Fighting the Global Slump: Less Is Dangerous

Amid a debt-deflation spiral, the governments' greatest risk is enacting stimulus measures that are too little to fight the slump
Richard Mia

For more than six decades, through oil shocks and terrorist attacks, the world's advanced economies have managed to expand their collective output at least a little bit each year. But that long lucky streak is probably about to end, a victim of the severe global credit crunch. The International Monetary Fund is now projecting that 2009 will bring the first aggregate decline in economic output in advanced economies since at least World War II.

The IMF still expects China and other developing nations to grow next year as a group, but it warns that "downside risks to growth, even for the emerging economies, remain significant." Some economists are even gloomier. "There is a very severe deleveraging which you can't stop," says Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington. "My guess is that [even] if we have good economic policies, the world will see a [gross domestic product] fall of 10%... . This is global, and it's fierce."

Even if things don't get that bad, it's clear that we're deep in uncharted territory—or at least territory that hasn't been explored since the Great Depression. Economists and policymakers are floundering. Since they don't know how severe the recession will be, they don't know how extreme their measures to combat the downturn should be. U.S. Treasury Secretary Henry Paulson, who has struggled to find a path for American policy, defended himself in a Nov. 18 op-ed article in The New York Times, saying: "There is no playbook for responding to turmoil we have never faced."

The greatest risk at the moment is that governments will do too little to fight the slide. BusinessWeek estimates that governments around the world have committed more than $2.6 trillion for bank bailouts and other efforts to spur growth. But even that may not be enough. Germany, the powerhouse of Europe, has moved only haltingly to stimulate its economy, fearing that aggressive steps might cause inflation. Holger Schmieding, chief European economist at Bank of America (BAC) in London, says Germany's tax-cut plan "is so small, I wouldn't even count it." Japan, once again in recession, remains unable to muster the energy to break out of an off-and-on performance that dates back to 1990. Britain, Ireland, and other nations with big government deficits are reluctant to spend too much on stimulus for fear it could invite a speculative attack on their currencies.


The U.S., where the crisis originated, may also be moving too slowly given the depth of the slump, many economists say. Washington is unlikely to pass a substantial stimulus package until after the new Congress and President take office in January. On Nov. 18, Treasury's Paulson clashed with lawmakers who want him to spend some of the $700 billion Troubled Asset Relief Program on aid to homeowners. Paulson said TARP is supposed to bolster financial institutions and "was not intended to be an economic stimulus or an economic recovery package."

The problem with slow or tentative measures is that they could allow the worldwide downturn to gain a momentum that would be even harder to reverse later. The lack of quick and massive intervention may have been one of the reasons why the Great Depression, which began in 1929, lingered until the outbreak of World War II revved up the war machines.

An unprecedented debt overhang is what makes this downturn both severe and hard to forecast. Consumers, particularly in the U.S., overborrowed to buy houses, cars, toys, and vacations. The bubble in housing prices misled lenders into thinking the loans were well collateralized. A similar dynamic was at work in other kinds of secured lending. Now the spiral has reversed. The declining value of collateral is causing lenders to withdraw credit. That forces borrowers to sell assets to raise cash, pushing prices down further in a vicious cycle.

Hardest hit are small, open economies such as Ireland, Iceland, and Taiwan (all island nations) that were exemplars of globalization and financial innovation just a few years ago. They relied even more than the U.S. on free flows of trade and investment. But big European countries such as Britain, France, and Italy also feel their ability to stimulate is limited. "The British government has been wildly promiscuous with public debt over the last 10 years," says Geoffrey Wood, an economist at Cass Business School of City University London. He says British public debt "will inevitably take its toll on the pound. There's no logical floor for how long it could go against the dollar."

Least affected are several big countries, such as China, that are beginning to switch from export-driven growth to domestic demand. The IMF expects China's economy to expand 8.5% in 2009—not bad, albeit the country's first year of single-digit growth since 2002. Beijing announced plans for $586 billion in stimulus over two years to keep things humming. Indonesia, surprisingly, chugged ahead at a 6.4% rate in the third quarter, driven by domestic demand. And sub-Saharan Africa is also likely to be spared, if only because much of it is desperately poor and barely tied to the global economy.

The world economy's ordinary shock absorbers are inadequate for a crisis of this scale. Central bank reductions in interest rates are becoming less effective because people are afraid to borrow no matter how low the rate. And of course, rates can't be cut below zero.

As a result, governments are being forced to turn to spending programs that are not part of their usual recession-fighting arsenal. In addition to the usual tax breaks and rebate checks, they are resorting to government loans and investments in financial institutions, as well as debt guarantees aimed at restarting private lending. Many countries are pursuing all three.

The bad news is that government responses do not yet match the scale of the crisis. The good news, on the other hand, is that governments have more elbow room than usual to borrow and spend because, with the plunge in commodity prices and slack in labor markets, inflation is no longer an immediate threat. On Nov. 19 the U.S. Bureau of Labor Statistics reported a 1% drop in consumer prices in October—the biggest monthly decline since the bureau began tracking those figures in 1947.

Recognizing the risks of a debt-deflation spiral, aides to President-elect Barack Obama are working on plans to ask Congress to spend up to $500 billion more. Other countries may have to follow suit. In the end, a synchronized recession will require synchronized stimuli.

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