Take advantage of the American crisis

By Dr Bharat Jhunjhunwala

America is slowly sinking into a recession. President George W Bush has reduced income tax rates to place more income in the hands of people, increase consumption and demand, and ward off the impending decline in living standards. The U.S. Federal Reserve Board has simultaneously slashed interest rates by an unprecedented 0.75 percent to boost borrowing-led consumption such as in buying of cars. It is also expected to lower costs for U.S. Corporations and enable them face competition from cheap imports. I reckon these measures will fail and, in fact, become the trigger for America sinking deeper into recession.

Think of a farmer family as a country. They invest in a well, produce more cotton, weave cloth and family members wear it. They cultivate neem and Jatropa and use the oil for burning lamps. They invest in teak trees and when ready, make furniture. Production and consumption both increase in tandem. This is economic growth. If they plant teak trees which they cannot use then the same investment will become a burden on their economy.

The wise economist establishes a balance between investment and consumption. Economic growth is sustainable only when consumption rises along with increase in production. Investment can pull the economy forward for a short while only. This sustains only if there is demand for the goods produced. A farmer is much benefited in planting of teak trees if there is demand for them when ready. This is similar to establishing a factory. The same investment leads to heavy loss if demand is not forthcoming. This point was made by the legendary economist John Maynard Keynes: "Consumption--to repeat the obvious--is the sole end and object of all economic activity... The consumption for which we can profitably provide in advance (by investment) cannot be pushed indefinitely into the future... Each time we secure today's equilibrium by increased investment we are aggravating the difficulty of securing equilibrium tomorrow."

We can examine the prospects of the American economy from this perspective. That economy is producing goods but demand is less. For example, real estate companies have built apartment complexes but there are no takers. The demand is less. Truly, this problem had reared its head five years ago after the bursting of the dotcom bubble. But the U.S. Federal Reserve Board, under the leadership of Alan Greenspan, reduced interest rates, especially for housing loans. American people borrowed and bought homes in expectation of future incomes. The party continued for five years. But the borrowers were not able to generate incomes to repay the loans. This has now led to seizure of their properties, loss to lending banks and America is sinking into a recession.

Question arises why American people are not able to earn money to repay the housing loans? I believe this is a direct consequence of globalization. The reduction in time and costs of transport and communications, thanks to the internet, has made it possible to produce goods anywhere in the world and import them into the U.S. at little expense. For example, the processing of American insurance claims is nowadays being done in India because the information can be transmitted easily. Wages of Indian workers is less. Cars are being produced in Thailand and exported to the U.S. The only way for Americans to compete with these cheap goods produced with lower wages is to accept lesser wages in keeping with the lowest. No wonder they are unable to repay their housing loans.

The success of measures announced by President Bush and the Federal Reserve Board should be assessed in this backdrop. The reduction in rates of income tax will lead to reduction in the income of the Government and increase of the same in the hands of taxpayers. This is not likely to lead to an increase in demand for American goods, however, for two reasons. A tax cut of $100 leads to reduction in government spending of that amount. The demand for cement and steel for the building of highways will decline in same amount. But the increase in demand by consumers will be less. A part of the additional income obtained by the taxpayers, say $40, will be saved. Consumer spending will increase by only $60 while government spending will decline by $100. In the end the total demand will be less. Further, the additional income will go partly to pay for imported goods. Thus wages are not likely to rise much.

The Government can undo this damage by increased spending by printing notes or incurring higher fiscal deficit. This will only give a very temporary respite. If printing notes was a solution then Government world over would have revved up their printing presses. This strategy provides immediate relief but soon leads to devaluation of the currency, increase in price of imports and lower consumption-which is opposite of the desired objective. The day of reckoning is only being postponed by such stratagems. My assessment is that the dollar will face a steep devaluation and I would not be surprised if the dollar-rupee exchange rate declines to say Rs 20 in the next 2-3 years.

The U.S. Federal Reserve Board has reduced interest rates. This too will be futile. Income of the people does not increase by borrowing. If that were the case our debt-ridden farmers would never have committed suicides. Remember that interest rates in Japan are near zero yet that economy is sinking into a recession. The basic point is that lower tax shifts income from Government to citizens and lower interest rates shift income from future to present. These measures do not create incomes.

In my reckoning America is in for deep trouble. That country has accepted the mantra of free trade. Agriculture is an exception that does not change the basic complexion of their economy. In consequence, goods produced by cheap Chinese labour and services produced by cheap Indian workers will be imported into the U.S. and lead to undoing of the American economy.

The truth is that the meek will inherit the earth. The rich will suffer. Countries where there is poverty, that is, where the wages are low, or where the cost of production of labour power is less, will win. The policies implemented by the American leaders do not deal with this problem. The correct solution for America is to abandon free trade and adopt a policy of protectionism to protect its producers from cheap Chinese and Indian labour. But that requires a change of mindset that is difficult. Such a policy is moreover harmful for their corporations that are making huge profits in China. These American corporations are the biggest enemy of America. They are killing American industries and jobs by producing in China and they determine America's economic policies. We must, therefore, brace ourselves for a steep decline in American fortunes and ready ourselves to lead the world in a more benign and less exploitative manner than done by the U.S.