Cedric Wilson

Bizarre is perhaps the word that best describes the present situation in the United States financial markets. Last Tuesday, chairman of the US Federal Reserve, Ben Bernanke, and Treasury Secretary, Henry Paulson Jr, announced a US$85 billion bailout for the world's largest insurance company, American International Group .

Lehman Brothers, one of America's financial giants with more than 150 years' experience, went bankrupt during last week.

Earlier this month, the Federal Reserve had to nationalise the assets of Fannie Mae and Freddie Mac, the two largest mortgage firms in the US, to save them from collapse.

In the latter part of last year, global financial markets were hit by the subprime crisis - a catastrophe triggered by reckless lending in the US mortgage market, which paved the way for a backlash of delinquencies and pandemonium across major financial centres worldwide.

Global fears

Global financial markets are so interconnected and interdependent that the crisis unleashed widespread fear that the global economy was about to descend into a nightmare not seen since the Great Depression of the 1930s.

Esteemed economists on every continent argued that if the crisis was allowed to run its course, consumer spending would shrink, investments would stagnate, unemployment would rise, and the global economy would slide into a hopeless downward spiral.

The logic was that when the belly of the American economy growls, the global economy has diarrhoea.

The Federal Reserve responded to the sub-prime crisis in January by slashing interest rates by three-quarters of a percentage point, the most dramatic cut in more than two decades. President Bush provided the US economy with a stimulus package, which included US$110 billion of tax rebate.

And, from all indications, it staved off what, arguably, could have been the most paralysing global depression the world has seen in a long time. So, the world breathed a collective sigh of relief when the US economy responded favourably.

During the second quarter (April-June 2008), the US economy grew at an annualised rate of 3.3 per cent, and although fuel prices continued to rise and there were job losses, consumer spending actually increased by 1.7 per cent.

Evidently, the measures implemented by US policymakers were not strong enough to cure the subprime virus deep within the guts of the financial sector. The latest round of failures, buyouts and rescues in the US financial sector demonstrates this.

Furthermore, during July, consumer spending declined by 0.4 per cent relative to the previous month, and the unemployment level rate is now at 6.1 per cent, the highest level in five years.

Frenzied week

All of last week, there was much drama in the major financial markets throughout the world. From New York to London, from Bombay to Moscow, stock markets were in a frenzy shifting one way in a trading session and rushing the other way the next.

In its latest move, the Federal Reserve, last Friday, pledged up to US$50 billion next year to support the troubled money-market funds. Indeed, the Federal Reserve is implicitly admitting that upheaval in the US financial markets is not over yet.

Undoubtedly, if the US economy meanders into a recession, it is likely to have an adverse effect on the Jamaican economy. Tourism, a pillar in the domestic economy, caters for approximately 80 per cent of stopover arrivals from North America.

Remittance inflows, which appear to be strongly correlated to activities in the construction sector, would also shrink if unemployment levels continue to rise in the US. Plus, it could deliver a blow to exports.

The question, therefore, is: What are the options available to a small, open, dependent economy that lives in the colossal shadow of the US?

The conventional response to a possible slowdown in the economy is to employ fiscal expansion. This requires a stimulus package which involves either increased government expenditure or tax reductions.

The effects of tax reductions are less predictable in the economy since there is no guarantee that the increased spending power will actually augment growth, given Jamaicans' enormous appetite for foreign goods. In addition, if there is the threat of hard times, people may actually save the extra income available from the tax cut and this will not boost the economy.

The surest way to simulate a sluggish economy would be to increase government expenditure. Of course, with the damage caused by Hurricane Gustav and the repairs to roads, bridges and other critical infrastructure, the value added to the economy would be significant. But, herein lies the problem: The Government would definitely have a problem funding the additional expenditure.

Funding problems

First, the Government cannot borrow money from the Bank of Jamaica without sending the already high inflation rate into stratospheric levels.

Second, it is difficult to imagine the Government raising the money on the domestic financial market without causing an increase in interest rates. Indeed, this would not be an encouraging sign for local investors.

Third, the present turmoil in the global financial market has resulted in the assignment of a risk premium to emerging markets debts. Consequently, this could translate to prohibitive interest rates from traditional sources of foreign loans.

Admittedly, the options available for fiscal expansion are limited, to put it mildly. It, therefore, requires a creative response, particularly in relation to seeking funds from non-traditional sources. In addition, there is a need for greater efficiency with respect to tax collection and government spending. This is where our salvation lies - finding a way when people say there is none.

Cedric Wilson is an economist who specialises in market regulations. He may be contacted at conoswil@hotmail.com. Feedback may also be sent to columns@gleanerjm.com.