Reflecting on the Great Recession - complacency and missed opportunity

Anis Chowdhury | Published: September 11, 2018 21:09:05 | Updated: September 17, 2018 21:30:23


A decade ago in September 2008, the investment bank Lehmann Brothers went belly up, dragging the global economy into the Great Recession; global gross domestic product (GDP) declined by -2.2 per cent in 2009. Lehmann Brothers' bankruptcy was preceded by the implosion of Bear Stearns, which had played with asset backed securities and bailing out of US government sponsored mortgage backers Fannie Mae and Freddie Mac.

The contagion of the US financial market turmoil into the rest of the world debunked the misleading hypothesis of a fundamental "decoupling of growth"between developed and developing countries, advanced by the Bretton Woods Institutions (BWI). Growth in developing countries as a whole declined from around 8.0 per cent in 2007 to 2.6 per cent in 2009 as the developed world experienced a negative growth of -3.8 per cent in 2009.

KEYNESIAN CONSENSUS AND ITS DEMISE: In the immediate aftermath of the crisis, a consensus rapidly emerged on the need for an activist response, as was formally mediated through the G20 proclamations in the London Summit of 2009. This included both a return to Keynesian macroeconomic policies including large-scale fiscal stimulus, supported by expansionary monetary policy, and a restructuring of national and global financial systems to reduce the danger of future crises, as well as additional funds for the International Monetary Fund (IMF) and the World Bank to support developing countries.These policy packages were largely successful in tempering the consequences of the global recession, although much more could have been done.

Sadly, however, this consensus was short lived. There was pressure to wind back fiscal stimulus because public indebtedness, rather than recession, was seen as the primary challenge. The G20 leaders at the 2010 Toronto Summit opted for fiscal consolidation, supported by two complementary initiatives: monetary policy accommodation to contain the contractionary consequences of fiscal consolidation and structural-cum-labour market reforms to boost supply-side sources of growth, especially in the advanced economies.

The Eurozone community responded by switching from stimulus to synchronised fiscal consolidation in response to a sovereign debt crisis in Southern Europe. Thus, the Eurozone countries fell into a double dip recession, while the unemployment rates in Greece and Spain rose to over 25 per cent as they were forced to swallow bitter pills of fiscal consolidation while bailout money from the European Union (EU) and IMF went to creditors.

There were also insidious trade restrictions, despite the G20 leaders' pledge to eschew protectionist measures in favour of enhancing trade openness. Reforms of the national financial sector and international financial architecture also stalled as policy coordination gave way to more nationalistic approaches.

IDEOLOGICALLY BIASED AND CALLOUS ANALYSIS: The intellectual backing for a retreat from the Keynesian consensus came from ideologically driven misleading empirical analyses by first Alesina and his associates and later by Reinhart and Rogoff. While Reinhart and Rogoff exaggerated the dangers of domestic debt, Alesina and his associates promoted the idea of expansionary fiscal consolidation - that any adverse impact of cuts in government spending would be more than offset by expansions in private spending with boosted investor confidence. The IMF devoted its May 2010 Fiscal Monitor ahead of the 2010 G20 Toronto Summit to destabilising impacts of public debt, and advocated rapid fiscal consolidation.

While both Alesina-associates and Reinhart-Rogoff studies were caught out for major methodological flaws and suppressed information, the IMF admitted that its advice for fiscal consolidation was based on the underestimated value of fiscal multipliers.Yet, ideologically driven policies continued despite rising unemployment and faltering growth in Eurozone that saw public debt-GDP ratio climb rather than decline.

The so-called short-term pains became prolonged sufferings for millions without any signs for promised long-term gains.

THE UN: AHEAD OF THE CURVE: The United Nations was ahead of the curve not only in forewarning about the impending crisis, but also in providing policy advice. For example, the United Nations 2006 and 2007 World Economic Situation and Prospects (WESP), warned about the possibility of a disorderly adjustment of the widening macroeconomic imbalances of the major economies as a significant risk to stability and growth of the world economy. It also warned that a reversal in house prices in one of the major economies, such as the US, could heighten the risk of default and trigger bank crises.

