verma (ed.) - recession and its aftermath; adjustments in the united states, australia, and the emerging asia (2013)

Recession and Its Aftermath

N.M.P. Verma
Editor
Recession and Its Aftermath
Adjustments in the United States, Australia,
and the Emerging Asia
Editor
N.M.P. Verma
Department of Economics
Babasaheb Bhimrao Ambedkar University
Lucknow, India
ISBN 978-81-322-0531-9 ISBN 978-81-322-0532-6 (eBook)
DOI 10.1007/978-81-322-0532-6
Springer Dordrecht Heidelberg New York London
Library of Congress Control Number: 2012943593
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In honor of Kamta Prasad

vii
Recession is an economic instability that touches every person, the economy, and
society. It ultimately also affects other economies depending upon the intensity of
cross-country integration, openness, and trading. Therefore, bringing out a book
like this is de fi nitely the need of the hour when the world has just witnessed a global
recessionary crisis.
The initial thoughts for creating this volume arose during my visit to Wisconsin,
Madison, USA, in the post recession year of 2010. There, a few contributors to this
book and many other academicians informally deliberated on the issue of fi ghting
the recession which took place during 2007–2009 in the USA. The US economy
was trying its best to recover by taking expansionary measures. It was also delibe-
rated by some that the US recession had probable impacts on Europe, Australia,
emerging Asia, and other continents. After my return from the USA, I formally
started this project, had discussions with a large number of researchers, and invited
many economists from this fi eld to contribute a chapter. Some of them have con-
tributed and some wanted much more time to contribute. As time is a very important
factor for this kind of study where the book should be published on time, only 11
contributions could be compiled in this volume. The chapters in this volume mostly
focus on the USA, Australia, China, India, and Malaysia. However, the contributors
also discuss European economies and Asian economies, such as those of Pakistan,
Nepal, Bhutan, the Maldives, South Korea, Indonesia, and a few other core countries

for a general description of recession.
In creating this volume we were assisted by a large number of people and institu-
tions. First and foremost we must thank the contributors, whose unconditional
commitment and prompt submission of their chapters made my job as the editor
quite smooth and easy. I am also thankful to many of my colleagues and friends,
including Nirankar Srivastava, P.K. Sinha, several colleagues from various other
institutions, and Ejaz Ghani, who is currently at the World Bank, for motivating me
to convert this dream project into reality.
Sagarika Ghosh, Sahadi Sharma, and their colleagues at Springer came forward
to bring out this volume. Their valuable comments on the preliminary draft further
reduced many shortcomings. I am extremely thankful to them for their work on the
Preface
viii
Preface
production of this volume in about 5–6 months. I also thank Madhu Patel, Atul
Kumar, and Vinit Kumar for typesetting and computational work. Lastly, I am
thankful to our postgraduate students and PhD scholars, to whom I have been teaching
macroeconomics for many years, for raising many complicated questions. This
helped to re fi ne the project.
I dedicate this book to Kamta Prasad, with whom I had a research association
and from whom I learned the workings of a complex economy. I expect this volume
to be of immense help as a reference book for postgraduate students, research schol-
ars, academicians, corporate consultants, fi nancial experts, and other members of
universities and research institutions in the fi elds of economics, management, and
commerce across the globe.
N.M.P. Verma
ix
1 Understanding Recession: Conceptual
Arguments and US Adjustments 1
N.M.P. Verma and V. Dutta

2 The Financial Crisis and the Great Recession
in the United States 23
Mukti Upadhyay and Tim Mason
3 Dynamics of Deflation and Unemployment:
Fall into an Abyss of Depression 47
Anson Wong and Michael Chu
4 Market Fluctuations and Country Risk
Relationships for Australian and Indian Energy 67
John Simpson
5 The Chinese Economy After the Global Crisis 81
Liang-Xin Li
6 The Role of Macroeconomic Fundamentals
in Malaysian Post Recession Growth 113
Lee Chin
7 Impact of Global Financial Crisis on Economic Wellbeing:
A Case of South Asia 129
Nikhil Chandra Shil
8 The Asian Economic Crisis and Malaysia’s Responses:
Implications for the Banking Sector 157
Balakrishnan Parasuraman, Beatrice Lim, Fumitaka Furuoka,
Catherine Jikunan, and Lo May Chiun
Contents
x
Contents
9 Output Growth in Post Liberalized India:
An Input–Output Structural Decomposition Analysis 179
K.K. Saxena, Sarbjit Singh and Rahul Arora
10 The Recent Recession: Impact and Future
Prospects for the Indian Banking Sector 215
D.K. Yadav

