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In search of a new economic equilibrium

The Fed’s ‘monitoring’ of markets is a sign that a steady state may be some distance away

editorials Updated: Jan 28, 2016 23:01 IST
The world economy’s current state fits perfectly into a theory of general equilibrium that involves the process of arriving at a set of best solutions to a matrix of problems.
The world economy’s current state fits perfectly into a theory of general equilibrium that involves the process of arriving at a set of best solutions to a matrix of problems.(Reuters Photo)

There would perhaps be few periods in recent history when economists and policymakers across the world were so unsure about which way the winds were blowing. China, the world’s undisputed growth engine for the better part of the last two decades, is perhaps battling its worst economic crisis in a quarter of a century. The globe’s second-largest economy grew at 6.9%, its slowest pace since the 3.8% in 1990. It could get worse. The International Monetary Fund (IMF), in its latest World Economic Outlook update last week, has projected that China’s growth would be slowing to 6.3% in 2016 and 6% in 2017 — from 7.3% in 2014. For the rest of the world, indeed for the US, it could be foolhardy to ignore the signals that lie layered beneath the dragon economy’s slowdown.

The world economy’s current state fits perfectly into a theory of general equilibrium that involves the process of arriving at a set of best solutions to a matrix of problems. In a real economy, however, the most favourable way out for one set of problems could harm prospects somewhere else. Ceteris paribus, or other things remaining the same, the most basic assumption in any economic modelling may not apply in most real cases in an inter-connected world. For instance, if commodity prices are falling steeply because demand for oil and other basics are sliding in China, it would influence the way inflation will trend in other countries. Likewise, the fact that financial markets across the world have been on a roller-coaster ride since the beginning of the new year only suggests that the world markets are struggling to find a new equilibrium in the wake of the shocks in the Chinese economy.

For the US, which hiked its benchmark short-term interest rates by 0.25 percentage points last month, after keeping it around zero since the start of the 2008 financial crisis, the fresh developments represent a new set of variables. The Federal Reserve, which maintained the status quo on interest rates on Wednesday, said it was “closely monitoring global economic and financial developments and is assessing their implications for the labour market and inflation, and for the balance of risks to the outlook”. Given the considerable sway that the Fed Reserve wields over global equity and currency markets, the statement can be seen as a sign of caution and a gauge that achieving a steady state may still be some distance away. The path to the textbook point of general equilibrium may involve a long process of slow, gingerly taken steps. In a world where billions of dollars move continents with a click of the button, it is important for policymakers to be extra cautious. The world can ill-afford to slip into another prolonged slide.