Is a Recession Likely?


The National Statistics Service of Georgia has published economic data which gives food for thought. Among the more important indicators published is the growth of Gross Domestic Product (GDP), which comprised 5.8% in the first quarter of 2011, stood at 6% in the second quarter, at 7.9% in the third quarter and at 8.5% in the fourth quarter. The corresponding indicators in 2012 were 6.7%, 8.2%, 7.5% and 2.3%, respectively. In December 2012, GDP growth decreased by 0.8%. The consumer price index dropped from 108.5 in 2011 to 99.1 in 2012. In fact, deflation occurred with the inflation rate decreasing by 1.4%. Foreign trade turnover grew by 973 million USD; however, the share of imports in this growth outstripped that of exports thus increasing the negative trade balance by 596 million USD. The data on foreign direct investments for the fourth quarter of 2012 have not been published yet, but judging by the indicators of the first three quarters, such investments dropped by 13% compared to the corresponding period in 2011. Turnover of Georgian enterprises was at 6% in October 2012, in November it was 3.6%, whilst in December it was 5.2%. Turnover from value added tax (VAT) payers’ totaled 8.5% in December 2011, whereas in December 2012 it was down by 1.5%.

There is a logical link between these indicators and with a certain degree of probability they all predict a recession. In particular, the past four months have seen a drop in total demand, mainly manifested in dwindling consumer spending in commodity and service markets. The situation is not favorable in terms of investments either. This does not only include foreign direct investments – bank loans and the population’s savings also show a downward trend. The negative indicator of inflation supports this reasoning as well. Deflation, or a decrease in the general price level, has also been observed (a decrease in price level can be caused, inter alia, by an increase in general supply, however, in the given case the data on VAT taxpayers’ turnover suggests a decline in production), which will entail a decrease in short-term production levels and accordingly, a rise in employment – in other words, a short-term recession. What could be causing this drop in total demand? Let’s start by logically excluding some of the potential causes.

1. Public spending is an integral component of total demand. A decrease or increase in public spending has a multiplication effect. In reality, overall spending may shrink or rise at a greater extent than public spending. The multiplication effect depends, on the one hand, on the marginal propensity to consume and, on the other hand, on the so-called crowding-out effect. Public spending is specified in the budget. The data show that public monies are basically being spent as intended. No delays or impediments are observed in paying salaries, pensions and for social assistance and the like. Nor have infrastructure projects been cut. Some reshuffles have been observed in various positions in the public sector, but the number of hired public employees remains unchanged. Total demand could not have dropped because of tax rates as the tax burden has not increased over the past few years. Stable interest rates on the capital market also indicate that the money supply has not shrunk either. Consequently, the change in total demand is not a result of any fiscal and monetary policies that have been implemented.

2. Revenues from investments have plummeted since the 2008 global economic crisis. This also includes remittances that Georgian citizens living abroad send to their relatives – which have also shown a downward trend. Even though accurate data on remittances are very difficult to obtain, one may assume that their decrease is not as dramatic as to significantly affect revenues from investments. Revenues have fallen because the volume of investments implemented and the turnover of Georgian enterprises decreased. The data of the past few months also points to a shrinking of loans and savings. It is obvious that in recent months there has been a money deficit in the market that has led to deflation. The data also reveal that the money deficit has resulted from neither fiscal nor monetary policies, but from a decrease in revenues which, in my opinion, is something that economists must consider.

In order to make a more accurate prognosis, we need to watch whether this downward trend will persist in the following six months. If it does, autumn 2013 will most likely see a rise in unemployment, which will likely be notable judging by the observed tempo of deflation. This, however, means a short-term recession. To explain this in simpler terms, economic activity diminishes and that becomes systemic. The turnover of enterprises decline and the number of businesses gradually shrink. This causes unemployment which pushes down total demand in the short term. Consequently, the level of prices initially decrease, thereby adversely affecting the economic activity of businesses still operating in the market and facilitating their being crowded-out from the market. In such a case, the economic situation becomes rather dangerous because, in the longer term, total supply will fall and increased unemployment will be compounded by such a significant rise in the price level that it may result in “unemployment plus inflation” (this is not necessarily the case, but the probability of this is high given the economic specifics of Georgia).

