Economics for everyone: Recession and its reasons
The global financial uncertainties were not entirely unanticipated but the intensity was not predicted nor was the duration expected. The outlook seems to be far more uncertain now forthe global situation than before… There will be considerable attention paid to this in the monetary policy
Prof. M. Guruprasad / 15:46, Jun 27, 2008
Recession And its Reasons
The US is slowing down and possibly heading for recession but India is growing at 8 per cent. Inflation fear has gripped the world. Turn the pages of any financial paper or Web site and the news and talk is only about how the general price level is rising much faster than at any time in more than the last decade.
It could not have come at a worse time. Growth is ebbing and the US is in recession thanks to its housing and mortgage crises. If central banks cut interest rates to stimulate growth, they risk inflation. And raising rates seems hardly the thing to do in the midst of an economic slowdown.
According to the RBI Governor Dr Reddy said, "The global financial uncertainties were not entirely unanticipated but the intensity was not predicted nor was the duration expected. The outlook seems to be far more uncertain now forthe global situation than before… There will be considerable attention paid to this in the monetary policy".
Alan Greenspan -- one of the most influential economists of our times -- described the sub-prime crisis in his book -- The Age of Turbulence. According to him the American economy was 'facing not a bubble but a froth -- lots of small, local bubbles that never grew to a scale that could threaten the health of the overall economy.'
Understanding Recession
The standard definition of a recession is a decline in the GDP for two or more consecutive quarters. However, this is still debated among the economists. Economists determine the amount of business activity in the economy by looking at things like employment, industrial production, real income and wholesale-retail sales. They define recession as the time when business activity has reached its peak and starts to fall until the time when business activity bottoms out. When the business activity starts to rise again it's called an expansionary period.
To understand the above concept further, it is important to understand the concept of business cycles.
Business Cycle
Business cycle refers to the periodic movements in the national income and output. The term cycle comes from the behaviour of these periodic movements. There is a period of rising output followed by a period of falling output, which is again followed by a rise in output. Many developed economies see such cyclical movements in their activity levels.
Business conditions never remain steady. Prosperity and boom are generally followed by panic and depression, which are in turn followed by revival leading to a new boom.
Fluctuations in total national output, income and employment, usually lasting for a specific period, marked by widespread and simultaneous expansion or contraction in many sectors of the economy. Recurring nature if the fluctuations and simultaneous and synchronized movements of several macro economic aggregates in the same direction are the major characteristics features of business cycles.
Phases of Business Cycle:
Business cycle can be broken up into four distinct phases: Peak, Recession, Trough and expansion.
Peak and tough represents the upper turning point and the lower turning point of the cycle respectively.
The peak is characterized by a high level of economic activity and is also referred to as the period of prosperity, while the trough is characterized by a very low level of economic activity and is also known as period of depression.Recession and expansion are the phases, which represents cumulative process, the former indicating a continuous movement on the downward direction while the expansion indicating a similar movement in the upward direction. During the phase of recession , production, employment, investment, profits prices are usually failing while in the phase of expansion all of them are usually rising.
The phase of recession comes to an end at trough where the reversal of the cumulative process takes place and the phase of expansion begins. The expansion phase comes to end at the peak where again the reversal takes place and the phase of reversal begins. Thus each phase of the cycle passes into the next trough the operation of certain economic forces trough the operation of certain economic forces, which may be either internal or external to the basic system.
Reasons
What are the factors, which cause income, employment, investment, etc., fluctuate in a regular cyclical pattern? To explain these factors, a large number of theories have been put forward by various economists. A variety of factors such as fluctuations in money supply and bank credit, underconsumption, overinvestment, clustering of innovations, interaction of the principles of the multiplier and accelerator, peoples expectation about the future etc., have been emphasized by different theories for explaining business cycles.
Various theories (factors) of business cycles can be broadly divided into two categories, external theories (factors) and internal theories (factors). In external factors, the basic cause of business cycles is found in events or factors outside the economic system like wars, revolutions, political events, growth and fluctuations in population, discoveries of new lands and resources, and finally scientific and technological innovations. The internal factors theorems emphasis on mechanisms or factors within the economic system such as money supply, over investment, under consumption, changes in consumption propensities and inducement to invest, etc.,
Many economists today agree that occurrence of business cycles is ideally explained, not by a single theory, but by a combination of theories, or more appropriately, but by a combination of external and internal theories.
One dominant practical explanation is linked to the expectations-linked behaviour of economic agents. Consider, for instance, a manufacturer. If he sees the level of activity going up, then he anticipates a higher demand for his goods in future and creates additional capacities. If all manufacturers think and act in a similar manner, the capacity addition is quite likely to overshoot what the demand can absorb.
