US economy: OECD predictions about US economy - Essay Example

? Introduction Right from the time of financial crisis US economy is facing troubles in the country’s economy. It has experienced bankruptcies owing to increased risks in the investment sector and easy financing operations of the banks. Subprime loans led to the collapse of the financial institutions. Thousands of people lost jobs and also became homeless. As a result in 2007 US became the biggest debited country. The curse of this financial crisis fails to die down and gives the country little scope for recovery. The country has recently been caught in a ‘debt trap’ as debt threatens to rise upto 101.1% of the country’s GDP. Rating agencies currently have rated the US economy much below its normal range. Standard and Poor has already taken back the ‘AAA’ status it once assigned to the US economy. OECD predictions about US economy OECD has in recent times predicted more trouble for US economy. The country has already adopted fiscal tightening as counter policies in order to get rid of debts meaning the loans of the country. But this measure may not be a very suitable one as it threatens to take the economy towards recession. It would be very difficult for the country to recover if it gets into recession. Even monetary policies can do little to help out (Padaon, 2011). The country is already experiencing an economic slowdown and such phenomenon is affecting its trade. OECD has predicted low trade growth of 6.7% in the current year. It is expected to decline further to 4.8% in the next year. The growth rate predicted for the US economy is also very low. It is predicted to grow by 2% next year. OECD has warned the 17 member countries bloc of a growth rate as low as 0.2% (Parussini, 2011). Making the assumptions about the demand and output based on the country’s monetary and fiscal policies OECD had previously made the following projections about the US economy for the year 2000 as shown in the diagram below: Figure 1: OECD projections for US economy for 1999-00 Source: OECD Economic Projections, 1999 The predictions have been made for annual growth rates which were seasonally adjusted. Clearly from the figure one can say that as per OECD projections for US economy since the year 2000 the economy of the country was showing an overall downward trend with real GDP growth falling out and unemployment increasing. Unemployment would continue to remain high in US as per OECD predictions. It is expected to stay around 8 % in the next two years. Fiscal measures adopted in United States needs to have credibility so as to overcome the sovereign debt crisis. Signs of improvement mostly depend on the effective policy implications of United States (Padaon, 2011). OECD has already confirmed that euro zone has fallen into recession and also proposed for an urgent requirement of decisive policies to prevent major economic disruptions. Strong measures consisting of sufficient increases in the European Financial Stability Fund are required to enlarge the economy’s capacity and overcome the euro crisis. To plan an effective bailout package there needs to be considerable utilization of the balance sheets of ECB (Parussini, 2011). Since Euro zone forms the key to world economy, disruptions in euro zone is surely to affect world output. The world output is projected to grow by 2% next year. Euro area would likely plunge into a deeper mode of crisis with deduction of economic activities in United States. With constant failure of United States in tackling fiscal deficit (fiscal expenses greater than fiscal revenues), OECD is expecting worst situations in the near future. Schools of thought dealing with current economic problems The two schools of thought that may be thought of for dealing with the current US economic problems are Keynesian and Classical schools of thought. The economic ideas of these two can be utilized to recover the US economy from the current crisis situation or any other European nation under similar kind of situation. a) Significant deficit reduction for Greek and Irish governments Among the European nations Greece is one of them experiencing a debt crisis. Such a situation has prevailed since 2009 warning a harmful effect in the Euro Zone. It has got somewhat relief from the110 million euros as financial assistance offered by other European neighbors. A similar kind of situation can be expected for Irish economy. After significant investigation it was found that the crisis was an outcome of salary cuts of employees for deficit reduction. But such reductions could not match up with deficits. Instead it drove the economy deeper into recession (Greece: Overview, 2011). The fiscal deficit scenario for Greece and Ireland is shown below: Figure 2: Deficit scenario for Greece and Ireland, 2008-09 Source: Public deficit by Country, 2011 Here for both the countries deficit has been measured as percentage of GDP of the respective countries. Familiar with the crisis situations for both the countries the two schools of thought are relied upon for policy implications to overcome the crisis situations. 