Opinion That sinking feeling

Actually,no one believes that the US will be able to reduce its debt over the next 10 years because the economy is showing all signs of having got into a long-term liquidity trap of the kind that afflicted Japan in the early 1990s. There is now a wide consensus on this aspect among leading economists. Simply put,a liquidity trap is a condition in which you keep trying hard to stimulate the real economy with excess finance capital (by printing money and reckless government borrowings). However,the lack of basic long-term growth impulse results in debt accumulating at a much higher rate than an increase in output or income.

For instance,Japan kept pumping more and more liquidity into the banking system to stimulate growth in the early 1990s after the twin collapse of both its stock and real-estate markets. But it managed to generate a long-term average GDP growth of just 1 per cent over the past 20 years. Economists feel the US is in a similar situation today. Its long-term average GDP growth had been 3 per cent in the past but could come down to a new normal of less than 2 per cent in the next few decades.

Also,Japan had pumped so much cash into the system that interest rates had come to near-zero and banks actually started discouraging deposits by charging the depositors a fee,rather than paying interest on small deposits. Last week,something similar happened in the Bank of New York which started charging for deposits! Of course,this was explained as a one-off event but big changes often have such small precursors.

A liquidity trap is characterised by a condition in which investment confidence is so low that there is a lot of cash lying around but no one has the confidence to invest it,largely because of the entrenched perception that real growth of income will not occur. American corporations are today hoarding about $2 trillion in cash but are not investing because they do not have the confidence that America will produce enough growth.

However,it takes time for investment confidence to get so low in the largest economy of the world,with a GDP of $14 trillion. The big factor that helped build this perception was the 2008 banking and mortgage collapse which brought global markets tumbling down. Emerging economies had a quick recovery because their fundamental growth impulse was strong.

The US and Europe have been struggling to return to their mean growth path. In both these erstwhile engines of global growth,massive monetary and fiscal stimuli have only resulted in the risk being transferred from the books of banks and indebted households to those of the government which seemed invincible in normal times. But then these are not normal times as governments have started to look extremely vulnerable. In fact,last week’s global stockmarket collapse began with a scare in Europe where Italian bonds became a target of speculative attack as they were subjected to large-scale dumping by bond holders. There was widespread fear that the European Central Bank,already saddled with the burden of bailing out Greece and Ireland,had no bandwidth to deal with Italy and Spain.

Europe was always seen as a bit of a laggard. However,the global markets had greater expectations from a quicker US recovery post-2008. That did not happen. The US authorities had pinned hopes on the two rounds of monetary and fiscal stimulus to help kick-start the economy. For brief periods in 2010,it even showed signs of revival before sinking again.

Consequently,in the absence of real growth,all we saw was liquidity-driven asset-price bubbles building up all over again in commodities and equities barely a year after the world suffered its worst recession. Driven by massive liquidity,the financial economy was yet again running way ahead of the real economy. Indeed,this was a classic symptom of a liquidity trap.

While the US economy may take long to come out of this vicious combination of accumulated debt and low growth,emerging economies like India will have to brace themselves for more volatility in the markets in the short to medium term. India will now have to start designing its macro-economic policies in a manner that would respond adequately to the emerging scenario. The global market crash last week brought down both stock and commodity prices. Lower international prices of commodities,especially crude oil and food,is healthy for India as it will be a growing importer of oil and food in future. However,another round of desperate monetary stimulus by the US could lead to a fresh round of speculative price build-up in oil and food. This needs to be seriously discussed at the G-20 meeting in France next month.

India will also have to prepare for the increasing internationalisation of the Chinese currency in this region. With the relative confidence in the dollar declining,China will push for greater weight being assigned to its currency in the IMF’s Special Drawing Rights (SDR). India too will have to analyse how its currency will evolve internationally over the next decade. It will be a pity if SAARC nations start adopting the yuan as part of their reserves ahead of the Indian rupee. Gradual easing of capital controls will become necessary as global money starts to chase safer instruments like the currency and government bonds of emerging markets in a big way. India will be called upon to rise to this challenge with internal reforms. Not doing anything will not work beyond a point.

The writer is managing editor,‘The Financial Express’
mk.venu@expressindia.com