11 Impact of the Global Downturn on the Indian Economy 233
Basanta K. Sahu
About the Book 257
Index 261
xi
Rahul Arora Department of Humanities and Social Sciences, Indian Institute of
Technology , Kanpur , India
Lee Chin Department of Economics, Universiti Putra Malaysia , Serdang , Malaysia
Lo May Chiun Universiti Malaysia Sarawak , Kota Samarahan , Malaysia
Michael Chu School of Continuous Education, Baptist University of Hong Kong ,
Kowloon , Hong Kong
V. Dutta School of Public Policy, University of Maryland , College Park , MD , USA
Fumitaka Furuoka Universiti Malaysia Sabah , Kota Kinabalu , Malaysia
Catherine Jikunan Fumitaka Furuoka , Institute of Asia-Europe Centre, University
of Malaya , Kuala Lumpur
Liang-Xin Li Catherine Jikunan, Malaysian Trade Union Congress, Kota
Kinabalu , Sabah , Malaysia
Beatrice Lim Universiti Malaysia Sabah , Kota Kinabalu , Malaysia
Tim Mason Department of Economics, Eastern Illinois University , Charleston , IL ,
USA
Balakrishnan Parasuraman Faculty of Entrepreneurship and Business , Universiti
Malaysia Kelantan, Kota Bahru , Malaysia
Basanta K. Sahu Indian Institute of Foreign Trade , New Delhi , India
K. K. Saxena Department of Humanities and Social Sciences, Indian Institute of
Technology , Kanpur , India
Nikhil Chandra Shil Department of Accounting, American International University ,
Bangladesh
Contrib utors
xii
Contributors

John Simpson School of Economics and Finance, Curtin University , Perth ,
Western Australia
Sarbjit Singh Department of Humanities and Social Sciences, Indian Institute of
Technology , Kanpur , India
Mukti Upadhyay
Department of Economics, Eastern Illinois University , Charleston ,
IL , USA
N. M. P. Verma Department of Economics, Babasaheb Bhimrao Ambedkar University ,
Lucknow , India
Anson Wong School of Account and Finance, Hong Kong Polytechnic University ,
Kowloon , Hong Kong
D . K . Ya d a v Department of Economics, Babasaheb Bhimrao Ambedkar University,
Lucknow , India
xiii
Market failure at medium intervals is inevitable in a capitalist economy. Such
failures may not be seen in a serious light in the short run because the market adjusts
to demand through hoarding of inventory or import of required goods and services.
The market also adjusts in the long run to demand through expansion of industrial
output and also by entry of new fi rms to the market. The crucial variable is price,
which also adjusts the commodity and labor market. A problem arises when there is
overproduction, overcapacity utilization of plants, excess liquidity and excess
supply of money, and a change in demand because of change in tastes and habits of
consumers, households, and the public. All these create knife-edge disturbances in
the economy. As a consequence, they need adjustment through variables such as
employment and growth of the population, saving propensity, technology, exhaustion
of existing inventory, and monetary and fi scal balancing.
In this volume an attempt has been made to appraise the working of a market
economy where short-term disturbances may occur, the market fails, a recessionary
cycle emerges, and after certain fundamental measures have been taken the market
recovers. Starting with a brief theory and recent history of the US crisis and the

recession in the fi rst, introductory chapter, the discussions in the second chapter turn
to the area of the fi nancial crisis and recession in the US economy. In this chapter
the authors have highlighted the fi nancial factors responsible for the severe historic
crisis. The third chapter relates de fl ation to unemployment. It discusses theories
about the relationship between de fl ation, price levels, and unemployment and the
reason why de fl ation is a bigger threat than in fl ation, and recommends recovery by
adopting appropriate policy measures. The chapter analyzes the cases of a few
European economies as well. The fourth chapter examines energy and resources
trade and equity investment relationships between Australia and India. The chapter
investigates macroeconomic and fi nancial economic risk. The study utilizes macro-
economic data. In the fi fth chapter, attention is diverted to the dragon, the biggest
economy, that of China. Here the author discusses the slowing of growth caused by
the recession and how to achieve and maintain a faster rate of growth in the future.
In the sixth chapter we focus on the Malaysian economy. The macro variables
chosen are exports, imports, price level, money supply, interest rate, exchange rate,
Introduction and Overview
xiv
Introduction and Overview
and government expenditure. The co-integration method was used to assess the
long-run equilibrium linkages among the selected variables. For the short-run
causality, the study uses the Granger tests based on the vector error-correction
model. In the seventh chapter, the global fi nancial crisis is seen from the South
Asian perspective. The author has tried to show the extent of the global fi nancial
crisis and its effects on South Asia. In this chapter, the impact of recession is dis-
cussed for core Asian countries such as Bangladesh, Pakistan, Nepal, Bhutan, and
the Maldives. In the eighth chapter the authors have tried to relate the Asian crisis
and the Malaysian economy. The retrenchment of workers is critically examined
here exclusively for the Malaysian economy. Further, the authors also examine the
recessionary impact in South Korea, Indonesia, and other Eastern countries.
In the ninth chapter, the focus is on the Indian economy. In this chapter input–