1. Keynesian School of Thought As per the basic concept of Keynesion economics demand supply apparatus has to be used for the current crisis situation. Since fiscal policies have an impact on output, aggregate demand and employment , appropriate fiscal policy have help significantly to reduce a country’s deficits. Increase in government spending (planned) can be thought of as a suitable policy. This can be explained as follows: The Keynesian equation is given as: Y=AD=C+I+G+(X-M) As output (Y) or aggregate demand (AD) is positively related to government spending (G), an increase will rise AD or output and hence help to reduce deficit. The intuitive explanation is that an increase in planned government spending will raise employment level by creating more jobs. Hence with increased income it will cause rise in demand for goods. Hence production will increase thereby raising output. Diagrammatic illustration is provided by the figure below: SRAS1 P LRAS SRAS0 P1 F E P0 AD1 AD0 Y0 Y* Y1 Y The figure illustrates the increase in output (from Y0to Y1) brought about by an increase in planned government expenditure. However the government needs to be careful about its AD increase and should not increase it a lot. Else it may cause rise in prices and thereby initiate inflation. One can already witness rise in prices due to demand increase. Potential Negative Effects Although government spending increase is considered suitable here for deficit reduction it may also have some negative effects. Firstly the country has a possibility of witnessing a rise in inflation with price rise due to aggregate demand increase. Secondly problem arises in framing policies when unemployment needs to be matched with fiscal tightening and balance needs to be maintained between the two. 2. Classical School of Thought By using classical school of thought the aim should be to reduce unemployment in the economy and increase output so as to reduce deficits. This needs reduction of excess labor supply and restoration of savings –investment equilibrium. This requires substantial wage reduction giving way to price reduction (Patil, SB, n.d). Monetary policy was thought about here and not fiscal policy. Flexible wage policies and interest rate could be effective to reduce deficit. The explanation is that- from labor side wage reduction would reduce costs of employment. This will create more jobs as labor demand will increase. If price fall exceeds wage reduction there should increased purchasing power into the economy. This will increase demand for goods and ultimately raise output. At the same time wealth holdings will increase leading people to consume more. As per monetary policy a reduction in interest rate is suggested. This will enhance returns on investment (Fiscal policy, n.d). This will obviously increase economy’s output through increased investment and thereby reduce deficit. Potential negative effects After experiencing financial crisis which occurred mainly due to speculative activities and increased risks in the economy, it is difficult to accept that fiscal policies have minimal or no role in the economy. Such an assumption cannot have practical implications. (b) Reforms undertaken for a progressive tax system 1. Keynesian School of thought Here as tax reforms contractionary fiscal policy can be suggested i.e. reduction in taxes. A general belief exists that tax cuts increases an individual’s incentive to work. By Keynesian economies tax deductions positively affects productivity of labor. Hence by lowering corporate taxes there is a possibility that people work more for higher earnings (Riley, 2006). This in turn will contribute for an economy’s increased output. Here one would have T= t.Y where, t=proportional tax rate. A fall in t would lead to increase in Y as people tend to work more. This can be illustrated diagrammatically using AD/AS schedule: SRAS0 LRAS P SRAS1 P0 E F P1 AD Y0 Y* Y1 Y As reduction in tax rates increases income of people they tend to work more. This in turn increases overall output as shown in the diagram below with an inward shift of supply curve. Chances for inflation are comparatively lesser here. Potential