What started as a mere financial crisis in the US has now manifested as a serious economic problem in many countries rendering the Governments and the Central Bankers helpless. The current crisis is comparable to The Great Depression as it impacts people from all walks of life. The road ahead looks gloomy with the writing already on the wall – its recession now in US, UK and Germany with many more countries on the verge of slowdown. It is high time we stopped pointing our fingers at somebody – and did our part in obviating a systemic collapse.
The relationship between ‘financial’ and ‘real’ economies is asymmetrical such that when the financial economy performs well, the benefits accruing to the real economy are lesser than the quantum of negative impact on real economy when the financial economy fumbles. With the financial crisis already hurting the real economy in many ways, two pronged strategy needs to be adopted. Needless to say the first task in hand is to check the financial market crisis (to arrest further problems in real economy) and the second is to restore the real economy.
Financial Markets Problem
The financial markets problem is the direct consequence of the sub-prime crisis. Blame it on falling housing prices, securitization, high leverage, lax in regulation or whatever; the direct loss is restricted to the erosion in the value of investments and job losses in the financial sector. Governments and Central bankers are doing their best to contain the problem from further swelling. The indirect loss is the impact on the real economy and is much severe.
The stakeholders in the financial crisis are few when compared to the numbers in the real economy where the whole system is under consideration. The financial markets sit on top of the real economy and have shaken the whole system.
The Real Economy Problem - Burning the rope at both the ends
As direct fallout of the global financial crisis, the following series of events have lead up to the recessionary fear: (Is US already into recession?)
Upon losing trust on each other, banks are reluctant to lend to other banks for overnight money requirements.
With banks running out of short term liquidity, cost of credit increases. The bailout package and other measures have injected liquidity into the system which has mitigated the problem only to some extent. With the liquidity problem not fully solved, banks are reluctant to lend in anticipation of credit squeeze.
The unavailability of credit and increased cost of credit has reduced consumption.
The quick and steep fall in prices of all asset classes – stocks, bonds, gold, real estate, commodities have eroded the value of assets held by people. The fall in prices has not only resulted in erosion of value of people’s savings but also has increased risk and pessimism in investments. People prefer to stash money neither spending nor investing. Hence the taps of liquidity in the financial markets go dry as the supply subsides.
Unavailability of credit coupled with reduced demand has urged producers to produce less. In order to earn profits, few producers are forced to mark up the prices. This leads to inflation only to introduce more problems.
Firms cut jobs due to declining profits
From a consumers’ perspective, all their savings are losing value against increased prices in consumption. It is like burning the rope at both the ends. Add to that the loss in jobs.
The reduced production has decelerated the GDP growth and has led to unemployment.
Today’s economic status quo is justified by the global financial crisis. Any further slowdown will be largely influenced by sentiments with inadequate backing up of real events.
Role of Sentiment: Is recession a perception game?
Sentiments are common in financial markets but I’m afraid today’s real economy is driven by sentiments. Real events needn’t drive real economy always. At times even perceptions or mere predictions can alter the rules of the game.
The recessionary fear in the minds of economic agents is justified but it should not be allowed to dominate the situation in determining the future state. The very thinking about recession begets recession quickly rather than obviating it. Here’s how stuff works: A consumer with such recessionary thoughts will try to cut down current consumption and save for future. A producer with such a thought will cut down production anticipating reduced demand. At the end of the day, the economic activity reduces and results in a shrinking economy. All stakeholders in the economic system stand to lose – thanks to the deadly perception.
It is at this juncture people have to exercise caution. Rather than falling prey to the perception, fear or just a prediction, let us fight recession. The deadlock has to be resolved:
Events 7-16 explain the deadlock
Don’t stash! Increase Economic Activities
Every stakeholder has to dirty his hand in solving today’s real economic problem. The collective fiscal action coupled with monetary actions will strengthen the defence against slowdown. Consumers should not cut back on their consumption levels but continue to satisfy their needs as they were during normal times. Producers should produce more deploying more capital even if it means considerable reduction in their retained earnings. The solution is similar to priming – you need a cup of water to run the air-locked motor initially and thereby pump more water. This leads to the spiral of growth.
Why wait till the economy recovers itself when someone can initiate it now? One group among consumers or producers has to take the first step in resolving the deadlock. Under the present cold economic condition hope the proposed solution brings in some warmth. This tacit agreement is not completely impossible. Only deliberate cheating can upset the apple cart. But I feel the solution might work well with a considerable number of participation. This might sound like textbook-solution strife with implementation challenges, but it also emerges as the best possible solution among the different alternatives available as of now. In sum let us ignore perceptions; allow our economy to be influenced only by tangible events by acting now. Are you ready to challenge the conventional wisdom?
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