output analysis is done with the help of time-series data. In the tenth chapter,
challenges and opportunities facing the Indian banking sector are examined. The
chapter states that the banking sector could perform miracles in the Indian economy
because it is better regulated and a plethora of service demands exist. The last chapter
is again con fi ned to the discussion of fi nancial sector activities and reforms. The
chapter highlights the experiences of India and the way other countries have reacted
to the recent global economic slowdown. This slowdown provides some challenges
and opportunities for the Indian economy. Since India is one of the emerging
economies, it has the potential to increase its exports to advanced economies. This
way, India can earn more foreign exchange. This will act as a cushion and dilute
the effects of a slump on the economy. The chapter concludes that despite India’s
high economic growth performance, it has not been able to remain insulated in this
global decline.
Each chapter concludes with deliberations on macroeconomic results, and the
implications for speci fi c policies, some of which have been tried and others have
still to be examined. Further, in this volume we examine the policies necessary for
the regulation of the economic system and give a brief assessment of the extent to
which global policy coordination has been discussed in policy circles even if it has
not been seriously implemented. Concluding remarks appear in all 11 chapters on
the relevant themes and speci fi c to the economies concerned. With this overview of
the following analysis, we present a summary of each chapter.
The opening essay by N.M.P. Verma and V. Dutta conceptualizes the working of
a market economy and the frequent occurrences of business cycles in a country
or in many economies simultaneously. The chapter reviews many dimensions
of economic activities, such as the issue of frequent market failure, various
approaches of cyclical movements, and conceptual concern for controlling reces-
sion. The authors have reviewed the opinions of classicalists and new classicalists
and the modern approaches. The classicalists were concerned with medium-term
fl uctuations in real GNP. This fl uctuation was explained through a few theories of
the business cycle. With the advent of Keynesianism, business cycle theories were

not being accepted. During the post-Keynesian period many economists, such as
Harrod, Domar, Hicks, Samuelson, Frisch, and Goodwin, gave their own views
on adjustments of market fl uctuation. With the introduction of new-classicalist
xv
Introduction and Overview
approaches, “short run” could not be a suitable duration for a macro study. Hence, a
new business cycle theory was developed which was based on rational expectations
and sustained market clearance. In the end, conceptual arguments have been linked
with the US slump. It has been argued that inadequate information and lack of
regulations in the fi nancial sector caused the US recession. A recession caused by
fi nancial factors lasts longer than a recession caused by other factors.
In the second chapter, Mukti Upadhyay and Tim Mason examine the US reces-
sion. The chapter provides the historical background to the fi nancial crisis. The
recent recession is termed the “Great Recession.” The recession lasted for about
2 years, and its intensity was severe. After the Great Depression of the 1930s, the
present recession showed the longest contraction of the US economy. The federal
government became indifferent in protecting the investor Lehman Brothers. Because
of this, uncertainty started in the credit market. As a consequence, the credit market
showed freezing tendencies. Other major fi nancial institutions are also reviewed,
including Citigroup, American International Group, and Bank of America, which
faced insolvency. Although many monetary and fi scal policies were adopted by the
government, the actual output of the economy still deviated signi fi cantly from the
potential output. The authors trace how the fi nancial system, left for all intents and
purposes to its own devices, has deepened the instability inherent in capitalist
systems found in the USA and many other countries. The chapter is full of discus-
sions on the macroeconomic dilemma. Finally, regulation of the fi nancial system is
examined. The chapter concludes with the need for global policy coordination.
The dynamics of de fl ation and unemployment globally is reexamined by Anson
Wong and Michael Chu in the third chapter. This chapter examines global economic
issues of de fl ation and unemployment after the fi nancial crisis of 2008. It starts with

