World recession: The way forward?

14 Nov 2008, 0000 hrs IST, Manoj Pant,

According to recent data, both the UK and US economies have shrunk (or at least certainly not grown) in the last quarter.
It is more than likely
that similar data will obtain for most of the other OECD countries in coming months.

We can also be certain that the shrinkage will continue (on a year-to-year basis) in the next year. Given the classical
definition of a recession as two or more quarters of shrinkage of economies, it would then be reasonable to assume that
the world is headed for a major demand contraction in the coming year.
As the financial meltdown translates into a decline in wealth (the stock markets and real estate markets) and income
(reduction in jobs), the world economy will suffer an almost certain contraction in the coming year. As I had argued in
this column last month, (US financial meltdown and India: ET, Nov 10) the similarities with the Great Depression of the
1930s are quite stark.
Two questions then are pertinent. First, are we in for four to five years of bad times as in the ‘thirties and how
important is the US to the solution? Second, what role can India and China play in any recovery? The last question
becomes particularly important given the invitation to these countries to the meeting of the G20 in Washington in the
middle of this month.
But first things first. It is interesting that some commentators have claimed credit for predicting the recession. The
usual argument is that the US was living beyond its means as reflected in its huge and growing trade deficits. (One has
been hearing this at least since 2000!) However, the growing trade deficits were matched by increasing inflow of foreign
investment into the US.
At the end of 2007, the stock of net foreign investment in the US was about $2.5 trillion and the surplus in yearly
trade in services like royalties, education, etc., was about $130 billion. Obviously, the rest of the world did not share the
same pessimism about the US economy. What seems clear is that the US economy (surprisingly like India in Asia) is a
net importer of commodities but a net exporter of services.
The recession is mainly due to a failure of expectations (as Keynes told us) which can be expected but never
predicted. The US simply happens to be the country where this failure of expectations manifested itself at the earliest.
However, as history warns us, pessimistic expectations are contagious and spread rapidly.
Recognition of this cause of any recession holds the key to understanding how 2008 is different from the 1930s.

The world economy today boasts of

several global coordinating mechanisms unlike in the ’30s. Thus, for example, there is a remarkable degree of
coordination today between central banks of various countries. Similarly, the WTO is a useful mechanism to combat
trade protectionism. We now know that tariff wars led to a major contraction in world trade in the 1930s.
The main problem in unilateral trade protectionism is that it is then extremely irrational for any one country to
reverse protectionism: only multilateralism works. This was in fact the rationale for the GATT agreement of 1948. Given
the globalised nature of today’s world, only multilateralism can reverse pessimistic expectations which also tend to be
self-fulfilling.
Does the US have an important role to play? The accompanying table gives some information. A recession is
always demand led. As the table indicates, the US has remained dominant, accounting for about 30% of world demand in
2007. It then stands to reason that the easiest recovery from recession will come about through demand recovery in the
US. It is also important to realise that, in this Keynesian world, mere increase in liquidity will not solve the problem of
expectations.
Governments will have to play an active role in stimulating demand thorough direct expenditure. It is not then
surprising that the first attempts in the US to stimulate demand by refund checks to individuals failed: given adverse
expectations the refunds only found their way to new savings.
From the accompanying table it is also clear that both China and India still constitute a very small part of world
demand. Hence it is unlikely that normal demand expansion in these countries alone would lift world demand.
However, developing countries also hold about 75% of world foreign exchange reserves of about $6 trillion. In
addition, the population demographics disfavour demand expansion in the developed world. Hence, in innovative
allocation of these reserves in developing countries along with a careful reading of Keynes lies a possible solution to the
recession. The Great Depression shifted focus from the Commonwealth countries to the US. Will the next shift be to
Asia? Is India ready? Only time will tell.
(The author is professor of economics, Centre for International Trade and Development School of International Studies,
JNU)