It is now widely acknowledged that the world economy is going through a global recession, the likes of which we have not seen in eight decades, and the inability to rely on export stimulus anywhere also makes it evident that no single country or group of countries can emerge from the crisis on its own. Cooperation among industrialized and emerging economies and coordination of policies across the board are essential.
Because the current crisis originated in the US and European financial systems, policymakers have tended to focus their attention on banking and financial market issues. Indeed, governments in the developed world have adopted a series of urgent rescue and stabilization plans to avoid the collapse of financial system. As part of this, agreement was reached at the April G20 summit to increase IMF resources to meet short term financing needs of developing countries facing currency crises.
This article argues that the main challenge of the global crisis has turned from solving the problems in the financial sector to tackling those in the real sector, specifically the issue of the large excess capacity to produce output. Persistent capacity under-utilization in the real economy will result in a downward deflationary pressure, deterioration of balance sheets in the financial and corporate sectors, and a higher risk of protracted global recession and currency crises in some developing countries. The existence of excess capacity on a global scale calls for a Keynesian type of globally coordinated fiscal stimulus, in both high-income and developing countries. However, to make the fiscal stimulus work, it is necessary to go beyond the conventional Keynesianism, by focusing on "bottleneck-releasing" projects, and to go beyond national boundaries, by supporting developing countries' stimulus efforts with loans from developed and reserve-rich countries.
Boom, Bust, and Excess Capacity on a Global Scale
The current crisis was preceded by six years of a boom in the global economy. Its origins can be traced to the burst of the Internet bubble in 2001 and the subsequent expansionary monetary policy pursued by the US Federal Reserve, as well as the high leverage in the financial sector as a result of financial deregulation. Deregulation had led to low interest rates and excess liquidity, contributing to the large increase in real-estate and equity investments in the United States, as well as to an unprecedented increase in private capital flows to developing countries, supporting their investments in the manufacturing sector. Financial innovations helped stoke the boom in the housing and equity markets, and as markets surged, wealth effects prompted households to divert a steadily increasing share of their income to consumption. Many households even decided to monetize their assets, most often housing, to fund further consumption. "Borrowing ballooned. US household debt as a percentage of annual disposable personal income (gross income minus income tax) increased from 77 percent in 1990 to 127 percent at the end of 2007. Household final consumption expenditure (a price index which represents consumer spending) surged from just over 67 percent in 1997 to 70 percent in 2001 and remained over that level afterwards.
The boom in mature economies further fuelled the stoking of growth in emerging markets, through increased export revenues and higher commodity prices, a surge in foreign direct investment, and increased remittances from abroad. Growth increased export demand sharply, so that developing country exports accelerated even beyond their rapid growth of the 1990s. The flow of foreign direct investment to developing countries soared as investors sought higher returns than they could earn domestically, given the low yields that prevailed in mature economies at the time. Net private capital flows to developing countries increased from US$200 billion in 2002 to a record US$1 trillion in 2007, while remittance flows to developing countries also increased by about 18 percent per year to US$305 billion in 2008. …