an overview of recent economic performance around the world. A number of fi gures
visualize the recent development of GDP, in fl ation, and unemployment in the USA,
the UK, and European countries. Then, it applies theories such as the quantity
theory of money to illustrate the relationship between de fl ation and unemployment.
It also discusses a number of determinants of the de fl ation and recession after the
crisis, so that readers can understand more easily the global issues. The examples of
de fl ation in Japan and Hong Kong during the 1990s and 2000s are reviewed. Besides,
the chapter describes the threats that de fl ation and depression pose to the economy.
A number of possible solutions to solve the problems of de fl ation and recession are
given, and the chapter concludes with examples of successful recovery from the
curse of recession.
In the fourth chapter, John Simpson examines energy and resources trade and
equity investment relationships between Australia and India. This chapter recog-
nizes the logic of the growing strength of trade and investment relationships in the
energy sector between India and Australia as a basis to build upon this relationship
for mutual economic bene fi t. India is a large and powerful economy with a depen-
dence on coal to generate electricity for domestic and industrial use. Australia is a
developed, low-political-risk country. Australia is well endowed with natural gas as
well as coal and other resources, such as iron ore. The opportunity exists here for
India to diversify its supplies of cleaner-burning natural gas through its imports and
xvi
Introduction and Overview
through foreign direct investment in Australia in natural gas and coal. India has a
dynamic and rapidly growing share market and economy, and this also presents
opportunities for Australian foreign direct investment in the resources sector.
Australia needs to diversify its inward and outward foreign direct investment as well
as its exports of natural gas, coal, and iron ore.
Econometric analysis of sectoral stock market and country risk data reaf fi rms a
strong basis for a substantial increase in two-way trade and investment. The caveat
for increased foreign direct investment in India’s electricity sector is that microeco-

nomic reforms need to continue to assist in making state electricity boards more
viable. The increase in economic cooperation is all the more important in the uncer-
tain times that have followed the global fi nancial crisis. Western Europe and
the USA are burdened by public debt problems, and their growth projections have
subsequently suffered. India and Australia share a regional location and both are
democracies with a belief in free enterprise. India’s growth rate is very high and
Australia’s growth rate is consistently the highest of the OECD countries. India and
Australia are not part of the European Monetary Union and have less exposure
to the same debt problems, either by accident or by design. They have a unique
opportunity to expand their cooperation over the ensuing decades.
Liang-Xin Li focuses attention on the Chinese economy since the global crisis in
the fi fth chapter. Since the Chinese economy took a fast growth path toward the top
of the world economy, it is interesting to examine China’s way of development. He
demonstrates what China was doing, is doing, and will do to achieve economic
expansion during and after the global crisis. Many thoughts and theories about
Chinese economic reforms are analyzed. The road map and goal of Chinese
economic growth are examined and outlined. How to keep the Chinese economy
growing faster after the recession is the chapter’s key issue.
The role of macroeconomic fundamentals in Malaysian post recession growth is
presented by Lee Chin in the sixth chapter. The Malaysian economy experienced
contraction during the 1997–1998 Asian fi nancial crisis. Nevertheless, the economy
started to recover in 1999 and grew steadily in the following years. The Malaysian
government has made much effort to help the economy recover, such as adopting
monetary policies that aim to promote monetary stability and suf fi cient liquidity in
the economy, keeping the in fl ation rates low, and adopting currency control which
pegs the ringgit at the rate of RM 3.80 to one US dollar. As a result of the stable
exchange rate, the external sector also achieved a good surplus. Thus, it is the aim
of this chapter to fi nd out the roles of monetary policy (money supply and interest
rate), fi scal policy (government expenditure), the external sector (exchange rate,
exports, and imports), and the general price level in Malaysian post recession growth.

