Since September 15, the global economy and financial system have been collapsing at an unprecedented speed. Now, in 2009, we're heading into uncharted territory, in which neither the depth nor length of the recession is known and the previous certainty of economic policy tools is in question.
The 1930s crisis wrought policy guidelines (monetary, fiscal and trade policies) that have allowed governments worldwide to avoid large swings in economic activity, to smooth the economic cycles, and to set economies on a path of constant economic growth.
In 2009 and beyond, the world is not facing a cyclical reduction of economic activity -- one that can be fought with lowering interest rates and a moderate stimulus package. Rather, we face a shift in the economic structure and secular financial certainties.
U.S. and Western Europe have become the epicenter of the turmoil. The collapsing real estate and financial asset markets in those traditional powerhouses are delivering the knockout punch to their citizens' conspicuous consumption.
The declining job market, which represents 71 percent of U.S. gross domestic product, has accelerated the collapse of consumption.
Decisions by households in the last decade to take on additional debt were made on several false assumptions: an ever-increasing real estate market; ever-increasing stock prices; and ever-present jobs. These forces are beyond the scope of economic policies to manage.
The $6.2 trillion valuation loss by the S&P 500 companies from October 2007 to December 2008 has had severe implications on both U.S. consumption and labor markets that can hardly be overcome by a mere stimulus package. Diminished retirement savings forced many close-to-retirement workers to remain in the labor force and many retirees to return to the labor force at much lower occupational levels. The barrage of job reductions is expected to help increase unemploymentsubstantially for several years, with real salaries decreasing.
The recent case in which investors were defrauded by Bernard Madoff's company of more than $50 billion was another blow to the most critical "currency" of the financial system: confidence. Lack of confidence between banks and financial institutions has already caused several security markets to disappear on lack of liquidity and lack of understanding of the underlying assets.
Macroeconomic projections for 2009 are being adjusted monthly as new actual data surpass previous recent projections. For example, the 6.7% unemployment rate released in November by the Bureau of Labor Statistics already surpasses the unemployment projections made for 2009 by the CBO in September 2008. Similarly, the International Monetary Fund revised downward its real GDP projections for the U.S. economy for 2009, just one month after releasing the World Economic Outlook in October 2008. Revisions are seemingly issued daily by the U.S. government or international institutions.
Given the uncertainty of the current forecast, there are two key questions to address: Are the current policy measures working? And how long will the recession last?
The challenges of introducing effective policies within this new economic environment are multiple, as the market has undergone a structural change.
Monetary Policy Challenges
Although reluctant at first, the Federal Reserve in 2008 used all of its tools to reduce the cost and increase the availability of money. Likewise, many central banks took decisive action, cutting rates and making funds available to institutions.
While lack of confidence among private financial agents remains, lowering the cost of money or making it more available has limited impact on stimulating demand. Banks have tightened their lending standards, perhaps overreacting to their own recent failures in proper due diligence, despite having more funds available and at a lower cost. It's the financially sound small businesses that are being severely affected.
Monetary tools -- because they have already been used to the fullest extent and are ineffective in the current financial environment -- are very unlikely to resolve this crisis. Although they were necessary to maintain the current economy, they are not sufficient to jump-start it.
Fiscal Policy Challenges
About 85 percent of the annual U.S. Gross Domestic Product (GDP) is comprised of personal consumption and private investment (71 percent and 14 percent, respectively). The other component of GDP, government spending, represents a mere 20 percent of GDP, and may represent the only tool that can jump-start the economy. (Note: Net export of negative 5 percent is the remaining component.)
Fiscal policy -- the use of government spending and taxation to affect the economy -- is the tool most governments are using at this point. However, government spending represents just 20 percent of the GDP. Each 1 percent decrease of personal consumption will require 3.5 percent in government spending to maintain the GDP level.
Searching For The Higher Multiplier
The purchase of goods and services by the government generates direct and derived economic activity that is a multiple of the original spending. That, in aggregate, can counteract the negative effect of reduced private consumption.
The government is acting to counter cyclical activity by increasing spending. The most critical task now is to choose projects with the largest multiplier effects. Those include long-term, efficiency-increasing benefits, such as infrastructure, and initiatives that help maintain the nation's long-term competitive position, such as education.
The magnitude of this crisis made clear that $600 stimulus checks will not bring the economy out of the doldrums. Rightfully so, the new administration is focusing on those structural economic policies that will produce higher economic efficiencies and a higher multiplier of public spending.
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