Monday 8 August 2011
One of the scariest aspects of the current market trauma, which sets it apart from the meltdown following the collapse of Lehman Brothers in 2008, is that policy makers seem helpless to break this vicious circle.
The only concrete measure to emerge during a weekend of frenzied financial diplomacy was the European Central Bank’s decision to start buying Spanish and Italian government bonds in the secondary market.
Although significant, the ECB’s initiative was not matched by any policy measures from either the Group of Seven industrial nations or the Group of 20 major economies that might have heartened investors about the prospects for growth.
Markets had to make do instead with warm words from the G7 and G20 about ministers’ determination to counter the twin-pronged crisis of crumbling faith in the euro and Friday’s downgrade by Standard & Poor’s of America’s top-notch credit rating.
“It’s the magic wand approach to policy-making,” said Stephen King, chief global economist at HSBC in London. “You wave it and hope something happens.”
What happened on Monday was that equities tumbled further, demand for safe-haven bonds was undimmed and oil skidded 3 percent as markets priced in lower growth due to evaporating business and consumer confidence.
After experiencing post-Lehman the deepest recession since the Second World War, the US had now been through the shallowest subsequent recovery despite massive fiscal and monetary stimulus, King said.
New York University’s Nouriel Roubini, writing in the Financial Times, said the US and other advanced economies were odds-on for second severe recession even before the latest panic. Former US Treasury secretary Lawrence Summers puts the odds of a double dip at one in three. Harvard University professor Martin Feldstein says one in two.
One of the ironies of the crisis is that the demands the markets are making of politicians — reduce your debt or we will cut off your funding — risk exacerbating the growth/debt trade-off.
J P Morgan estimates suggest that a global fiscal adjustment amounting to slightly more than 1 percentage point of gross domestic product is in the cards, led by the US and Western Europe.
Bruce Kasman, a global economist for the bank based in New York, said contracting US spending had shaved more of off GDP growth over the past year than any time since 1970.
Moreover, the imminent expiration of temporary tax cuts and unemployment benefits was set to combine with discretionary spending cuts to take 1.7 percentage points off GDP growth next year, Kasman said in a note.
“Just as S&P are pessimistic about the capacity of Washington to deliver medium-term fiscal consolidation, we are pessimistic that an agreement can be forged to prevent a significant fiscal drag next year,” Kasman wrote.
Barry Eichengreen, an economics professor at the University of California, Berkeley, agreed that last week’s debt-ceiling deal had boxed in the administration of President Barack Obama, preventing it from doing anything substantive to revive the economy.
In an article for Australian National University’s online East Asia Forum, Eichengreen said fiscal policy in Europe was even more contractionary than in the US.
And whereas China was able to unleash a fiscal stimulus in 2008 worth 14 percent of annual GDP, backed by open-ended lending by state banks, policy makers in Beijing have much less room today to respond to a global slowdown, Eichengreen argued. Inflation is uncomfortably high and bad loans are a growing concern.
“Were China’s exports to the West to drop off as sharply as they did then, there would be no way that the government could substitute a commensurate amount of domestic spending. Chinese growth would fall. The implications of other economies that sell parts, components and, above all, raw materials to China would not be pretty,” he wrote.
What is to be done?
King with HSBC sketches a benign scenario for correcting the global imbalances underlying the current market mayhem.
To shift the balance of global demand from the United States and Europe toward the emerging world, the United States would make an advance commitment to serious budget deficit reduction, while China would agree to revalue the yuan, permitting an export-led US recovery.
“If you have reasonable international policy coordination, you can get out of this mess,” he said.
But politically deadlocked Washington could not promise to stop living beyond its means, as Beijing insists it must, while China has a visceral fear from Japan’s experience in the 1980s that a surge in its exchange rate would usher in economic stagnation.
In the absence of rebalancing, King fears the US will be stuck with slow growth of about 2 percent a year that leads, as in Japan, to a high, suffocating debt-GDP ratio.
“The problem is not so much another recession, but the absence of a recovery,” King said.
“We could be stuck in the perma frost for years to come.”