Anyone who thought that the €750m IMF-EU bailout would calm markets has had a rude awakening. The MSCI index of global stocks has fallen by over 15% since mid-April. Even more ominous is the return of fear in the credit markets, with interbank risk spreads hitting their widest levels since spring 2009. Investors are fleeing riskier assets and moving back to the relative safety of the dollar and U.S. Treasuries.
New nervousness about geopolitical risk, with tensions rapidly rising in the Korean peninsula, is feeding the panic. But that comes on top of two wider worries.
One is about the underlying health of the world economy. Fears are growing that the global recovery will falter as Europe’s debt crisis spreads; China’s property bubble bursts; and America’s stimulus-fuelled rebound dies out. The other worry concerns government policy. From America’s overhaul of financial regulation, to European restrictions on short sales, hedge funds, and proposing to raise taxes on any euro that moves somewhere that politicians don't like. The scale of sovereign debts has also forced many governments into austerity programmes, and few of those that have not yet been forced to do so have much room to counter any new downturn.
The danger is that these fears reinforce each other in a reversal of the dynamics of 2008-09. Then, co-ordinated government action stopped the global financial crisis from turning into a depression. Now, thanks to incompetence and collapsing balance sheets, governments may become the problem that will drag the world economy down.
The Economy
On the face of it, fears about the fragility of the global recovery are exaggerated. Led by the emerging economies, the world’s output is probably growing at an annual rate of more than 5%, far swifter than most seers expected. This pace will slow as the big emerging economies move to tackle rising inflation and asset bubbles. China is a risk, which is why its government has moved to rein in its banks and constrain loans and property prices.
America’s growth will probably also slow as firms stop restocking and the impact of fiscal stimulus tapers off. However for all their heavy debts, American consumers have returned to the shops. Their confidence is rising as the economy is producing jobs (albeit not enough of them). And Congress seems likely to slow the pace of fiscal tightening with a new “mini-stimulus” of temporary spending.
Growth prospects look grimmest in Europe. Yet even there the likely immediate outcome of the euro zone’s crisis is the enfeeblement of an already weak recovery, rather than a sudden slump. The region’s profligate economies will struggle for longer as austerity kicks in. But waning confidence will be mitigated by the boost that exports receive from the euro’s recent sharp depreciation.
Look only at those probable short-term prospects and it is hard to see why financial markets are suddenly in such a panic. The reason is that the risks of a far worse outcome have risen, and those risks lie mainly with governments.
The Governments
So heavy is the debt burden now facing most of Europe, the US and especially Japan, it is not impossible to think that before long they too will start to do a Greece. This capitulation will happen either by way of outright default as could still happen in Greece, or as disguised default via devaluation as is already happening in the UK and Eurozone.
The Eurozone is in the deepest trouble, as its over-leveraged governments have the weakest economic growth prospects and a limited monetary policy to work with. For the euro to survive, Europeans therefore need to be prepared for both painful fiscal adjustment (to stave off a short-term liquidity crisis) and for profound structural reform (to ignite long-term growth) as well. Profligate governments, primarily the southern European PIIGS (See March 2010 edition of Marketviews), must become more prudent. But even so it is hard to see a way forward in which these governments will be able to avoid restructuring their debt.
Bank for International Settlement data indicate that German banks’ exposure to Greece is about $50bn, while the French exposure is $75bn, and both countries banks also have exposure of more than $250bn to Spain and Portugal. If, in a worst case scenario, “haircuts” were ever imposed on a chunk of that, it would be tough for the banks to swallow, particularly given that countries such as Germany have been very slow about actually writing off the legacy rot from the credit bubble. Hence the widely held view that the €750m is another disguised bank bailout rather than a bailout for Greece.
But the alternative to restructuring will probably be grim too. If Greece staggers on, without a miracle, fears about future “haircuts” will continue to poison the bond markets and interbank world. That will essentially produce a pattern similar to Japan in the late 1990s; where asset prices kept stealthily slipping because investors could not shrug off their fears of more bad news to come.
Governments outside the euro zone are at risk of drawing flawed conclusions, especially on exchange rates and fiscal policy. China seems to think that the euro’s decline makes it less urgent to allow the yuan to appreciate. However with its biggest export market in a funk, China surely needs to accelerate the rebalancing of its economy towards domestic consumption, with the help of a stronger currency.
In America, paradoxically, the Greek crisis has removed the pressure for deficit reduction, by reducing bond yields. America’s structural budget deficit will soon be bigger than any other OECD member (a $1.6 trillion budget deficit is forecast for the year ending Sept. 30) and the country badly needs a plan to deal with it. Thanks to its population growth and the dollar’s role as a global currency, America has more fiscal room than any other big-deficit country. But it is no healthier. The IMF forecasts that gross U.S. borrowings will amount to the equivalent of 99.5 percent of annual economic output in 2011 (The U.K.’s are expected to reach 94.1 percent and Japan’s will spiral to 204.3 percent).
Conclusions
The underlying problem for the global economy is that we have reached the end of the road for the Keynesian economic paradigm. Keynesian economics advocates active policy responses by the public sector to stabilize output over the business cycle and was widely used to justify the massive government interventions of 2007/2008.
However the government spending blowout of the last two years has now turned into a sovereign debt rout. Investec Strategist Michael Power reminded me recently of Keynes’s classic quote, “in the long-run we are all dead.” This was a response to concerns over the long-term impacts of the excessive government debt that could accrue through ongoing government intervention in the economy. Power’s view is that “the long run is now”, in other words we need a new way of thinking about economics because the old paradigms have no more answers for us, and we are running out of road.
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