Globalization of the US Recession

by Kanes
The little hope that the US economy could achieve a soft landing and the world could avoid a recession vanished with the horrific terrorist attack on the World Trade Centre and the Pentagon on the 11th of September, causing damages estimated at $ 60 billion ($ 20 billion in property damages and $40 billion in lost output). The economic landscape has changed. For months the American economy had been teetering near recession and the terrorist attacks have stuck such a blow to consumer confidence that most experts see the economy in recession. Consumers are abruptly pulling back, halting travel, postponing home purchases and putting off buying new cars.

The stock markets lost $ 1.4 billion in book value as shares plummeted faster than they had since the Great Depression; nervous investors dealt the stock market its biggest one-day point drop in history, with Dow Jones down by 14 per cent for the first week of trading since September 11. Airline bookings have dropped by more than 50 per cent and airline schedules have been cut; the estimated loss for September alone is $ 5 billion.

The authorities have enacted a $ 15 billion bailout for the airlines, but many experts say that even with the bailout, the weaker carriers will go bankrupt. Drop in air travel has adversely affected the tourist industry; occupancy rates in many hotels have fallen below 20 per cent. Airlines, aircraft production and the hotel and travel businesses have seen layoffs in the hundreds of thousands.

Drop in Air Travel

Within days of the terrorist strike, airlines announced plans to layoff more than 80,000 and with the drying up of orders for new aircraft, Boeing plans to lay off 30,000 employees. Job cuts in all the sectors, announced since the attacks are estimated at 144,540. American production is expected to shrink from now until the end of the year: growth in the European Union is also expected to be negative and Japan’s negative growth rate will now be even higher. These powers account for two-thirds of the world output and their recession will undoubtedly cause a slowdown in the global economy.

Recession in the US would reduce the consumer demand for electronics and other goods further and create havoc in the developing countries, particularly East Asian economies like Singapore, Malaysia and Taiwan which are highly export-oriented and excessively dependent on electronics exports and on the US market and Sri Lanka which is heavily dependent on garments exports to the US. Falling stock prices and wider corporate bond yield spreads as investors flee to quality mean higher capital costs for US corporations. That means lower investment both at home and abroad. Stock markets around Asia will reflect the fall in the US markets thereby further damaging corporate investment plans. Unemployment is expected to reach record levels. Until the US picks up there is little hope for a recovery in the developing countries.

Fiscal and Monetary Policies

A significant feature of the current downturn is that inflation is lower than in the previous ones. This leaves sufficient room to ease monetary policy to stimulate the economy. In fact, the Federal Reserve has cut interest rates eight times this year and reduced them from 6.5 per cent to 3.5 per cent. Interest rate cuts take effect through lower long-term bond yields, higher share prices and weaker dollar, but so far the long-term interest rates have fallen only slightly, share prices have actually fallen and the dollar still remains strong. Lower interest rates however have helped to sustain the demand for housing.

Monetary easing such as interest rate cuts generally take 6 to 12 months to take effect and when it does commercial lending to business and to consumers for purchasing cars and other consumer durables is expected to pick up and stimulate new sales. The current downturn, it is important to recognize, has been caused by over-investment and not a collapse in demand. The long expansion in the US in the nineties encouraged rosy expectations about future growth and profits encouraging over-investment financed by heavy borrowing. When there is excessive capacity in industry and an overhang of debt, interest rate cuts are less effective in reviving demand and new investment; it takes longer to purge financial excesses and over-capacity than it does to control inflation.

The easing of monetary policy in the US is also being accompanied by easing of fiscal policy. The US entered the downturn with budget surplus and this has made it easier for the authorities to cut taxes to stimulate spending. The authorities are already pumping $ 40 billion in relief and reconstruction money into the New York area and they will provide further relief of $ 50 billion in tax rebates to consumers and measures allowing businesses to write off investments against tax. In fact, the projected amount of Federal stimulus package under consideration to prop up the economy, including tax cuts, is estimated at $ 140 billion.

Fiscal and Monetary Easing

Fiscal and monetary easing is expected to fill the gap created by the consumer pullback. Some analysts point out that the high-tech collapse is now 18 months old and much of the wreckage of failed firms has been cleared away and most surviving firms are ready to grow again when demand turns up.

Some analysts want the dollar to fall in value to stimulate exports and revive the economy, but a big fall in the dollar may undermine confidence, knock share prices down and weaken consumer spending. It would also make it more difficult to finance the US current account deficit and consequently limit Fed’s room to cut interest rates further. The rise in the Euro and the yen as a result would weaken Europe and Japan and delay their recovery. Easing of monetary and fiscal policies rather than depreciation of currency thus appears to be more appropriate.

In Europe, easing of monetary and fiscal policies is hamstrung by the Stability Pact under which Euro-members are required to keep budget deficits and inflation below low specified ceilings. — 3 per cent of GDP for budget deficits. The European Central Bank has cut interest rates only once this year, to 4.5 per cent; it could have cut more particularly as inflation is declining and the Euro is gaining strength, but it is unable to do so by the fear of exceeding the ceilings. As the European economy needs to be stimulated by easing of monetary and fiscal policies, some suggest that the European Union reviews the Stability Pact and revise the ceilings.

