Long-Term Implications of the Financial Crisis

Monday, October 27, 2008

By Jagadeesh Gokhale

Jagadeesh GokhaleThe raging global financial crisis is likely to tip the world economy into a recession, which, contrary to what many pundits suggest, is likely to be long lasting. The coming recession might well mark the beginning of an era of permanently higher taxes and slower economic growth in rich countries. And it will hasten a fiscal crisis in entitlement programs.

Financial markets declined in reaction to both the initial failure, and the eventual passage, of the U.S. bailout plan. As home prices decline, financial institutions’ balance sheets continue to weaken and the crisis spreads. Calls for broad-based bailouts in Europe and elsewhere are growing stronger but it is uncertain whether such fiscal and monetary initiatives will succeed.

The past two U.S. recessions were mild and global economic growth was interrupted only briefly. The hope is that bailouts will keep the current economic recession short-lived and shallow. But what’s the likelihood that it will be so? The two previous recessions-in 1991 and 2001-occurred under sound economic fundamentals: highly productive workforces, strong consumption growth, continued advances in global trade, and low taxes. This time around, however, those forces appear to be much weaker.
Consider, first, earnings growth. The most experienced baby-boomer cohorts of U.S. and European workers are now retiring. Although a larger percentage of older workers have remained in the workforce in recent years, a recession could reverse this incipient trend. Credit shortages have begun to force firms to cut costs or downsize. These pressures are likely to hit older workers the hardest with layoffs forcing earlier-than-planned retirements. Forced or voluntary exits by the most experienced workers will reduce overall labor quality and slow productivity and earnings growth. This phenomenon will last for two more decades.

American consumers, widely viewed as drivers of global growth, are already cutting back on spending. The recent oil-price surge slowed spending on non-oil goods. Although oil-prices have receded under the threat of a global economic slowdown, other factors will continue to slow consumer spending: As the baby-boomers approach retirement, concerns about the viability of public retirement programs, recently devalued 401(k)s from stock market declines, and reduced job security from rising unemployment may induce many of them to increase saving.

Slower consumption growth among developed economies could be replaced by faster consumption growth in developing ones-especially China and India. Trade has been the one silver lining for the U.S. economy during 2007-08-as the dollar depreciated, burgeoning exports sustaining growth in U.S. output. But this might change with bleaker global economic prospects.

China’s rapid economic growth thus far resulted from high domestic saving and investments geared toward infrastructure, manufacturing, and exports. With slowing global consumer spending, the Chinese should encourage faster domestic consumption growth to sustain its manufacturing sector. Some of the increase in Chinese spending would be on non-Chinese goods and would benefit developed economy exports and earnings. However, China’s policymakers might raise trade barriers, in an effort to insulate the economy from a global recession. India is less exposed to a global recession because of its high import controls and tariffs, but a severe recession in western countries could provoke a more protectionist posture from Indian policymakers as well.

Slowing consumer demand, labor productivity and, potentially, trade growth worsens the prospects of a mild recession. If the bailout does not soon restore financial stability-and many economists doubt that it will-bailing out the broader economy will require additional public funds and increase burdens on future taxpayers.

Future generations’ earnings are already significantly burdened by government obligations to pay public pension and health care benefits to aging baby-boomers. In addition, growing imbalances in regional and state government budgets will require steep cuts in services and, quite possibly, higher taxes. Unless government entitlement and other commitments can be reduced, the current raging financial crises will become a watershed to a new era of permanently higher taxes and, therefore, permanently slower economic growth among developed nations.

In the past, politicians promised to reduce the size and scope of government when seeking office, but then avoided the difficult choices involved. The runaway cost of entitlement programs is the most egregious example of failure in political leadership. This failure will severely constrain the future choices of policymakers. Conventional wisdom holds that entitlement reforms are unlikely until those programs face an imminent financial crisis. If the current financial crisis metastasizes, and the tax base shrinks while tax rates become permanently higher, the fiscal crisis will be upon us much sooner than we currently expect.

Jagadeesh Gokhale is a Senior Fellow at Cato Institute.