The techniques of co-integration and Granger causality are employed to examine
the relationships between economic growth and these macroeconomic variables.
The results show that an increase in exports and government expenditure or a depre-
ciation of the exchange rate will promote long-term economic growth, whereas an
increase in in fl ation, the interest rate, and imports will reduce economic growth.
Furthermore, the price level and government spending in fl uence economic growth
in the short run. In a nutshell, the fi ndings suggest that fi scal policy is probably the
xvii
Introduction and Overview
most appropriate tool in promoting economic growth in Malaysia during the post
recession period.
Nikhil C. Shil examines the fi nancial crisis from a South Asian perspective in the
seventh chapter. The global fi nancial crisis came as an economic devil and swiped
away a lot, imposing a signi fi cant toll on the world economy. The crisis that started
in September 2008 lasted for about 2 years, but by now most of economies have
started reviving. Thus, now is the time to look back and evaluate what happened.
Initially, the South Asian countries were affected much owing to a high level of
integration with economically advanced countries, but later they managed to mitigate
their problems. The author tries to present a complete picture, covering the back-
ground to the global fi nancial crisis, its impact on South Asian countries, the present
status, and future challenges. The contribution is a conceptual one depending on
different secondary sources of information combined with the author’s own judgments.
The scenario of recessionary impact is shown in the case of core Asian countries
such as Pakistan, Nepal, Bhutan, Bangladesh, and the Maldives.
The Asian economic crisis and Malaysia’s responses and the implications for
the banking sector are studied by Balakrishnan Parasuraman , Beatrice Lim ,
Fumitaka Furuoka , Catherine Jikunan , and Lo May Chiu . This chapter examines
the Asian economic crisis which occurred during 1997–1998 and the Malaysian
economy’s responses. The chapter chooses the Asian fi nancial crisis as a case study
to examine its impact on the Malaysian economy and describes how the Malaysian

government responded to the crisis. It also focuses on the impact of the Asian fi nancial
crisis on employment in the banking sector in Malaysia. The Asian fi nancial crisis
created havoc in countries such as Thailand, Indonesia, and South Korea, where
these countries had to seek assistance from the International Monetary Fund in
order to save their economies. However, Malaysia took a different step in saving
the country by refusing the International Monetary Fund package and aiming for a
stricter fi nancial adjustment. What is important here is how the crisis affected a
number of people, most of whom were workers. During the Asian fi nancial crisis,
many workers lost their jobs because of the closure of many businesses (manufac-
turing, construction, etc.), mergers and acquisitions, and other forms of reducing
the workforce in order to save costs. The unemployment rate in the country
increased from 2.6 % in 1997 to over 5 % in 1998. In the fi nance, insurance, real-
estate, and business service sectors, 6,596 workers were retrenched. As a result of
the crisis, the banking sector in Malaysia began to experience increasing nonper-
forming loans, bringing about tight liquidity conditions. This situation forced the
banks into merger and consolidation exercises initiated by the government. Besides
mergers and acquisitions, the banks also embarked on downsizing, lean-trimming,
organizational changes, and the introduction of new technologies. In other words,
many small banks were forced into merging with bigger banks and many
excess workers were offered a “voluntary separation scheme.” These retrenched
workers became the urban poor, facing the high costs of living and no opportunity
to obtain jobs as there was no safety net.
The sources of output growth during the postliberalization and recessionary era
in India through an input–output structural decomposition analysis are described in
xviii
Introduction and Overview
the ninth chapter by K.K. Saxena , Sarbjit Singh , and Rahul Arora. They have made
an attempt to decompose the changes in output growth in the Indian economy.
The study highlights four key components:
1. Mean growth of fi nal demand

2. Variations in the composition of fi nal demand
3. Fluctuations in input–output coef fi cients
4. Interface of both change in fi nal demand and technological change
Input–output tables have been utilized for this purpose. Owing to the unavailability
of recent input–output tables, the analysis of recent years (2007–2008 to 2009–
2010) was done using data from different economic surveys provided by the Ministry
of Finance, Government of India. The modi fi ed method of decomposition of output
growth from the demand side was utilized to calculate the percentage share of each
component in the total fi nal demand change. From 1993–1994 to 2006–2007, the
total change in output was approximately 200 %. Of this change, 89.27 %
(87.46 % + 1.81 %) is explained by a change in fi nal demand by assuming constant
input–output relations. For the share of the interaction factor where changes in both
the fi nal demand and the input–output relations were assumed, the contribution is
just about 7 %. To better understand the changes, the growth in output was further
divided into fi ve more factors, that is, private consumption, government consumption,
gross investment, exports, and imports. Among these fi ve demand categories,
domestic demand (sum of private consumption, government consumption, and
investment expenditure) is the dominant source of output growth in the postlibera-
lization era, which supports the hypothesis that the Indian economy is a domesti-
cally demand driven economy. From 1993–1994 to 2006–2007, the contribution of
investment demand was highest and afterward, owing to the fi nancial crisis, con-
sumption expenditure took the lead, with increased government consumption
expenditure to overcome the negative impact of the crisis. The economy again came
back on track in the later half of 2009–2010, with more growth of investment
demand in the economy.
The recent recession and the challenges and opportunities for rebalancing Indian
banking are considered in the tenth chapter by D.K. Yadav . India is an emerging
economy. Its growth rate was close to 10 % in prerecession years and was 7–8 %
even during the recession. This high growth rate of the economy is supported by the
Indian fi nancial system. After 1991, when the structural reform process was imple-

