Friday, 15 August 2008

How will Economy Turnaround?

Don't look where you fall, but where you slipped." - African proverb

Excessive Subprime lending, Inflated Home Prices, High Leverage, High Energy (Oil) prices, Low Dollar rate and countless other factors were breeding in the back drop of booming economic growth (some might like to call it as a bubble). When so many factors were cruising on the wrong track, it was a disaster waiting to happen.

Mid 2007, the news of Subprime Crisis hits the so thought resilient economy. To the discomfort of all, the so called resilient economy has stretch too far to stand ground. Countless job cuts (yet to unfold), massive banking write-downs, banking and financial disasters - Northern Rock, Bear Sterns etc., zero trust in the economy, high inflation (thanks to oil and commodity prices), low consumer sentiment, and various other aftermaths which nobody knows yet, have happened ever since and are yet to happen. Everybody talks about the crisis and the pain. The bigger question is what can turn this sliding economy back to prosperity and turn the arrow green and facing back towards the sky. Let me be different, let me be optimistic.

World Economy cannot be in recession forever. Yes, it happened for a long period in Japan in the last decade, but it was the monetary policies that were to blame. 1930 and 1992 felt the wrath of recession but things did turn out good at the end. So what are these self healing powers that market possess?

What else can turn the economy? Lets discuss

1. Consumer and business confidence is said to be low in times of recession. In fact, the confidence level is over depressed than required. Households as well as business community hold back on their spending and save for any unforeseen possibilities like layoffs, softer cash-flow etc. This held back demand creates a potential future demand. It can be comparable to potential energy created by holding water back in a dam to be released. To release this potential demand, an external impetus might be needed in the form of new entrepreneurial idea (a new service), fiscal policy (tax cuts or favourable tax treatment), monetary policy (interest rate adjustments) or any other external catalyst. The power at which this supressed demand gets released determines how quick the recovery happens.

2. A new invention which is yet to be known can change the direction of the economy. Computer was an innovation which helped the world economy over the last few decades to take a different height. Securitization helped the economy to grow (by also helping a lending business like American Express and others). This was an invention. But yes, I agree, misuse of this same invention has led to the current recession. Will there be anything new? Yes the possibilities are high.

3. Stock Markets are always known to anticipate the direction of the economy. But there is a hidden truth. The truth of self-fulfilling prophecy. When stock markets are high, the cost of capital to the business is low as it can raise needed capital with ease and at favourable price. This motivates business to invest and grow which helps the economy. On the other side when the economy is at recession, stock markets are at its lowest. Raising capital is difficult and the prices are not favourable to the business, hence higher cost of capital. Again I repeat, stock markets are known to anticipate the direction of the economy. One or few favourable news might lead to this surge in stock prices, without anything to do with the real economy. Nevertheless, surging stock prices lowers cost of capital to the business and induces higher investment thus creating the path to economic recovery. In this way the stock market feeds the self-fulfilling prophecy.

4. Political Change can have a major impact on the sentiment of the whole economy. New reforms can help the economy to grow; examples are that of India and China. Or the change in government can also do the trick, for example when Bill Clinton was elected the president of US, market responded favourably.

Fall in oil prices, rising dollar prices, Govt. (or whoever) induced market optimism and never to forget government (central bank included) intervention can play a part in helping heal the economy.

The question has never been whether the economy will regenerate or not, the question is when. The economy has the power and the tools (discussed above) to heal itself and there is no doubt about its intention.

- Raghab R Nepal, July 2008,

No comments: