Time to Revisit Capitalist Crises amid Global Slump
Recently, addressing a conference at the London Business School, Reserve Bank of India (RBI) governor Raghuram Rajan said the global economy is slowly slipping into problems reminiscent of the Great Depression of the 1930s. To him, it is time for the central banks across the world to define “the rules of the game” to find a solution. His prediction has triggered a debate among policy makers and economists.
Despite zero interest rates in developed economies, economic growth remains fragile and unemployment is high. But the poor return on fixed income securities has led to capital flight to developing economies where the interest rates are high, resulting in appreciation in the values of developing economy currencies. To protect their competitiveness, some nations like India are intervening in markets and others suggest capital controls. Such actions and reactions in markets could lead to depressionary tendencies.
The immediate cause of the Great Depression was the stock market crash of October 1929. Though it initially happened in the US, it soon spread to other countries which had trade and economic relations with the US. This led to a contraction of economic growth and huge unemployment. Most nations tried to solve this problem by devaluing their currencies against other currencies to increase their international competitiveness. This only led to a deepening of the depressionary spiral.
In macroeconomics, depression is one of the phases of a typical business cycle. The periodic fluctuation in output, employment and price level characterising market economies are known as business cycles. They refer to alternating rhythmic increases and decreases in the level of economic activity, sometimes extending over many years.
Phases of a typical business cycle are prosperity, recession, depression and recovery. Prosperity is a phase characterised by expansion in all macroeconomic variables such as GDP, consumer and capital expenditures, prices of raw materials, prices of finished goods, level of employment, inventory levels, bank credit, etc. The prosperity phase is followed by recession—a period of decline in total output, income, employment and trade lasting six months or longer. This downturn is marked by widespread contraction in many sectors of the economy. Recession can lead to a depression.
During the phase of depression, economic activity slides down the normal growth rate. All the variables decline rapidly. The rate at which they fall is high. Prices of output fall resulting in low profits. Entrepreneurs lose their motivation. Demand for all inputs decreases. Workers lose jobs. Debtors find it difficult to pay debts. Demand for bank credit falls. The weaker firms quit the industry and the level of national income declines rapidly. During depression firms may cut back output, retrench workers and purchase less raw material. Excess capacity adds to overhead costs. The Great Depression of the 1930s resulted in a 40 per cent decline in real GDP over a three-year period in the US and seriously impaired business activity for a decade. During the same period 30 per cent of the employed lost their jobs. International trade is estimated to have more than halved during the 10-year period of the Great Depression.
Due to anti-depressionary policies like effective fiscal and monetary policy interventions and government bailouts a recovery phase can set in. During the recovery or expansion phase, output and employment increase toward full employment. As recovery intensifies the price level may begin to rise before there is full employment and full capacity production.
The Great Depression was a serious macroeconomic event that engulfed the world 85 years ago. Though not of the same type the global economy is susceptible to similar challenges. The inequalities in the distribution of wealth in most countries, the plummeting commodity and real estate values, widespread unemployment and underemployment, recurring and prolonged recessions and similar economic setbacks are possible indicators of something very serious and critical yet to happen.
The governor and the deputy governor are the only spokespersons on RBI communication relating to important issues. The RBI has to communicate with great care, being aware of the damage a misunderstood message can inflict on financial market participants, households and business. To be effective RBI’s communication must be clear and credible. There is no reason to downplay the warning given by Rajan who is among the few to have rightly predicted the financial crisis triggered by the September 2008 collapse of Lehman Brothers Holdings Inc.
Rajan’s comments on the impending depression come in the backdrop of so-called quantitative easing by the US Federal Reserve and economic stimulus programmes undertaken by other central banks that led to a global gush of liquidity in the aftermath of the 2008 crisis.
The global economic environment has undergone much metamorphosis after the Great Depression of the 1930s. Now economies are stronger and have stronger policy making frameworks. A most recent IMF Working Paper authored by Bank of England economist Ambrogio Cesa-Bianchi and Alessandro Rebucci of John Hopkins University criticises Rajan’s view saying easing of monetary policy alone cannot be blamed for triggering a financial crisis. To them the bigger cause of a global recession or depression could be the absence of an effective regulatory framework aimed at preserving financial stability. They have made this conclusion after studying the global financial crisis of 2007-09 and the role of policies for stability of the financial system or economy as a whole at that time. It is to be noted that India was not much affected by that financial crisis since to a great extent India was insulated by the still-prevalent control Raj.
The important question to be answered is whether a depression of the magnitude of 1930s is inevitable, or rather if the global economy can afford one of those severities. The Great Depression resulted in massive levels of poverty, hunger, unemployment and political unrest. With the October 1929 stock market crash lakhs of investors lost nearly the entire value of their investments. In just a year after the crash 23000 people committed suicide in the US.
Many economists still believe that the Great Depression was the result of the unchecked ideology of capitalism in practice. It is time to revisit capitalism and capitalist crises. Definitely the world cannot afford a catastrophic depression which now is not inevitable with proper regulations in place.