This leads to over-capacity, higher inventories, falling prices and consequently a decline in output. Similarly in a downward trend, the producers are likely to overreact and postpone their investments leading ultimately to an excess demand position.
Impact Assessment
One way of assessing the impact of slowdown is measuring business confidence. Business confidence refers to the collective sentiment of the decision-makers in the enterprises in the economy. The assessment of the overall business conditions made by business leaders is likely to be based on far more information and 'ground feel' than what the common people are capable of. And secondly, this assessment is likely to get reflected in their future business decisions and would, thus, impact the course of the economy.
Macro Economic Policies Stabilization Policies
From the macroeconomic perspective the cause of business cycles can also be viewed in terms of demand shocks and supply shocks. Economists generally agree that business cycles are caused by both demand and supply shocks.
Demand shocks can arise from the private sector as well as the government. Fluctuations in private sector consumption and investment can generate instability and demand shocks. Demand shocks can also be caused by government actions - government expenditure, taxation and money supply. Supply shocks can, however, be generated both by theprivate sector and the government sector. In the private sector , cartel formations or monopolies, technological progress and trade unions are important factors: wage-price rigidity is considered by many as a very important factor for business cycles. The government can cause supply instability or shocks through credit policy, physical controls and regulations and proclamation of emergencies or wars.
Demand shocks and supply shocks thus, bring in the roles of stabilization policies for moderating business cycles or reducing the intensities of fluctuations in income, investment and consumption spending. Stabilisation policies, conventionally, take the form of fiscal (government expenditure and taxation) and monetary policies (interest rate and banking sector).
Economists from all schools of thought agree that to counter the extreme fluctuation (boom (expansion) and recession) and destabilization (in output, employment, prices and other economic factors) caused by business cycles we need to apply appropriate corrective measures in terms of monetary and fiscal policies.
Analysis of the Current Scenario
Having gone through the basic factors governing recession or business cycle let us have a look at the current slow down in U.S and its impact on India
The recent recession is a culmination of various factors
Internal Factors
Prima-facie the current crisis in the U.S. is basically a housing-led (read sub-prime crisis) slowdown. The crisis has its effects on the stock market and causes heavy volatility and affecting the investors and this overall affects consumers and thus consumption. All these factors cause the slowdown.
Some experts view that this crisis has the potential to be far deeper than the collapse of the dotcom boom at the start of the decade. The decline in home prices is causing a broader set of problems than what was witnessed during the technology bubble.
The indications of slowdown were there during the start of 2008. Infact, the US Commerce Department confirmed that the US economy grew by 0.6pc in the last three months of 2007.Fresh economic data also revealed that the number of jobless claims in the US rose by 19,000 recently to a seasonally adjusted 373,000, showing a weakening labour market. It is estimated that as many as two million Americans could lose their homes as a result of the sub-prime crisis this year
External Factors
According to Nobel Prize-winning economist Joseph Stiglitz,the Iraq war has cost the US 50-60 times more than the Bush administration predicted and was a central cause of the sub-prime banking crisis threatening the world economy. According to the former World Bank vice-president said the war had, so far, cost the US something like $US3trillion ($3.3 trillion) compared with the $US50-$US60-billion predicted in 2003. The spending on Iraq was a hidden cause of the current credit crunch because the US central bank responded to the massive financial drain of the war by flooding the American economy with cheap credit. "The regulators were looking the other way and money was being lent to anybody this side of a life-support system," he said. That led to a housing bubble and a consumption boom, and the fallout was plunging the US economy into recession and saddling the next US president with the biggest budget deficit in history, he said.
Stabilisation Policies
On the lines of stabilization the U.S government is planning a government-led funding package and plans such as to encourage mortgage lenders to ease restrictions on certain borrowers in tandem with fiscal policy are being worked out.
Indian Scenario
India and in general any developing country in Asia will face the following challenges
[*]Impact of the slowdown on the IT/ITES industry (Indian companies have major outsourcing deals from the US).
[*]Impact on the Stock Markets
[*]Impact on Indian Exports.
[*]Impact on Indian Rupee
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Already India is facing a huge challenge of rising Oil prices and Inflation. With the signs of slow down, could it be a "Stagflation" (- where stagnant economic growth and inflation coincide)
All these may be a farfetched assumption considering the strengths of both Indian and the U.S and the Indian Economy.
While the U.S. is too big to be eclipsed by this crisis, the Indian economy is fast growing and progressive. With so many instruments of stabilization policies with the policy makers in both the economies along with the inherent economic strength of these countries, the impact of the slowdown may be is selected sectors and for specific period of time. As we can observe prospective investors, consumers and the employers are still bullish about the Indian market.
Prof. M. Guruprasad
Aicar Business School