On the other hand, the IMF and the OECD (Organisation  for Economic Cooperation and Development) simply ignored these warnings and projected a rosy picture, and at worst a 'soft landing'. Both were more interested in chasing the 'fairy', and talking up investor confidence.

The April 2007 IMF World Economic Outlook (WEO) emphatically dismissed widely held concerns about disorderly unwinding of global imbalances, claiming that global economic risks had declined. In July 2007, it claimed: "The strong global expansion is continuing, and projections for global growth in both 2007 and 2008 have been revised up". Although the IMF's World Economic Outlook acknowledged the severity of the crisis that originated in a small segment of the US financial sector, in November 2008, it projected a global growth rate of 2.2 per cent for 2009 as opposed to WESP's base-line projected growth rate of 0.9 per cent.

The OECD June 2007 Economic Outlook insisted that the US slowdown was not heralding a period of worldwide economic weakness. "Rather, a 'smooth' rebalancing was to be expected, with Europe taking over the baton from the United States in driving OECD growth… Indeed, the current economic situation is in many ways better than what we have experienced in years."

The United Nations took steps to set up a commission under the leadership of Joseph Stiglitz to look into the impact of the crisis, especially on development and to recommend policies to prevent future such crises. Sadly, its findings and wide-ranging policy recommendations that included reregulation of finance to serve the real economy and reforms of international financial architecture to reflect the changed realities of the global economy were ignored, even though they were endorsed at a UN conference in 2009.

Ignored too was the UN Secretary-General's proposed Global Green New Deal (GGND) in 2009 to accelerate economic recovery and job creation while addressing sustainable development, climate change and food security challenges. It envisioned massive, multilaterally cross-subsidised public investments in renewable energy and small-holder food agriculture in developing countries.

The United Nations has been consistent in arguing for policy coordination and against premature withdrawal of stimulus packages.  Clearly, the policy-mix of structural reforms and fiscal consolidation was not working.

MISSED OPPORTUNITY, MISLEADING HYPOTHESES AND HEIGHTENED VULNERABILITY: As the UN's policy advice was disregarded, global economic recovery remained tepid for a prolonged period. This has prompted the misleading hypothesis of 'secular stagnation' to hide policy failures and missed opportunities to address structural weaknesses of the national economies and global economic governance architecture.

Meanwhile, another misleading hypothesis of 'inclusive inequality' has been invented to justify rising inequality of income and concentration of wealth, arguing that the deregulated system has made it easier for wealth accumulation as evidenced by a rising middle class. The vested interest groups blocked governments' attempts to rein in obnoxious executive salaries and boost wages of common workers, arguing that these measures dis-incentivise business and job creation. Policymakers have been forced to abrogate the redistributive role of fiscal policy by reducing top tax rates and widening the net of regressive indirect taxes, such as VAT, while cutting social expenditure. Non-conventional monetary policy (quantitative easing or QE) has also contributed to widening income and wealth gap as it fuelled financial asset bubbles.

QE or 'zero-bound' interest rate policy of major central banks also has made emerging economies more vulnerable, as short-term capital flowed into them in search of higher returns, resulting in rising dollar denominated external debt burden. Their currencies now risk free fall, as capital exits in response to monetary policy normalisation in the US, Europe and Japan - already evidenced by the crash of Argentina's peso and Turkey's lira.

Trump's trade war has only heightened the fragility and vulnerability of the global economy.

Unfortunately, having failed to re-ignite robust recovery and address structural weaknesses, developed and developing countries alike do not have much fiscal space to tackle a financial crisis that seems increasingly likely.

Anis Chowdhury, Adjunct Professor, Western Sydney University and the University of New South Wales (Australia), held senior United Nations positions in New York and Bangkok during 2008-2016.

anis.z.chowdhury@gmail.com

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