Monday March 9, 2009

Potholes, sinkholes and stimulus packages

Tableau Economique - By Steven C.M. Wong

There are good reasons to believe that stimulus packages in general are not magic bullets to kill the beast of deflation

IMAGINE you are driving home from work and you come across a small pothole in the middle of the road. As an experienced Malaysian motorist, you do not find this unusual and you simply reduce speed before going over it. It is a minor inconvenience.

The next day, the pothole has grown much wider and deeper. You have to slowly make your way into and out of the hole. This takes some time and traffic is completely backed up. The pothole has become a serious problem.

On the third day, the pothole has developed into a gigantic sinkhole. The surrounding houses and trees have collapsed into it and cars that have gone into it have been unable to get out. Traffic has come to a complete stop and nothing can move. This is a major disaster.

The vast sinkhole is an analogy for the aggregate demand deficit that the world economy faces today. Governments are desperately trying to fill the void with cheap money, government spending and income handouts so that their economies will not be sucked into its depths.

The US Congress recently approved US$787bil for this purpose. China’s government earlier announced a US$585bil package and is expected to add to it. Japan has introduced two packages that exceed 8% of its gross domestic product (GDP) and more will be seen in the coming days.

With all eyes so expectantly focused on Malaysia’s mini budget to be announced tomorrow by the Finance Minister, it may seem ornery to want to pour cold water on it.

Yet, there are good reasons to believe that stimulus packages in general are not magic bullets to kill the beast of deflation.

It could be wise, at the very least, to keep an air of healthy scepticism about us lest unrealistic and unrealised expectations be dashed.

To begin with, no government knows exactly how deep the demand sinkhole is. There is no guarantee that the earth and concrete poured into the hole will not simply disappear into the caverns below.

The stimulus packages announced by various countries so far do not seem to have made a dramatic difference in halting the downward spiral. The equities markets, which are supposed to be forward-looking, have continued to nosedive. Properties are still shedding value at an alarming rate. Oil prices have firmed but those of other commodities remain weak.

These facts suggest the stimulus packages have not inspired a great deal of confidence or added much resilience to the global economy. Of course, the problem could just be a matter of their size or the delayed timing of the effects.

In recent days, we have heard otherwise sober economists argue that “bigger is better” as if there were no constraints to the resources that can be spent. Yes, domestic savings, at around 38% of gross national product, are high. Yes, liquidity in the banking system at around RM180bil may be large.

But this does not mean that deficit financing is straightforward. Already, the cost of funding in Malaysia has begun to edge upwards due to the increased borrowing requirements of the government and the latter are expected to rise much faster through 2009. Rates would have risen by more if Bank Negara had not cut the overnight policy rate by 125 basis points.

There is another fundamental constraint. Malaysia is an open economy and demand management in open economies differs from those that are not as open. For all of Japan’s export prowess, total trade (i.e. exports plus imports) to GDP is only around 31%. In the United States, this figure is around 28%. China has a much higher trade dependency at 72% but even this fades into insignificance when compared to Malaysia’s 214%!

Malaysia’s growth is not only highly export dependent; imports are also very important component of aggregate supply. When domestic economic activity is stimulated, it can lead to a significant increase in imports of goods and services, as well as capital outflows. Already, some are forecasting a balance of payments deficit this year. This can rapidly run down a country’s foreign exchange reserves especially if the downturn in demand for commodity and manufactured exports persists. Oil revenues have been very important in bailing us out of tight spots in the past but their ability to do so again this time around is greatly constrained.

Targeted government spending, especially to boost output and productivity and in support of the vulnerable segments of society is to be welcomed at any time, what more in times of growing economic distress. Keynesian-type deficit spending, however, is not new and its practical limitations are well known.

These cannot easily be ignored or discounted just because it has become economically and politically popular to do so. At the end of the day, Malaysians must be prepared for the most difficult economic weather ever faced. The consequences of not doing so could be devastating.

● Steven Wong is assistant director-general of the Institute of Strategic and International Studies Malaysia, responsible for the bureau of economic policy studies. He can be contacted at steve@isis.org.my. Let us have your thoughts on this story/issue. Send your feedback to starbiz@thestar.com.my

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