mented, Indian companies became global, and multinational companies also entered
the Indian economy. This changing structure of the Indian economy is providing an
opportunity for the Indian banking and fi nancial system to expand its business at the
world level. According to the Indian Bank Association report “Banking Industry
Vision 2010,” there will be a greater presence of international players in the Indian
fi nancial system and some of the Indian banks will become global players in the
coming years. The current competitive position of the Indian banking system,
however, is not satisfactory in terms of numbers and ranks. Only 20 Indian banks,
including private sector banks, appear in the list of the top 1,000 world banks, as
listed by the London-based magazine The Banker . However, the current recessionary
xix
Introduction and Overview
problem, which started with the fi nancial crisis in the US economy and which now
has European countries in its grip, has revealed the strong competitive position of
Indian banks in terms of qualitative factors such as asset quality, capital adequacy
position, and ef fi cient responsive regulatory structure. When the leading large banks
of the world are collapsing, Indian banks are not only safe but have also produced
signi fi cantly positive returns in terms of pro fi t. This chapter is an effort to evaluate
the competitive position of Indian banks in the postreform period, particularly in the
post recession period. It was found that Indian banks are competitive enough in
comparison with their foreign counterparts and the current recessionary problem
has improved their competitiveness in the global fi nancial market. However, increas-
ing their size by the well-structured process of bank consolidation, cost manage-
ment, legal aspects of recovery management, improving risk management skills of
banking staff, and speedy reform on the policy front are some of the challenges to be
overcome to make a world-class competitive banking system a reality.
In the fi nal chapter, Basanta K. Sahu examines the impact of the global downturn
on the Indian economy. Owing to increased integration of world markets, transmis-
sion of the economic crisis from one country to the rest of the world has become
easier. Although the recent global economic slowdown has taken center stage in

policy debates and discussions across the world, the variability and volatility of
economic growth and trade performance are worrying and differ for different
economies. An impact has been experienced in almost all regions and sectors, with
different degrees and dimensions. This chapter seeks to analyze how the recent
global downturn has impacted the Indian economy and resulted in an increasing
sense of insecurity. For India the crisis made matters much worse by causing sharp
declines in exports of goods, reversal of capital fl ows, reduction in the volume of
remittances, worsening balance of payments, increasing joblessness, rising prices,
and deteriorating socioeconomic development scenarios. Within the economy the
performance of different regions and sectors has been different. In this context, the
chapter highlights the experiences of India and the way different economies reacted
to the recent global economic slowdown, which provides some challenges and
opportunities for India. India, being one of the emerging economies, has relied
heavily on advanced countries for its exports and has experienced diverse impacts
of global slowdown. Despite its good economic growth performance, India has not
been able to remain insulated in this global decline. In real terms, the growth in
India’s exports and imports of both goods and services has declined and joblessness
has been experienced owing to contraction of output in the export sectors. However,
transmission of the impacts through different channels seems to have been different
for the Indian economy in comparison with other economies. The chapter also
discusses the precrisis macroeconomic scenario in India and critically analyzes the
argument that the Indian economy has been less affected owing to its lesser integra-
tion with the world as compared with its size and potential.
The impacts of the crisis are differentiated spatially and sectorwise because many
core sectors of the economy are driven by huge domestic demand and are able to
absorb some kind of shocks originating from the global slowdown. However, there
are some important lessons for policy makers to consider, such as the balance
xx
Introduction and Overview
between development of the export sector and development of the nonexport sector,

to achieve and maintain the desired growth with strong macroeconomic fundamentals,
especially in a crisis situation such as the recent global slowdown. The chapter con-
cludes with some policy suggestions, especially for developing economies, based
on trade and service sector led growth like in India.
Thus, an attempt has been made to cover the broad perspectives of the global
recession in all 11 chapters. The volume starts with conceptualization of the issue.
It highlights the US scenario and its probable effects on other larger economies,
which include those of Australia, China, Malaysia, and India. Nevertheless, it does
not mean that European and other Asian economies have been left out. While
analyzing various issues, the authors have substantiated the arguments by citing the
cases of a few European and many Asian economies.
1
N.M.P. Verma (ed.), Recession and Its Aftermath: Adjustments in the United States, Australia,
and the Emerging Asia, DOI 10.1007/978-81-322-0532-6_1, © Springer India 2013
1 Introduction
Recession is an economic phase when various sectors of the economy re fl ect working
at the bottom for at least two quarters of a calendar year. Investment declines, unem-
ployment increases, income declines, the growth rate falls, asset values collapse,
consumption falls, and overall the economy is in crisis. Conventionally, a recession
is said to occur when GDP falls for at least two consecutive calendar quarters. For
the US economy, a recession is of fi cially indicated by the National Bureau of
Economic Research. “Recession” is also termed “contraction” or “slump.” Following a
recession, there is often a boom, i.e., expansion, and thus this reverses the effects
of a recession. In a recession, there is a reduction in production, resulting in high
unemployment. During a boom, however, there is a rapid rise in prices. The period
from recession to recovery and boom is called a business cycle or trade cycle. There are
short-run macro problems but these do not last long because of corrective measures
taken by one or many market players, including interventions by the government.
Recession is also known as failure of a market because its ef fi ciency declines.
The market is really a place of complex transaction relations. A large number of buyers

