The Hindu Business Line : Tortuous route of US recession

The origins of the current US recession lie in the sub-prime crisis and the consequent housing boom bust. Soaring oil prices have also added to the woes. The lessons for India are stark. Banks and FIs must follow strict prudential norms while advancing housing loans to prevent the boom from going bust, says ALOK RAY.

Economists define “recession” as falling GDP for two consecutive quarters. According to that definition, recession has not yet arrived in the US. But it is very much in popular mind. Further, policymakers can not wait for its announced arrival to take corrective action, as it would be too late to avert it. It may even be counterproductive.

Fiscal and monetary policies take time to have their full impact. If the timing of stabilisation policies is wrong, it may aggravate the business cycle. For example, expansionary policy to fight recession may impact the economy at a later time when the economy on its own has started to move up. In that case, it may stoke inflation.

At this time, many economists believe that the US economy is definitely going to go slow down for quite some time, increasing the unemployment rate and at the worst a recession may have already started.

Mr Ben Bernanke, the Chairman of US Federal Reserve, has asked the US Congress for an immediate fiscal stimulus package to avert a recession. In addition, he has brought about the largest single-day cut in the benchmark interest rate (fed fund rate) in recent memory to stimulate the economy, on top of several rounds of smaller interest rate cuts.

How did the economic downturn come about? What are the likely consequences? The questions are important since what happens in the US economy would have significant impact on the rest of the world, including India. Moreover, do we have some lessons to learn from what happened in the US?

Housing sector

The problem in the US started in the housing sector. For quite some time, greedy banks – with the help of officials and brokers getting hefty cuts from the deals – were pushing loans to people to buy houses.

As a result, some people got more loans than would be justified by their credit standing. So, they bought more expensive houses with loan money than they could really afford. It helped create a housing boom. Inevitably, some of the borrowers failed to pay back the loans, especially when the interest rates were adjusted upwards under variable interest rate mortgages. Banks and other financial institutions now began to be saddled with bad loans. The housing bubble burst. When finally prices of houses fell below a threshold, the amount of loans advanced by banks could not be recovered even by selling the houses against which the loans were given. Financial institutions, faced with losses, were then forced to cut back credit not only to the housing sector but to other sectors as well. In addition, people became poorer as the market value of their wealth (houses) plummeted and felt the need to tighten their belts. The trouble originating in the so-called sub-prime mortgage market spread to the rest of the economy.

The oil factor

Another aggravating factor was rising oil prices. As people had to spend more and more on transportation costs, they had less to spend on other goods. It pushed the economy further downhill.

Now, the latest figures show a rise in unemployment rate in the US after a long time. Naturally as people lose jobs and income, they are forced to cut back spending. Even people with jobs, when faced with a greater chance of losing jobs, would try to reduce expenditure and save more for the rainy day. That is further bad news for business sales, production and jobs.

The US stock market (Dow Jones index) has already fallen by more than 10 per cent since January 1. The jitters from the US market have spread to stock markets all over the world. One reason is that the risky sub-prime mortgage loans by US institutions have been converted by Wall Street investment banks into securities (in technical jargon, “derivatives”) under various fancy names in which financial investors from all over the world (like even the Chinese central bank) have invested. So, their positions too have become vulnerable and the full extent of their exposure is not yet publicly disclosed. The prevailing uncertainty is causing wide gyrations in global stock prices.

Weakening dollar

Meanwhile, US dollar has been steadily falling against Euro, Yen and many other currencies. As American goods and services become cheaper, US trade deficit may shrink, creating some net demand for US goods which would help the US recovery. At the same time, for foreigners, US is becoming an increasingly cheap place for buying assets.

Using the opportunity of a cheap dollar and several major US financial institutions (involved in housing market loans) desperately looking for bailout money from anywhere in the world, sovereign (government) wealth funds from Asia and West Asia (like Singapore, South Korea, Saudi Arabia, Kuwait) are buying up significant stakes in flagship US financial institutions like Citigroup, Merrill Lynch and Bank of America.

The US is facing a takeover of significant parts of its economy by agencies closely connected with foreign governments which a lot of American politicians view as security risks.

The Fed Chairman has already gone for several rounds of interest rate cuts (monetary policy) which is under his control. But the expansionary monetary policy has not yet succeeded in averting the slowdown. In theory too, monetary policy works only with a considerable lag.

So, Fed now wants to take the help of expansionary fiscal policy for a more immediate effect. But, cutting taxes or increasing government expenditures (fiscal policy) is in the domain of the US Congress. Both the Fed and the US administration at this moment are considering fighting unemployment to be the top priority (especially in an election year) even at the risk of some rise in inflation later.

Now, enter politics and lobbying. Most economists agree that, dollar for dollar, temporary tax rebates to low income people and more government expenditures like higher unemployment benefits would stimulate expenditures more immediately and by larger amounts than tax cuts or investment credits granted to business. This is because poorer people would spend a larger fraction of any additional income than a richer person and it is doubtful whether investment credits can stimulate investment spending in a recessionary situation where already existing production capacity is remaining underutilized.

Though many Democrats want a package that would include a rise in unemployment benefits and food stamp entitlements targeted mainly to the poor (their solid vote bank), many Republicans want tax concessions to business (their support base) as part of the stimulus package.

Finally, President Bush has agreed to a $150-billion compromise package which gives temporary tax rebates to low and middle income taxpayers (the unemployed and the poorest families are not taxpayers and hence they would not get these additional benefits) as well as some business investment incentives.

Lessons for India

What are the lessons for India? Country after country — both developed (like Japan and now the US) and developing (like many East Asian countries) — has gone through the housing boom and bust cycle. India is currently in the boom phase. Utmost care needs to be taken by the RBI and Finance Ministry to ensure that strict prudential norms are followed by banks and financial institutions while advancing housing loans and any violation should be severely punished.

It is very difficult to prevent the contagion effect of a burst housing bubble from spreading to the rest of the economy. The US has at least one advantage over many other countries. The debt of US banks, when they have borrowed money abroad to finance their loans at home, is fixed in US dollars. Hence, the debt burden for US banks does not go up even when the local currency depreciates. Other countries are not so fortunate.

So, countries like India need to be particularly watchful against foreign currency loans being used by banks to finance domestic currency investment in real estates. The extra caution may slowdown the real estate boom and lower our GDP growth rate a little. But it is preferable to subjecting our economy to the severe fallouts of a real estate bust at a later point of time.

(The author is currently a Visiting Professor of Economics at University of Pittsburgh, US. E-mail: alokray15@yahoo.com)