Global Economic Crisis: Recovering from a Tailspin

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Includes: DIA, SPY
by: Krish Gudipaty

A tailspin occurs when an aircraft descends rapidly while rotating in a corkscrew path. The global economy can be aptly described as headed in that direction. We are spinning and falling simultaneously. Is there a way out? The outlook is grim but certainly it’s a crisis that will be overcome sooner than later.

The financial stimulus package and other forms of Government funding are artificially creating borrowed money from the tax payer. The borrowers need to pay back the Government (which acts on behalf of the tax payer) the entire principal and interest. If it's not paid back, it will soon cause inflation. The borrowers could be private banks or other Government institutions that would spend the funds in an economically feasible manner generating revenue to pay back the loan (for example, collecting tolls after constructing a highway bridge to pay for the cost of construction). The project is defined as economically feasible if it's foreseen that the project will be sufficiently utilized to be able to collect revenue. In order to drive the utilization of such projects, the economy must experience fundamental economic growth – we do not want a bridge to nowhere.

Let's examine what is required for economic feasibility or fundamental growth where GDP is the metric (simply said a measure of productivity). Productivity means creating goods and services that people want to consume or buy. How can GDP grow? By working long and working hard. By working, I mean work done by humans and machines. The smarter the people and their machines, the greater is their efficiency and output. These are popularly referred to as labor productivity (capital investment, human capital and technology). Multiply this increase with time (or labor hours) and ooh la la we are back in business. But wait a second, we just produced the best high tech gadget by the most intelligent people using the most efficient method that could be put in every room in every house and corporation – are we done? Not so fast. Does anyone want them, let alone export? We need to match supply and demand or simply put match sellers to buyers.

For sellers to make the product, certain incentive preconditions need to be met like well functioning markets, monetary exchange system and property rights. Property rights (ownership, patents etc.) are more relevant to developing economies, so let's focus on the first two. (Alan Greenspan in his 2007 book, The Age of Turbulence explains why the protection of property rights is crucial to foreign direct investments.) Firstly, we need well functioning markets, where buyers and sellers do business with each other and send signals regarding what to create and how much of it. Responsible spending or consumption is critical for free markets to work. A little inflation is always good because it gives us a reason to spend. During deflationary periods, we have a natural tendency to wait if we know that tomorrow we can get the same product for a lower price. If nothing, the stimulus can at least kick start the inflation process. Secondly, we need a stable, well functioning credit markets whereby there is monetary exchange between private parties without the fear of unexpected losses. The efficient market creates incentives for people to trade, invest and do normal business.

The efficient market will dictate how many gadgets to make, what would be the selling price, etc. while the monetary exchange system or credit markets will provide safe borrowing and investments, transferring profits and dividends to investors and shareholders. However, will this kind of fractional growth via incremental Government spending be enough to repay the massive bailout stimulus loan? Although it is intended to increase employment, the new money could be reflected in higher prices. In order to be competitive in a global economy and offset inflation, especially in times like these, we should achieve much more than the traditional growth rates in GDP. But how?

Faster growth rates can be achieved in several ways, starting with increased savings. In fact saving finances investments. This task is left to financial institutions to select the most economically feasible project. After all, the financial institution needs to pay your savings back with interest. Tax incentives can further stimulate savings. Increased international trade can stimulate growth by exchanging goods and services that each nation is specialized in. Funding companies which have a potential for breaking technological barriers will ensure above average returns for investors. Institutions both public and private can fund basic research making sure that there are sufficient tangible technological returns or intellectual development. And finally by heavily funding education a nation can define its economic growth potential by the quality of its human capital. All this would lead to increasing growth rates via innovations and inventions for the new millennium. Inventions result from choices and they bring profit. Competition destroys profits, however new inventions continue. This leads to a perpetual motion economy arising from a pursuit of higher standard of living by profiting from innovation.

Somewhere in the last decade, we took a detour. We may have focused too much on financial returns (from real estate, hedge funds etc) and went to sleep listening to our iTunes. Although we developed cutting edge technologies, the rate of innovation was low. Slowly and steadily, as the Government steps back and hands over private enterprises by regulating them and not by running their day to day operations, I strongly believe that Adam Smith's 'invisible hand' will emerge to stop the tail spin and propel our economies to higher altitudes.