and sellers gather in a market and submarkets for clearing products and inventories.
In classic economic theory, there was a small market and, therefore, there was hardly
any effect on short-run macroeconomic balances. The adjustments in cases of deviations
from output and full employment take place through price and wage variations.
The classicalist was, however, concerned with medium-term fl uctuations of real GNP.
N. M. P. Verma (*)
Department of Economics, Babasaheb Bhimrao
Ambedkar University , Lucknow , India
e-mail:
V. Dutta
School of Public Policy, University of Maryland ,
College Park , MD , USA
Chapter 1
Understanding Recession: Conceptual
Arguments and US Adjustments
N. M. P. Verma and V. Dutta
2
N.M.P. Verma and V. Dutta
This fl uctuation was explained by a few theories of the business cycle (Van der
Ploeg 1985 ). With the advent of Keynesianism, business cycle theories were not
accepted. During the post-Keynesian period, many economists such as Harrod, Domar,
Hicks, Samuelson, Frisch, and Goodwin gave their own views on adjustment of market
fl uctuation. With the introduction of new-classicalist approaches, “short run” could
not be a suitable duration for a macro study. Hence, a new business cycle theory was
developed which was based on rational expectations and sustained market clearance.
This opinion was developed by Lucas (
1975 , 1977 ) . The market plays a crucial and
ef fi cient role in coordinating production and distribution of goods and services. It is a
concept that is virtually a few decades old. After the failure of the central planning
system of the Soviet Union in 1992, the market economy suddenly became important.

The central planning of Russia was burdened with bureaucracy. It neglected consumers
and the agricultural sector. It concentrated seriously on big industry and defense
products. Market exchange was partly decentralized and producers received many
incentives to ful fi ll consumer desires. Therefore, this led to a more ef fi cient system.
A market economy also provides choices to ful fi ll desires. There is no coercion in a
market economy. Therefore, it is considered superior and ef fi cient, and the new clas-
sicalists believe in “free markets” for major economic decisions. However, Keynesians
emphasize how real-world markets might differ from the coherent activities of markets
in theory. The real-world markets require illustrious institutions to work. Markets on
their own often cannot address numerous economic problems. Thus, for very ef fi cient
working of a market there should be prevalence of societal trust, infrastructure for
smooth fl ow of goods and services (including information), and money as a medium
and measure of exchange (Suresh 2009 ) .
1

In this introductory chapter, the theoretical literature is critically analyzed. The
recent US recession is described in the light of theoretical developments. The chapter
ends with a description of the various macroeconomic measures already taken and
likely to be taken by the US government to achieve economic recovery.
2 Frequent Market Failures
The mechanism of a market is constrained and becomes less ef fi cient because of
reasons such as public goods, externalities, transaction costs, market power, complex
information, and escalating expectations (Akerlof and Allen 1985 ; Barro and
Sala-i-Martin 1995 ; Varian 1979 ; Zarnovitz 1985 ) and concerns for consumer
welfare and equity. The failure of a market is thus a condition where the market
produces inef fi cient and below-optimum outcomes. Since public goods are unrivaled,
nondiminishable, and nonexcludable, it is generally not possible to transact in the
market. In the situation of free riders, public goods can be provided and even delivered
through public outlets and agencies. Often, they may be delivered by levying various
taxes so that the cost is virtually borne by the public. Externalities both positive and