Inflation, as a rule, is generally caused by the state influencing the total demand. The state possesses numerous direct and indirect means to do that – from money supply and interest rates to pubic procurements and tax rates. The state pushes up the total demand which results in a rise in the price level in the long term and imitates economic growth in the short term. There is temptation for any state with a market economy to do this; good example of this is the economy of the United States. However, the level of prices also rises during an economic crisis, when the total supply declines.

An important aspect worth noting is what period of time is considered the base period against which any new price level is measured. Let’s assume that the base period is taken as that before economic activity started to decline. If we compare the price level which has increased due to a decrease in total supply with the price level of the base period, and also assume that before and during this period the state has not undertaken any excessive economic activity, we must assume that after a drop in total supply the price level will again reach the indicator of the base period. To explain that in simpler terms, a drop in total demand will decrease the price level, but the total supply will also decrease by almost the same amount and the price level will rise again. That the price level has been decreasing at present represents a short-term economic fluctuation that creates false signals and incentives in the market.

In short, the economy is moving into a new reality characterized by shrinking economic activity. However, it takes time for such a reality to become established and this will not occur until the price level together with increased unemployment rebounds to the base level of prices. Before that happens, economic fluctuations will take place, with the price level first falling and then rising, which will hinder the performance of rational economic transactions. The change in the price level affects not only consumer prices but also the GEL exchange rate on the foreign currency market and interest rates on the capital market. The wider the range of fluctuation, the greater unemployment is pushed up.

As I noted, the price level will rebound to the base level if the state is not excessively active. However, very few modern states remain economically passive and Georgia is no exception. I will cite one example. The foreign debt of Georgia is a little higher than 30% of its GDP. Nothing seems particularly alarming in that fact, but the danger comes from the reality that as of 2013 Georgia must start repaying its half a billion USD debt (which the government took in the form of Eurobonds in 2008) at an annual rate of 7.5%. That amounts to about 800 million GEL, but may even exceed one billion GEL if the national currency depreciates. If we cover this debt public procurements will diminish, which will contribute to a deeper recession and will increase the likelihood of budgetary crisis. Alternatively, it may mean we need to take out a new loan which will have to be repaid at the expense of future economic growth. This is the reality. When an ordinary person takes out a loan he/she hopes to repay it from his/her future income, but when the state takes out a loan each and every taxpayer has to cede part of their income, regardless of whether they wanted to take our that loan or not. The trust of the world’s markets towards this or that country being able to repay loans is a separate question. Here the issues of risk and confidence come to the fore – these determine the interest rate on the loan. I doubt that the trust in the world capital market towards the Georgian government is higher than it is towards even the “bankrupt” Greek government. We cannot simply extend our hand in the hope of receiving aid. It is no longer the 1990s or 2008. The reality is different.

The problem in the current situation is that the government of Georgia has increased its funding of social programs. Pensions have increased, requiring an additional 700 million GEL. The issue of universal health care is also high on the agenda, requiring at least the same amount of funding. Additionally, the government intends to spend one billion GEL to subsidize agriculture. No matter how much we turn so-called “untargeted” costs into so-called “targeted” ones, the fact is that state expenditures will significantly increase. This factor will push up the level of prices in the longer term and, as a result, we will get inflation together with unemployment, which will cause living standards to deteriorate to a greater extent than expected. Consequently, the likelihood of a budgetary crisis will also increase.

We economists are not asserting that this is the only possible scenario that will develop. We are just arguing that, if the data of the National Statistics Service are true, the probability of this scenario has increased. We must ponder over the fact that dramatic changes have been observed in the economic indicators over the past two months. These changes indicate that the economy is preparing for a transition towards a new reality. If the downward trend continues over the next two quarters a recession is inevitable. Against that backdrop, increased public expenditures will fuel inflation and, consequently, the probability of a budgetary crisis will increase.



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