The U.S. economy has plenty of resilience and ability to bounce back

What ails the economy of the U.S. and those of some European nations? Is there a possibility of the developed countries slipping into a recession for the second time in less than half a decade? What will be its consequences for the rest of the world? Will the U.S. be able to maintain its economic leadership?

The consensus opinion is that the U.S. economy, the world's largest, is having anaemic growth, even if it has not slipped into a recession yet. It is also clear that high indebtedness both on the part of the government and individuals has landed the U.S. and many European nations too in this predicament. However, there is far less agreement on what needs to be done to revive these economies.

The current crisis that the U.S. and Europe is facing, unlike the 2008 global crisis, is not rooted in the financial sector. The disastrous lending practices of leading banks then in the ‘sub-prime' housing loan segment landed not only the financial sector and the U.S. economy in a mess but also dragged most developed countries into a mess because of the strong global linkages. Much has been written on the culpability of the banking system in the great financial and economic crisis. But apart from being wrapped on the knuckles as it were, banks in the U.S. have not only survived but prospered.

It is a matter of great irony that while the ‘real' economies of the developed world have been tottering, their financial sector, which inflicted so much pain, has prospered. For some banks, at least, a regulatory cap on managerial remuneration, executive bonuses and so on is anathema. The days they received large infusion of public money just to stay afloat have obviously been forgotten.

Eurozone debt crisis

On the other side of the Atlantic, leading European banks, which have bought sovereign debt of Greece, Portugal, Ireland and a few other countries are under stress as the eurozone's debt crisis intensifies.

The crisis in the U.S. is a crisis of confidence, writes C. Rangarajan in a financial daily on August 22. The downgrading of its sovereign debt by Standard & Poor's (S&P) has been a unique event, bringing down the quality of American government paper by one notch.

Even though other rating agencies have retained the highest grade, the comments of S&P are noteworthy in that it attributes its action as much to the fiscal process as to the political imbroglio which almost caused the federal government to default.

Not only the rating agency, but banks and financial agencies, investors and governments around the world have questioned the credibility of a political process that apparently enabled sections of the political elite place their individual dogmas and partisan interests above national interests.

The debt reduction programme approved by the Congress and the Senate also lacks credibility. What the U.S. economy needed at this juncture was a deal that kept up spending in the short-term, with a stress on the much needed infrastructure investment and a big medium-term reduction in the federal deficit centred on a major tax reform. Instead, the deal works in the opposite direction, failing to shore up the economy in the short-term without identifying worthwhile means to reduce the deficit in the medium-term.

Besides, certain recent developments may be coincidental but do cast doubts on the state of the recovery in the U.S. Official revisions to the GDP statistics of past few years, released at the end of July, showed that the 2008 recession was deeper than what was assumed and the subsequent recovery flatter. Over the past year, output has grown by just 1.6 per cent and even that is showing signs of petering out. According to economists, if past experience is any guide, the rate of growth is such that the economy is poised to trip into a recession.

If that happens, the rest of the world, including India, will suffer. It is often argued that India's foreign trade, as a proportion of GDP, is relatively small. Hence, outside influences on the economy will be minimal. This view is too narrow as there are many other channels, besides foreign trade, that connect the Indian economy to the rest of the world.

Notably India's balance of payments has been dependent on capital flows. Uncertainty over the U.S. economy may cause capital flows to behave irrationally, often going back to the sanctuary of safe haven instruments in the U.S. On the other hand, if the U.S. Federal Reserve, as part of its efforts to provide succour to the U.S. economy, does another round of quantitative easing, that is, buying government bonds with freshly minted money, cross-border flows towards India and other emerging markets may increase exponentially, posing major policy challenges for these economies.

For all its recent troubles, the U.S. will retain its leadership position. The American dollar will remain the world's number one currency, in trade, dealing rooms and a currency of choice for governments to park their export surpluses.

Though weakened by the crisis, the U.S. economy has plenty of resilience and the ability to bounce back.

However, weak economic growth and the political squabbling do portend a diminished role for the U.S. in the days ahead.