Fighting the Global Slump: Less Is Dangerous

Amid a debt-deflation spiral, the governments' greatest risk is enacting stimulus measures that are too little to fight the slump

By Peter Coy

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Richard Mia

For more than six decades, through oil shocks and terrorist attacks, the world's advanced economies have managed to expand their collective output at least a little bit each year. But that long lucky streak is probably about to end, a victim of the severe global credit crunch. The International Monetary Fund is now projecting that 2009 will bring the first aggregate decline in economic output in advanced economies since at least World War II.

The IMF still expects China and other developing nations to grow next year as a group, but it warns that "downside risks to growth, even for the emerging economies, remain significant." Some economists are even gloomier. "There is a very severe deleveraging which you can't stop," says Anders Aslund, senior fellow at the Peterson Institute for International Economics in Washington. "My guess is that [even] if we have good economic policies, the world will see a [gross domestic product] fall of 10%... . This is global, and it's fierce."

Even if things don't get that bad, it's clear that we're deep in uncharted territory—or at least territory that hasn't been explored since the Great Depression. Economists and policymakers are floundering. Since they don't know how severe the recession will be, they don't know how extreme their measures to combat the downturn should be. U.S. Treasury Secretary Henry Paulson, who has struggled to find a path for American policy, defended himself in a Nov. 18 op-ed article in The New York Times, saying: "There is no playbook for responding to turmoil we have never faced."

The greatest risk at the moment is that governments will do too little to fight the slide. BusinessWeek estimates that governments around the world have committed more than $2.6 trillion for bank bailouts and other efforts to spur growth. But even that may not be enough. Germany, the powerhouse of Europe, has moved only haltingly to stimulate its economy, fearing that aggressive steps might cause inflation. Holger Schmieding, chief European economist at Bank of America (BAC) in London, says Germany's tax-cut plan "is so small, I wouldn't even count it." Japan, once again in recession, remains unable to muster the energy to break out of an off-and-on performance that dates back to 1990. Britain, Ireland, and other nations with big government deficits are reluctant to spend too much on stimulus for fear it could invite a speculative attack on their currencies.

"PROMISCUOUS" WITH DEBT

The U.S., where the crisis originated, may also be moving too slowly given the depth of the slump, many economists say. Washington is unlikely to pass a substantial stimulus package until after the new Congress and President take office in January. On Nov. 18, Treasury's Paulson clashed with lawmakers who want him to spend some of the $700 billion Troubled Asset Relief Program on aid to homeowners. Paulson said TARP is supposed to bolster financial institutions and "was not intended to be an economic stimulus or an economic recovery package."

The problem with slow or tentative measures is that they could allow the worldwide downturn to gain a momentum that would be even harder to reverse later. The lack of quick and massive intervention may have been one of the reasons why the Great Depression, which began in 1929, lingered until the outbreak of World War II revved up the war machines.

An unprecedented debt overhang is what makes this downturn both severe and hard to forecast. Consumers, particularly in the U.S., overborrowed to buy houses, cars, toys, and vacations. The bubble in housing prices misled lenders into thinking the loans were well collateralized. A similar dynamic was at work in other kinds of secured lending. Now the spiral has reversed. The declining value of collateral is causing lenders to withdraw credit. That forces borrowers to sell assets to raise cash, pushing prices down further in a vicious cycle.