|With countries around the world in recession, the global economy is in need of treatment [EPA]|
The world economy is in intensive care and the situation is looking pretty grim.
Countries are trying different forms of treatment, but what do they mean and what do they do?
In times of recession, all activities are geared towards kick-starting our economies – stimulating the economy by trying to put money in our pockets so that we can go out and spend.
The first treatments is fiscal stimulus, an idea of John Maynard Keynes, the British economist.
He believed that an economy can be fine-tuned – that it can be steadied through its ups and downs.
So when times are hard, as they are now, the government reduces taxes and starts increasing government spending. It employs more people in projects building roads, schools and hospitals.
The sister strategy is all about the interest rate and the quantity of money, this is known as quantitative easing.
This financial mechanism is what you might term a trial drug.
|The central bank can pump money directly into smaller banks [Reuters]|
In times of recession, central banks make the cost of money cheaper by lowering the interest rate.
They hope that by pushing rates close to zero, banks will take this money and use it to start lending to businesses.
But if bank managers are scared to lend to businesses and households because they think they will not get their money back, they use the central bank’s cheap money to buy more secure, government-backed bonds.
Bonds that also give them a yield, of say two per cent, so they also make some money.
The closer the interest rate gets to zero, the less power central bankers have over the economy.
At this stage the economic “patient” becomes resistant to the treatment. So the central bank starts to manipulate the quantity of the money – as opposed to the price of money – to get bank managers to lend again.
Central banks buy the same government bonds that banks managers have been buying.
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The more demand they create for these government bonds, the more their yield goes down and the less incentive there is for the bank managers to buy these bonds as they are making less money.
The hope is that this forces the bank managers to look to the wider economy to invest in companies through regular business loans.
The central bank also pumps money directly into the banks – by buying assets, often toxic assets, from the banks.
Toxic assets are bad loans, dodgy securities which are often backed by mortgages.
|Toxic assets are bad loans which are often backed by mortgages [GALLO/GETTY]|
They are securities based on cards that were never going to be paid or on mortgages that were never going to be maintained – and they are dragging the banks’ balance sheets down.
The root problem is that these assets have been bundled together with other less risky assets, and it is difficult to differentiate the good from the bad.
This is a major problem in a capitalist society. When the economy is about how much we have – when we don’t know the value of something, we call that toxic.
If we do not deal with this toxicity, it can poison the whole economy.
And if that happens, we might have to call on the services of the International Monetary Fund (IMF) – the world’s bank of last resort – which has 185 members.
Countries go to it when they have tried everything and are facing bankruptcy.
In technical terms, governments go to it when they have a “balance of payment” crisis.
The loan it gives usually comes tied with a set of conditions.
Its power structure though has been a reflection of the world order of the past 60 years. While the United States has a veto, Europe has 32 per cent of the voting power and China has just 3.9 per cent.
If policy co-ordination fails between these 185 countries, they will each go it alone and protectionism will rear its ugly head.
|Old-fashioned protectionism involves sticking a high tariff on an import [GALLO/GETTY]|
This is the practice of a country imposing barriers to imports in order to try to promote its domestic industry and goods.
Protectionism can take many forms: subsidies, playing around with the currency so that foreign goods become more expensive, or “in your face” old-fashioned protectionism, which involves sticking a high tariff on an import.
All in all, the prognosis for the world economy is worrying.
The patient has been over-pumped, overdosed with money, and the side effects of these treatments can be deadly.