From financial crisis to real economic crisis

Two issues need to be considered at this stage of the analysis of the financial crisis and credit crunch. First, to consider to what extent these financial occurrences have already negatively impacted the real economy. And, secondly, to evaluate the prospects for further damage, including spill-over effects to Caricom economies.

Several considerations confirm the already negative effects on the real economy and provide a gauge to future prospects. It would be useful, however, to begin the discussion by recognising two recent policy actions taken in the United States and Europe as an indicator of these effects.

Coordinated EU action

Despite sharp differences in the policy stances adopted by EU member states on the financial crisis and credit squeeze there was unanimous agreement to support a massive stimulus package of public expenditure to the equivalent of 1.5 per cent of the GDP of the 27 EU countries. This stimulus package is projected to complement that promised by President-elect Barack Obama after he takes office on January 20, 2009. The massive size of the EU stimulus package is a clear indicator of how seriously the authorities see the threat. This fiscal stimulus package has been accompanied by a coordinated reduction in interest rates. Indeed, in the US the Fed Funds rate has been reduced to its lowest level ever -025 per cent

Auto bail-out

The second set of actions concerns the efforts to prevent the collapse of the US domestic automobile makers. Congressional failure to provide a short-term bridging loan from the US government of between 15-34 billion US dollars to the three leading auto makers (Ford, General Motors and Chevrolet) will force the hand of the US President George W. Bush to act. Unwilling, no doubt, to end his presidency with the demise of the US once renowned domestic automobile makers an agreement will definitely be reached to provide some sort of assistance.

There should be no doubt that if the American domestic auto industry collapsed, the economic fall-out would be horrendous. Although the transplant auto sector (Japanese and European manufacturing plants in the US) would expand their production, the adverse effects on the US economy would be considerable. It is estimated that the industry, including suppliers of its inputs, car sales outlets, and finance houses account for about 10 per cent of US GDP and about 2.5 million jobs. Added to this there will be further fall-out in terms of reduced spending and tax payments by those who become unemployed and the associated firms that go out of business.

Indeed, it is estimated that the losses in tax payments from job losses and reduced expenditure in the US economy could comfortably exceed all the current estimates of the public funding required to salvage the auto industry. In this sense therefore the situation without a bail-out of the auto firms is likely to cost the US government more than the bail-out being requested.

Other sources of damage

While the two actions discussed above signify the magnitude of the economic problems posed by the financial crisis and credit crunch, they represent a tiny fraction of the total damage already done to the US and the global economies. The US is projected to lose 2 million jobs by year end.  The rate of job losses has been increasing as the months have gone by this year, reaching over 530,000 jobs for the month of November!

As a consequence the US unemployment rate is estimated at 6.7 per cent at the end of November. This is a national average and as such it varies by region across the country. The expectation, however, is that particularly disadvantaged communities (like the north-east auto production belt) would be well above the national average. It is also expected that by year end the unemployment rate could be in excess of 8 per cent.

Accompanying these job losses there is the expected decline in tax payments, both as a result of workers losing jobs, and the decline in sales and profits for many firms. Simultaneously there is increased pressure for public expenditure on items like unemployment assistance.  Consequent to the financial crisis and credit crunch, unemployment assistance has been extended by several weeks for recipients in order to take them through the year end holidays.

Inflationary pressure or deflation

This type of demand for public relief expenditure combined with reduced tax payments put inflationary pressure on the national budget. Indeed when all the various stimulus expenditure for this budget year is totalled, the expenditure can reach to US$1.5 trillion. The inflationary pressure on the US national budget and economy will be unprecedented.

Contrarily, the major fear expressed in the US is not inflation, but deflation. Deflation is a situation in which prices are falling as national output is declining. It is one of the worst manifestations of a depression.

Although as a rule economists believe they now have adequate tools to deal with inflation, they are far less confident about these when trying to bring an economy out of a deflation. The chief reason for this is that during a deflation, psychological considerations become paramount, as the business outlook discourages private investment and consumer spending. Expanding government expenditure, without complementary increases in private investment and consumer spending cannot by itself bring an economy out of a deflation.

Already in the US consumption spending has declined significantly and so have the sales of major retail outlets and service providers. Some well-known firms have gone into Chapter eleven bankruptcy. Business losses and reduced consumer spending discourage new investment and the expansion of existing firms. The consequence of this has been a recession which is defined as two successive quarters of GDP decline

Typically, economists have only been able to statistically diagnose recessions late, after the economy has turned around and is already on the upswing. This is of course because recent recessions have been short-lived. The official data however show that the US economy has been in recession for about a year now — since December 2007. Statistically, we also find that this is the worst recession for decades. Indeed, to some economists the US economy is probably closer to a depression than a recession.

The decline in consumption expenditure is very significant because about 70 per cent of total expenditure in the US economy is consumer-based. While this present decline reflects in the main the bleak economic circumstances prevailing with increasing job losses and reduced take home pay, it has been further accentuated by the credit card squeeze.

More than any other country US consumers create debt to purchase consumption items. They in fact dis-save. The effect of a credit squeeze on consumer spending can be, as it has been, quite dramatic.