In Japan, ten years after its real estate bubble burst, it is still in a mess. Prices are falling as consumers are not buying expecting the goods will be cheaper next week. Banks are crushed by bad debts. The reforms launched by Prime Minister Junichiro Koizumi to allow the bankrupt firms go to the wall will increase unemployment. In this situation, the Bank of Japan is expected to pump money into the economy to stimulate demand and let the yen slump to boost exports. This would, however, threaten to destabilize the Asian currencies.

Globalization Effects

The increasing cross-border trade and investment in recent years have bound the world economy closer together than ever before. It has integrated national markets into one global market and increased the interdependence between countries. This is what is described as globalization. The pivot of the process of globalization is the US economy, the largest trader and investor in the world and the largest market for both world’s exports and investments. Globalization has in fact integrated the economies of the world with that of the US and made all of them more dependent on the US economy than ever before. In good times, globalization spreads the wealth.

The astonishing growth of the US economy in the late nineties, fuelled by high technology and the strong dollar, spilled over into both developed and developing countries promoting their rapid growth and at the same time making them more entwined with the US economy. The US economy became their largest export market and the largest source of foreign investment while providing the largest financial market offering the most attractive investment opportunities to those who had investible surpluses. Thus, the US has become the engine of growth of the world economy and the forward gear of globalization.

We have seen in the last several years the brighter side of globalization when the booming American economic prosperity brought prosperity to other countries of the world. Now we see the darker side of globalization when the US downturn is devastating the rest of the world through globalization links. The high-tech boom has simply gone bust. After five years of remarkable growth, fuelled by an irrationally exuberant stock market that showered money on everything to do with the Internet, both businesses and consumers decided that they had all the high-tech gadgets they needed. High-tech firms had vastly overestimated demand with the result they are left with massive inventories on their shelves.

High-Tech Products

The downturn then spread to the rest of the manufacturing sector such as autos. The reduced demand for imports, particularly of high-tech products has hit the countries exporting them, such as East and South East Asian economies very badly and caused a recession in many of them. The recession in the East Asian economies, has in turn led to a shrink age of their imports from the US, Europe and Japan thereby aggravating their difficulties. Interdependence in the globalized world has generated a self-reinforcing feature to the economic upswings and downswings, magnifying their effects.

Globalization has thus made this recession more widespread than the former ones. In the 1991 recession, for example, although the US economy slowed down, the economies of Japan and Germany were booming thereby helping to cushion the fall in demand in the US In the 1997-1998 financial crisis, the crisis stricken countries in East Asia, Latin America and Russia were fortunate to have the US economy performing well to sustain their exports. This time, however, all the developed countries, the US, European Union and Japan are experiencing a slowdown. Industrial production is declining in the US, UK, Canada, Italy and Japan, and in the developing world in Singapore, Malaysia, South Korea, Hong Kong and Taiwan, in Asia and in Brazil, Columbia and Mexico in Latin America. Most countries are suffering the ill effects of over- investment and weak demand.

Vulnerability of Export-Oriented and Open Economies

The developing countries who are the biggest casualties of the US downturn are those which have liberalized their economies and embarked on export-oriented development. Mexico is the best example. Thanks to the North American Free Trade Agreement (NAFTA), some 30 per cent of Mexico’s GDP is generated by exports to the US linking Mexico’s fortunes to those of the US. This year the looming recession has cost Mexico a 4.4 per cent drop in shipments to US consumers and it is estimated to have very low growth. Brazil’s economic growth has fallen to a very low levels too this year — below 1.0 per cent. Brazil is the largest economy in Latin America and it is the key to the emerging situation in the region. Argentina is in a deep crisis and for months there have been fears that it would default on its large debt of $ 148 billion or devalue the currency, which is pegged at parity to the US dollar.

The IMF has, however, come to its rescue with a $ 8 billion loan; it fears that if Argentina defaults, investors will pull out from other emerging markets triggering a crisis. None of the Latin American countries have been able to achieve high growth or stability through free market policies; in fact, they have been living on foreign loans so long that their external debts are the highest in the world — Brazil $ 245 billion, Mexico $ 167 billion and Argentina $ 148 billion. Debt service as a ratio of exports of goods and services in 1999 was 110.9 per cent in Brazil, 75.9 per cent in Argentina and 25.1 per cent in Mexico.

The countries that are not expected to suffer much from the US downturns are those that have been slow to liberalize their economies and are not overly dependent on exports, like China and India. China is estimated to grow at 7.4 per cent in 2001 — perhaps the highest growth rate in the world, and India at 5.6 per cent. Both countries have opened their economies only to a limited extent and they have not financed their consumption and investment from foreign funds as the more open economies. The debt service ratio is very low: in 1999 it was 9.0 per cent of exports of goods and services in China and 15.0 per cent in India. They are not excessively export-oriented. Exports form only about 10 per cent of the GDP of India and 22 per cent in China as compared to over 100 per cent in Singapore and Malaysia and over 50 per cent in Thailand, Taiwan and the Philippines.