negative also affect the market. They create problems in the measurement of the real
social value of goods or services, which differs from the market value. Externalities
often damage the natural environment because of negative side effects. Since damage
3
1 Understanding Recession: Conceptual Arguments and US Adjustments
is not priced, it does not have a price tag. Similarly, higher transaction costs may
lead to higher prices, which may discourage demand. This may thus also lead to
market imbalances. Further, every fi rm wants to grow and get more market share.
Even in the case of military goods and defense services, the major part of the market
is shared by government agencies. These growing market shares may lead to their
affecting the price of inputs and outputs and also employment in a market. This way,
the market is less ef fi cient (Goodwin et al.
2009 ) .
In neoclassical analysis, there is no discussion of resources being allocated in
such a way that people can satisfy their basic human needs. If platinum can result in
more pro fi t than medicines, then a fi rm would invest in platinum production and
marketing rather than in medicines. This makes the market inef fi cient. Further, the
market does not consider social obligations, such as caring for the sick, elderly,
children, the otherwise able, widows, and other needy persons. Lastly, information
systems and investment expectations also create market failure. In a neoclassical
model, decentralization leads to ef fi cient consequences. The consumers and producers
have easy access to all the relevant information they need to make the best choices.
In a static macro analysis, this is possible because there is a low data requirement.
In a dynamic analysis, however, a lot of data and information are required relating
to choices and expectations. This complicates the analysis based on market data and
the results deviate from the expectations and choices. As a result, the market is less
ef fi cient and, therefore, it is termed a market failure. The classical macroeconomists
believed that a market generally operates smoothly as long as various government
agencies do not intervene. But often government intervention is necessary for the
welfare of people when a market fails, and various service deliveries do not take

place. In contrast, Keynesian economists believe that market economies need more
interference from the government side. In the case of both shortage and surplus
of marketable goods and services, the government has to intervene rationally for
stabilization (Sloman and Sutcliffe 2004 ) .
Unemployment in a recession is like a cyclical unemployment which is caused
by fl uctuations in many macro variables. There is a fall in aggregate demand for
goods and services in the national boundaries. In the USA in the period from 1961
to 2007, the unemployment rate was 3.4% in 1969 and 10.8% in 1982. According to
the National Bureau of Economic Research, the recession ended in 1991 but reap-
peared in 2001. The continued loss of employment up to 2003 was a period of “job-
less recovery” because GDP grew but its growth rate was too slow for jobs to be
created for new entrants. During the phase of contraction, unemployment rises,
whereas in a recovery or boom, unemployment falls. When production in an economy
is falling, producers require fewer workers. The opposite of this is true for a boom.
According to Okun
1981 , a 1% fall in the unemployment rate causes an approxi-
mately 3% boost to real GDP. Thus, there is a direct relationship between the rate of
unemployment and rapid real GDP growth. Monthly data from the Bureau of Labor
Statistics for 1990–1991, 2001, and 2007 show that unemployment increased swiftly
in the US economy. During a recession, the rate of in fl ation falls or even becomes
negative. As an economy moves toward a boom, investors invest more. The demand
for raw materials and labor increases; these factors raise the cost of production and
thus the rate of in fl ation increases. During a recession, this process is reversed and
4
N.M.P. Verma and V. Dutta
thus the rate of in fl ation falls. So during a recession there is rising unemployment
and a falling rate of in fl ation, whereas during a boom there is falling unemployment
and an increasing rate of in fl ation (Goodwin et al. 2009 ) . These tendencies are often
analyzed by the theory of the trade cycle or business cycle.
In Fig. 1.1 , GDP contracts from an upswing to a downswing and expands from a

downswing to a boom. Y
0
Y
1
, or the dotted block, shows the full employment range.
If the output is outside this area, then there is macroeconomic instability. To stabi-
lize the economy, a few corrective policy measures are required. There are many
theories concerning the economic cycle (Begg 1977 , 1982 ; Black 1982 ; Blinder 1981 ;
Farmer 1998 ; Fischer 1988 ; Frisch 1933 ; Hansen 1985 ; Harrod 1963 ; Hicks 1950 ;
Kalecki 1935 , 1937 ; Macmallium 1988 ; Mellander 1993 ). In the following analysis,
many key theories are critically discussed.
3 Macroeconomic Theoretical Dynamics
In the multiplier–accelerator information theory, consumption depends on previous
income. Investment can be either autonomous investment or induced investment.
Autonomous investment is a function of infrastructure and other basic needs of
the economy and thus is virtually determined by the rates of growth of consumers
and technical prosperity. It is not governed by various market forces and operations.
In contrast, an induced investment is guided by market operations and accelerator-
Contraction Expansion
GDP
Upswing Upswing
Y
1
Y
0
Downswing
O
Yea
r
Fig. 1.1 Formation and movement of the economic cycle