The Hindu Business Line : Staving off a recession

The US Administration has resorted to a powerful combination of fiscal and monetary stimuli to avert a recession. Indian planners should not be averse to taking a lesson or two from the Bush-Bernanke effort. Will the Reddy-Chidambaram combine be ready with an answer, asks S. VENKITARAMANAN.

Last week saw a disturbing, almost catastrophic, fall in stock markets around the world. This has basically been triggered by the expectation of a recession in the US and its ripple effect on the markets. In spite of economists urging that India was not too dependent on exports to US and that India is decoupled from the US economy since its growth is led mostly by domestic consumption and investment outlays, the fear of recession in the US struck a blow to Dalal Street, which saw a fall of 20 per cent or more in the Sensex.

$140-billion plan

Ironically, on January 19, the US President, Mr George W. Bush, announced a $140-billion Plan to avert a recession, which the recent events in US financial markets arising from the sub-prime crisis, were threatening to lead America into, in the opinion of many analysts.

This plan is for a fiscal stimulus by way of reducing taxes, which is expected to induce the consumer to spend more. The details of the proposed Plan, which have been published, indicate that the US Secretary of the Treasury has spent considerable time on negotiating a bipartisan agreement with members of Congress on the proposal.

The authors of the plan felt that the package has to be big enough to make a difference to an economy as large as US and that, for this purpose, it should be at least 1 per cent of the US’ GDP. President Bush visualised that it should be based on a broad-based tax relief and not on spending projects that would have, in his view, little immediate impact on the economy.

Opinions are divided as to whether the relief will encourage a surge in consumption and investment for the American economy sufficiently to offset the threat of recession. Broadly speaking, the fiscal stimulus proposed by Bush corresponds to the proposal put forward recently by Mr Lawrence Summers, US Treasury Secretary under former President, Mr Bill Clinton.

The fact that the American administration has realised that the fisc has a role to play in stimulating the economy is worth noting. So long, the administration had relied mainly on monetary measures, such as reduction of lending rates and excess credit flow to stimulate the economy.

Fed Reserve moves

Close on the heels of Bush’s proposal, the Federal Reserve has also decreased the Fed funds rate by 75 basis points. All in all, a powerful combination of both fiscal and monetary stimuli! The Federal Reserve has seemingly reconciled the conflict that the US economy depends on capital inflows to balance its current account deficit. A lower interest rate, as decided by the Fed, may, in fact, affect such inflows. Be this as it may, the US President and the Fed have taken bold initiatives for averting a recession. This is all to the good.

The cost of the tax cut will naturally increase the national debt. The proponents of the proposal argue that this is preferable to the danger of loss of output, which a recession would have entailed. Far better is for the President to increase the fiscal deficit than face the loss of jobs and increase of unemployment, which a severe recession, brought on by the market collapse and consequential credit squeeze, would result in. How long the Congress will take to pass the necessary legislation, especially in this year of election is a billion-dollar question.

Hopefully, all potential candidates for the Presidential position are united in appreciating the need for a fiscal stimulus. It is also reported that a bipartisan agreement has been reached, thanks to the efforts of the Treasury Secretary, Hank Paulson. This should pave the way for quick implementation.

It is interesting that the last few weeks have seen a return of Keynesianism in many parts of the American economy. A few days ago, there was a proposal by Fred Bergsten, an American economist, to issue SDRs (special drawing rights) on the IMF as a solution to the dollar surpluses faced by various central banks. Now, the Americans have returned to the use of fiscal deficit to create jobs.

The above experience has a number of lessons for India. Whenever a financial system seizes up in a market-oriented economy, finance for investment and consumption suffer grievously. Both the RBI and Government of India should consider carefully how best the problems in a likely Indian market collapse can pose to our fragile financial system. It is no use quoting the Fiscal Responsibility Act as an impediment to action.

The recent financial crisis in the US has spurred a number of economists to study the experience of different countries on similar problems. An interesting study has been made by Carmen M.Reinhart and Kenneth S.Rogoff on the question: “Is the 2007 US sub-prime financial crisis so different? — An international historical comparison.” The authors have attempted to study the patterns of different crises in various rich countries. The majority of historical crises, they say, is preceded by financial liberalisation. But in the case of the US, there had been no striking de jure liberalisation. Certainly, there has been a de facto liberalisation, unregulated or lightly regulated financial entities have come to play in the US financial system.

This expert analysis of similar crisis in various rich countries appeared at the latest Annual Conference of American Economists’ Association. This was preceded by intense debate in the US media. The conclusion of the authors is that the historical comparison points to likelihood of a recession. The fear of the authors seems to have justified the initiatives of Bush and Bernanke.

Assurance and more

I hope the political masters of India will learn a lesson from the US experience. Above all, we have to realise that financial shocks to stock markets cannot be left to be handled by investors only. Monetary and fiscal action may be necessary to avoid the loss of jobs, which a credit squeeze-led recession may bring.

It is true that the Finance Minister of India has recently affirmed that the Indian economy is robust enough, its fundamentals are strong and investors should not panic. But the US economy was no less robust and its productivity and credit rating were high. Still, there was need for remedial action.

The failure of markets leads to a reduction in resource flow to various equity issues by corporates and can thus affect future investment outlays. The RBI and Government of India have to take into account the dangers of benign neglect of a potential grievous market collapse.

A mere assurance that India’s macroeconomic fundamentals are strong will not do. Both fiscal and monetary action may be needed. We should not be averse to doing a repeat of the Bush-Bernanke effort in India. Will the Reddy-Chidambaram combine be ready with an answer?

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