Negative Benefits These types of fiscal policies fail under the existence of rational expectations. It explains the individual’s belief that a tax cut in current year will be matched by a tax increase in future. Under such circumstances people tend to save more. Fiscal policies fail to change any prevailing economic conditions (Riley, 2006). Credit crunch in US economy Credit crunch was surely an outcome of increased risks in the banking sector. It occurred in US in 2007 when mortgage defaults became frequent and house prices fell. The situation was a sort of ‘liquidity freeze’ when banks and other financial institutions stopped giving loans. Background Since 2007 US economy had become stagnant in employment activities. The published monthly reports indicated huge unemployment in US economy. Around 4000 people had lost jobs by 2007. Such an economic phenomenon was sure to have its effects on stock market. Panic among the investors had caused immense fluctuations in stocks. With fall in stock prices and job cuts next came the turn of loan defaults. With high number of defaults banks ceased houses and people became homeless. The economic condition had almost stopped transactions. Banks failed to supply loans. It became very difficult to acquire capital for investments (Whalen, CJ). The history of credit crunch actually dates back to the Great Depression of 1930. Crisis was a result of a shortage of financial capital as well as decline in quality of borrowers. Easy financing operations of banks for giving credit had surely set the stage for such a crisis. It was due to a decline in the bank’s capital value (Mizen 2008). Impact on US and UK economy US economy was left in a disastrous situation. It first became and then started to contract from December onwards. US housing markets were experiencing a slowdown. With a rise in interest rates homeowners could not afford to pay for their mortgages. Such a credit crunch signaled a danger to the economic growth of UK and US. The Federal Reserve had lowered the bank rate to 5.75%. During that time bank’s labor rate (6.79%) was higher than bank of England’s base rate (5.75%). This endangered the survival of banks. They were heading towards bankruptcy. Other than housing and finance industries automobile industries were also badly hit by the crisis. They are also in the process of revival of growth. The figure below presents a scenario of the annual production and growth levels of automobile industries in different countries during the year 2007-2008 after experiencing the crisis (Sturgeon & Biesebroeck, 2010). Source: Sturgeon & Biesebroeck, 2010 The data shows that production levels have reduced owing to the crisis. There is a downward trend. This is because due to crisis the demand for cars has come down. Consumers are spending less on such goods. Moreover with the new regulations of banks, loans have become more restrictive. Major losses began to emerge at that time. Swiss bank incurred a loss of $3.4 billion (Sturgeon & Biesebroeck, 2010) References 1. Padaon, PC. (2011). OECD calls for urgent action to boost ailing global economy, OECD 50, http://www.oecd.org/document/47/0,3746,en_21571361_44315115_49095919_1_1_1_1,00.html (Accessed on December 5 2011) 2. OECD Economic Projections, Policy brief- OECD, (1999), OECD Observer , available at http://www.oecd.org/dataoecd/24/19/2670811.pdf (Accessed on December 5 2011) 3. Parussini, G. (2011). OECD Cuts 2012 US GDP Growth Forecast, Sees Recession in Euro Zone, Wall Street Journal, available at: http://online.wsj.com/article/BT-CO-20111128-702755.html (Accessed on December 5 2011) 4. Greece: Overview, New York Times. (November 11, 2011). Available at : http://topics.nytimes.com/top/news/international/countriesandterritories/greece/index.html (Accessed on December 5 2011) 5. Patil, SB. (n.d). 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The Credit Crunch of 2007-2008: A Discussion of the Background, Market Reactions, and Policy Responses, Federal Reserve Bank of St. Louis Review, Vol 90 No 5, pp.531-567 available at : http://research.stlouisfed.org/publications/review/08/09/Mizen.pdf (Accessed on December 5 2011) 11. Sturgeon, TJ and Biesebroeck, JV, (2010). Effects of the Crisis on the Automotive Industry in Developing Countries: A Global Value Chain Perspective, http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/RDs/Automotive%20Industry%20and%20Crisis%20%28Sturgeon%20-%20Jun%202010%29.pdf (Accessed on December 5 2011) 12. Timeline: Credit crunch to downturn, BBC News, (August 7, 2009). Available at http://news.bbc.co.uk/2/hi/7521250.stm (Accessed on December 5 2011) Read More