Will the world economy collapse?

John Maynard Keynes said in 1927. “We will not have any crashes in our time.” Dr Irving Fisher, another distinguished economist, said on October 17, 1929. “Stock prices have reached what looks like a permanently high plateau.” US Treasury Secretary and Harvard Economic Society, among others, publicly shared their confidence.

They were reflecting on the state of the economy that was booming. It was a time when drivers and window cleaners eves-dropped on the conversations of their patrons to collect tips on shares. The DJ Index doubled from little less than 200 when Keynes made his prediction to almost 400 when Dr Fisher announced the high plateau of the state of the market. Within two weeks of Dr Fisher’s forecast, it had crashed by over 40% to reach 200 again. All those who had invested their savings from 1927 to 1929 were impoverished overnight. Several of them committed suicide. By 1933, the DJ Index lost 90% of its value from the day of Dr Fisher’s ‘high plateau’ proclamation to reach 40. Industrial production declined by two-thirds. The prices of farm land collapsed to nothing. The United States imposed high trade barriers, inviting retaliation by 25 other countries. Since Europe was dependent on exports to pay its World War I debts and Japan to be able to import the most basic necessities of life, high trade barriers devastated their economies. The Germans elected Hitler, a failed artist, to lead them. In Japan, too, nationalist extremism grew at a fast pace. The World War II followed from 1939 to 1945.

Why should one recall those dreadful days when the US economy has been growing at 3.5-4% almost since the beginning of this decade? Moreover aren’t these boom times in Asia, with China and India growing at 9%? Finally Germany and Japan are also on the recovery path. There is a big party going on. The bars of Pudong, Ginza and Colaba are packed with young people high on martinis. Housemaids in Asia and taxi drivers in Europe and North America can be seen soliciting stock market tips from their patrons. Housing prices are moving up, up and up. If Dr Fisher were alive, he would proclaim this time that the stock markets all over the world have not yet reached their plateau. There are miles to climb before they reach their peak.
The problem is that much of US recovery is made possible by high consumer spending, financed by debt, except in Q2 of 2007 when exports contributed significantly to growth. The US public debt has increased from $5.5 trillion at the time of President Bush’s first election to $9 trillion now and perhaps $10-11 trillion by the time he leaves. The US currency has been depreciated by 0.9 at the end of 2000 to almost 1.40 by the end of 2007 against Euro. If the US current account balance and external debt continue to expand, at some stage the fall of dollar, rise in interest rates and recession may prove to be difficult to avoid. The critical question is if the dollar will fall below 1.5 against Euro, and if it does, at what rate of dollar the creditors will press the panic button.

However, if the new President gets too trapped in a war to sort the economy out, the dollar can collapse in an unpredictable and violent manner. As most central banks have two third of their foreign exchange reserves in dollars– and the Chinese have already lost $300 billion for this sin – they will have no option but to switch from dollar holdings to other currencies or gold. This will create a run on the dollar, forcing individuals around the world with dollar holdings to lose their savings, leaving Federal Reserve with no option but to hike interest rates, inviting collapse of thousands of banks and recession in the United States. The failure of Doha talks is a clear indication that a strong recession in the United States (with reduction in demand for Chinese and European exports) will lead to a trade war. China’s fragile banking system may come under pressure, creating a spate of bankruptcies in that country. At such a time, if the leaders of Iran, Russia, and Venezuela decide not to quote oil contracts in dollars, there will be a complete collapse of the American economy also causing a severe damage to European and Asian economies.

Will the world economy collapse? The rational economic answer is – unlikely but not impossible. However, politics can be irrational and therein lays the danger. There is no consensus among economists about why the crash of 1927 took place. So, we may not have strong economic lessons to learn from that experience. However, lessons from politics that preceded and followed the crash are clear. If we want to avert a crash in the next decade or half, which can have several times more horrendous consequences than the one in the last century, we will need to get both our politics and economics right.
Author : Sundeep Waslekar

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