The Rocky Road to Recovery

The US Federal Reserve, which helped create the problems through a combination of excessive liquidity and lax regulation, is trying to make amends- by flooding the economy with liquidity, a move that, at best, has merely prevented matters from being worse.

In some ways, the Fed resembles a drunk driver who, suddenly realizing that he is heading off the road starts careening from side to side.

• The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system?
• Will America face a bout of inflation?
• Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us.

For a long time, the US has played an important role in keeping the global economy going. America’s profligacy- the fact that the world’s richest country could not live within its means—was often criticized. But perhaps the world should be thankful, because without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.

Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can’t spend it all.
The world’s unending appetite for oil, beyond its ability or willingness to produce, has contributed a third factor. Rising oil prices transferred money to oil-rich countries, again contributing to the flood of liquidity. Though oil prices have been dampened for now, a robust recovery could send them soaring again.

For a while, people spoke almost approvingly of the flood of liquidity. But this was just the flip side of what Keynes had worried about—insufficient global aggregate demand. The search for return contributed to the reckless leverage and risk taking that underlay this crisis.

We need not just temporary stimuli, but longer-term solutions. It is not as if there was a shortage of needs; it is only that those who might meet those needs have a shortage of funds.

1. We need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilize the economy, through what economists call ‘automatic stabilizers’. It would also help if the advanced developed countries fulfilled their commitments to helping the world’s poorest by increasing their foreign-aid budgets to 0.7% of GDP.
2. The world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.
3. A global reserve system is needed. It makes little sense for the world’s poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency could help fuel global aggregate demand, and be used to promote development and address the problems of global warming.
   This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?