this as a rescue for the banks rather than for the economy and also from bankers, who dislike the interference from the governments which will come with successful refinancing. At the same time, fiscal stimuli are opposed by those who misunderstand the debt problem.

We are slowly muddling our way to a solution of our problems rather than meeting them with prompt and decisive action. We should not therefore expect a speedy recovery to the world economy but, equally, we can reasonably hope that the necessary programmes will be introduced during the course of this year, so that we can look forward to recovery starting some time in 2010.