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A Time to Experiment

CAMBRIDGE: The world economy enters 2009 with more uncertainty (and anxiety) than at any time in recent memory. Although the financial crisis appears to be contained in the United States and Europe, its full repercussions will not be clear for some time. The advanced countries are in for the worst economic downturn since the Great …

CAMBRIDGE: The world economy enters 2009 with more uncertainty (and anxiety) than at any time in recent memory. Although the financial crisis appears to be contained in the United States and Europe, its full repercussions will not be clear for some time. The advanced countries are in for the worst economic downturn since the Great Depression. But how long and deep will this recession be, and how badly will it affect emerging and developing nations?

We don’t have the answers to these questions, in part because the consequences will depend on what actions policymakers take. The right responses will ensure that the world economy can begin to recover by late 2009. Poor policy choices, on the other hand, will at best delay recovery and at worst do permanent damage. Here is a list of things to watch for.

Will the US response be “bold enough?

Barack Obama has promised that it will be, echoing at least part of Franklin D. Roosevelt’s famous call for “bold, persistent experimentation at the height of the Great Depression in 1932. Obama has a first-rate group of economists on his side, which ensures that he will not do anything silly. But America’s circumstances are sufficiently exceptional that he will need advisers who are willing to try new, untested ideas – in other words, experimentation à la FDR.

In particular, he will need to go beyond Keynesian fiscal-stimulus policies to heal the deep wounds to economic confidence that lie at the root of the current crisis. So far, confidence-building measures have been limited to financial markets, through public guarantees, liquidity support, and capital injections.

But workers who worry about being laid off are unlikely to go spend, regardless of how much money fiscal stimulus puts in their pockets. Just as banks are hoarding cash, households will try to preserve wealth by increasing their saving. So incentives targeted directly at preserving employment will have to be part of the solution.

Will Europe get its act together?

This could have been Europe’s moment. After all, the crisis originated in the US and left American policy focused on its domestic troubles, opening up room for global leadership by others. Instead, the crisis demonstrated the deep divisions within Europe – on everything from financial regulation to the requisite policy response.

Germany has dragged its feet on fiscal stimulus, stymieing what should have been the second leg of a globally coordinated fiscal action plan. If Europe wants to pull its weight on the global stage, it will have to act with greater unity of purpose and shoulder a greater share of responsibility. Alas, the best that can be hoped for at this stage is that Europe will not undermine the global fiscal stimulus that even the International Monetary Fund, the guardian of fiscal orthodoxy, regards as absolutely essential.

Will China hold together?

Even though a weak US response is the biggest risk on the economic side, what happens in China may well have deeper and more lasting consequences on the broader historical canvas. For China is a country of enormous hidden tensions and cleavages, and these may erupt into open conflict in difficult economic times.

Experts on China differ on the rate of economic growth needed to create employment for the millions of Chinese who flock into the country’s cities every year. But it is virtually certain that China will fall short of this threshold in 2009. This explains the almost continuous stream of measures that emanate from Beijing these days: increased public spending, monetary easing, pressure on state enterprises to expand activity, subsidies to exporters, partial convertibility of the remninbi to spur trade with neighboring countries, and so on. But will this do enough to stem the slowdown in an economy that has become hooked on external demand in recent years?

If social tensions rise, China’s government is likely to respond with greater repression, which will bode ill both for its relations with the West and for its medium-term political stability. Experience shows that democracies hold the edge over authoritarian regimes when it comes to handling the fallout from crises. It was democratic India (in 1991) and South Korea (in 1997-1998) that turned around their economies quickly, while Pinochet’s Chile (in 1983) and Suharto’s Indonesia (in 1997-98) fell into deeper quagmires.

Authoritarian regimes lack the institutions of conflict management that democracies provide. So tensions spill over into the streets and take the form of riots and protests. However the Chinese leadership responds, future generations may remember 2009 less for its global economic and financial crisis than for the momentous transformation that it caused in China.

Will there be enough global economic cooperation?

When domestic needs become paramount, global economic cooperation suffers. But the costs of protectionism in trade and finance are especially large at moments like these. The Great Depression was aggravated by the trade barriers that countries imposed to protect domestic employment. This will be a temptation this time around as well. And banks – whether explicitly nationalized or not – will be under pressure to prioritize domestic borrowers.

So far, the IMF has reacted with newfound vigor, establishing a much-needed short-term lending facility, which may well need to be expanded if emerging markets come under greater pressure. The World Trade Organization, meanwhile, has wasted valuable time on the irrelevant Doha round. It should have focused its efforts on monitoring and implementing the G-20’s commitment not to raise trade barriers.

Policymakers need to shed received wisdom and forget useless dichotomies such as “markets versus government or “nation-state versus globalization. They need to come to grips with the reality that national regulations and international markets are inextricably linked with – and in need of – each other. The more pragmatically and creatively they act, the more quickly the world economy will recover.

Dani Rodrik, Professor of Political Economy at Harvard University’s John F. Kennedy School of Government, is the first recipient of the Social Science Research Council’s Albert O. Hirschman Prize. His latest book is One Economics, Many Recipes: Globalization, Institutions, and Economic Growth. This commentary is published by Daily News Egypt in collaboration with Project Syndicate, (www.project-syndicate.org).

Topics: Wael Ghonim

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