In October, Christine Lagarde, the International Monetary Fund (IMF)'s managing director, noted that seven years after the global financial crisis of 2007 the global economic recovery remained uneven and disappointing. She added that there was a significant risk that future growth would remain "mediocre" without concerted policy action. Similar sentiments were expressed by the Organisation for Economic Co-operation and Development a month later, setting the stage for the G20 Leaders' Summit in Brisbane in mid-November.
Since then, the United States Federal Reserve has terminated its most recent round of so-called quantitative easing (buying government bonds to boost its balance sheet). Its decision has been vindicated by official growth estimates for the third quarter being revised upward to 3.9 per cent at a seasonally adjusted annual rate and strong employment growth, in turn prompting a sharp rebound in equity markets.
While the United States recovery has gained traction, and the United Kingdom growth also seems robust, Japan and several European countries both within and outside the euro zone continue to flirt with deflation. This has prompted further quantitative easing in the first case and a strong expectation of the same in the second case. Given these diverging economic trajectories, the dollar has been engaged on a steady climb against most currencies. Meanwhile, the price of oil for near-term delivery, measured in dollars, has also declined sharply, with the drop gaining further momentum following the decision by the Organization of the Petroleum Exporting Countries at its meeting of November 27.
To a confusing global economic picture, geopolitics adds further uncertainties. Tensions in West Asia, discord between the North Atlantic Treaty Organization and Russia, and skirmishes in the seas around China further test economic resilience. Most recently, Greece has added its flavour to this stew by advancing its presidential election. The fear in markets is that this could trigger elections that would bring in forces hostile to the country's IMF-supported programme.
What now lies ahead, for the world, and, therefore, for India? It remains useful to go back to the financial crisis that began in 2007, and to follow three separate narratives. These are the advanced market economies, notably the United States, Europe and Japan; China; and the larger emerging markets excluding China.
For the United States and much of Europe, 2008 was what economists call a "balance-sheet" crisis, rather than a normal business cycle recession. The former is characterised by the destruction of wealth and the need to repair balance sheets in both the financial sector and in the real economy (corporate, household, government). The latter is driven by imbalances between total expenditure and available supply, reflected in inflation or a current account deficit.
As the current conjuncture demonstrates vividly, the two are deeply connected. By depressing demand, a balance-sheet crisis can and does lead to an imbalance between demand and supply. From the work of two American economists, Carmen Reinhart and Kenneth Rogoff (among others), we now know that such balance-sheet crises have been a feature of capitalist societies since the invention of banking, and that recovery, even in the presence of effective and timely policy, can take almost a decade. The so-called East Asia crisis of the late 1990s was also such a crisis, and the countries affected (Korea, Indonesia, Thailand, Malaysia) recovered at various speeds depending on the swiftness of policy response. The principal surprise this time around is that the crisis originated in the United States, which regarded itself as the most sophisticated and well-regulated financial system in the world.
What is most relevant for our discussion has been the nature, sequencing and relative speed of the United States response, despite a deeply divided political landscape. The United States authorities prioritised repairing a discredited and an unpopular financial system with public funds and chose to bear the political odium for doing so, deferring fiscal adjustment till recovery was well-established. There is still some distance to go, particularly in the labour and housing markets, and in the return of corporate investment. In addition, there is limited scope for additional policy response should the financial system suffer another shock. Fortunately for global adjustment, of the major advanced economies the United States is probably most willing to accept an appreciation of its real exchange rate, and thereby to provide a boost to demand elsewhere in the global economy.
By contrast with the United States, the specific institutional arrangements of the euro zone have impelled it to privilege fiscal adjustment over bank cleansing. The growth costs of this choice (or necessity) have been amplified by the reversal of capital flows from the peripheral members of the zone to the core, and by the greater reliance by European business on bank finance. As the case of Greece demonstrates, this delay is politically costly, although other programme countries, such as Spain, Ireland and to some degree Portugal, have a better story to tell. However, two major euro-zone economies, France and Italy, remain stagnant. Finally, Japan is once again making an attempt to break out of its deflationary mindset, but 20 years of low growth have significantly reduced its global significance.
The stories of China and of the other emerging markets are intertwined, but are fundamentally different. These countries did not suffer the same kind of banking crisis on this occasion (although they have before and could again), but arguably overdid their stimulus in response to the crisis. This was good for the global economy and for commodity exporters, both rich (Australia, Canada) and the less rich (Brazil, Russia, Indonesia), not so good for commodity importers such as India. But it has left China with massive over-capacity that, together with monetary policy tightening, is the source of its flirtation with "low-flation", if not outright deflation.
What then is the prospect facing India? Since early this year, Reserve Bank of India Governor Raghuram Rajan has warned that moves in the advanced countries to tighten monetary policy could cause ructions in global financial markets, and this is proving to be the case. Fortunately, the impact of Federal Reserve tightening is being considerably tempered by the continued easy money of Japan and the prospect of the same from the European Central Bank. The slowing of Chinese growth is similarly a silver lining with a cloud: its impact via low oil prices helps us, but it reduces demand for our direct exports and those of our neighbours. My overall judgement is that while the level of uncertainty has risen, the deeper trends are largely in India's favour. It is a moment, therefore, to be seized to put our own house in order.