By: Manoj Pant

It is certain that a full blown global recession is now on. The indicators are too stark. Stock markets, prices and outputs are down everywhere without exception indicating a general global contraction of demand. At the same time unemployment is up everywhere and rising. Even in the US where wages and prices tend to react quickly to demand and supply there is no respite with unemployment levels crossing 8%: a level never reached after World War II.

So now it's not about just a sub-prime crisis or a financial crisis of banks due to a faulty regulatory structure though this might have helped things along. The world is contracting in real terms and it is time to read John Maynard Keynes not Milton Friedman.

Some commentators have linked the recession to last year's spurt in oil prices, like in the 1970s when a sharp rise in oil prices between 1971 and 1979 sent the economies of the OECD countries into a tailspin. A minor recession did occur in the developed countries in the first few years of the '80s. But at that time the world went through what we now know was a structural adjustment. There was a transfer of purchasing power from the developed countries to the oil producers.

But that time also saw a boom in all commodity prices (not only oil) and some of the new liquidity of banks found its way to Latin American countries. Today, commodity prices are also headed downward and banks are lending to no one. Clearly, the only recent parallel to today can be found in the Great Depression of the 1930s.

So the current crisis cannot be a developed country (DC) vs. less developed country (LDC) issue. This was certainly relevant in the 1970s and reflected in the trade negotiations of the Tokyo round of GATT. But this is not where the answer lies today. A serious reading of Keynes (something I have been arguing in the last few months in these columns) would indicate that all countries must act together to tackle adverse expectations by 'pump priming' world demand. Mere reform of the regulatory system in financial markets (though essential) will not solve the present problem.

One good way to look for a Keynesian solution is to think of the world as one single country faced with demand contraction. Then we have two halves of this economy: the developed world with excess consumption (in relation to incomes) and the developing world with excess saving. Presently between the US, EU and China roughly about $2 trillion of pump priming is in place (some having been undertaken by the former US administration). However, much of this expenditure is based on domestic deficit financing which may create problems in the future.

The solution also lies in trade. As elementary trade theory tells us, the main reason why a country exports is to import. In other words, exports are an expression of a countrys demand for products of other countries which it cannot efficiently produce itself. In an ideal situation no country should run trade surpluses (deficits). Hence trade surpluses constitute a potential demand for future imports and withdrawal from current demand.

The accompanying table shows that developing countries like China have been running huge trade surpluses and much of this accretion to reserves has come in 2007 itself. Since these reserves are only a potential demand, running them down provides a perfect Keynesian solution to the present crisis. In fact, as the accompanying table indicates, China and Japan alone have a potential demand of almost $3 trillion. Running down these reserves through expanded imports of these countries would create additional demand without too much financial pain.