Economists run out of rabbits to halt double-dip recession

Shanghai Daily, September 29, 2011

The massive volatility and sharp equity-price correction now hitting global financial markets signal that most advanced economies are on the brink of a double-dip recession.

A financial and economic crisis caused by too much private-sector debt and leverage led to a massive re-leveraging of the public sector in order to prevent Great Depression 2.0. But the subsequent recovery has been anemic and sub-par in most advanced economies given painful deleveraging.

Now a combination of high oil and commodity prices, turmoil in the Middle East, Japan's earthquake and tsunami, eurozone debt crises, and America's fiscal problems (and now its rating downgrade) have led to a massive increase in risk aversion.

Economically, the United States, the eurozone, the United Kingdom, and Japan are all idling. Even fast-growing emerging markets (China, emerging Asia, and Latin America), and export-oriented economies that rely on these markets (Germany and Australia), are experiencing slowdowns.

Until last year, policy makers could always produce a new rabbit from their hat to reflate asset prices and trigger economic recovery. Fiscal stimulus, near-zero interest rates, two rounds of "quantitative easing," ring-fencing of bad debt, and trillions of dollars in bailouts and liquidity provision for banks and financial institutions: officials tried them all. Now they have run out of rabbits.

Fiscal policy currently is a drag on economic growth in both the eurozone and the UK. Even in the US, state and local governments, and now the federal government, are cutting expenditure and reducing transfer payments. Soon enough, they will be raising taxes.

Another round of bank bailouts is politically unacceptable and economically unfeasible: most governments, especially in Europe, are so distressed that bailouts are unaffordable; indeed, their sovereign risk is actually fueling concern about the health of Europe's banks, which hold most of the increasingly shaky government paper.

Nor could monetary policy help very much. Quantitative easing is constrained by above-target inflation in the eurozone and UK. The US Federal Reserve will likely start a third round of quantitative easing, but it will be too little too late.

Last year's US$600 billion QE2 and US$1 trillion in tax cuts and transfers delivered growth of barely 3 percent for one quarter.

Then growth slumped to below 1 percent in the first half of 2011. QE3 will be much smaller, and will do much less to reflate asset prices and restore growth.

Currency depreciation is not a feasible option for all advanced economies: they all need a weaker currency and better trade balance to restore growth, but they all cannot have it at the same time.

So relying on exchange rates to influence trade balances is a zero-sum game. Currency wars are thus on the horizon, with Japan and Switzerland engaging in early battles to weaken their exchange rates. Others will soon follow.