AMERICAN FUTURE

I’m having trouble coming up with new titles, so I’m going to use this one, starting today.

Gavyn Davies, “What Went Wrong with the Global Recovery”

. . . macroeconomic policy has been tightened in recent months, and some of this has been unexpected.In the US, there has been a lot of focus on the fiscal policy of the federal government, which has barely changed this year compared to last, but in fact the main change in the fiscal stance this year has come from expenditure cuts by the state and local government sectors. This has tightened overall fiscal policy by about 1 per cent of GDP in Q1 and Q2. In the UK, fiscal tightening has been running at about 2 per cent per annum, and in peripheral Europe the austerity programme is now much bigger than that.

A year ago, we knew that the era of fiscal easing had ended in the developed world, but the extent of the tightening which has occurred in 2011 has come as a surprise. Governments have routinely responded to any form of financial trouble by tightening the near term fiscal stance, while failing to address their long term sustainability problems. This, according to almost all economists who have opined on the subject, is precisely the wrong way around, but that has not stopped them. It now seems most unlikely that this trend will be reversed, short of a second leg of recession.

Furthermore, self inflicted policy failings in the US and the eurozone in recent weeks have resulted in financial stress and widening credit spreads. This has tightened monetary conditions much more than the ECB and the Fed intended when they started to press the “exit” buttons in Q2. We do not yet know the full consequences of this tightening, but consumer confidence in the US has plumbed 30 year lows, and business surveys have tumbled everywhere.

The final factor, which could turn out to be the most enduring, is the process of debt deleveraging in the western economies. This has left households in a much weaker state to cope with oil and policy shocks than is normally the case. Instead of dipping into savings when faced with temporary shocks, households have rapidly reduced their spending, so a weakening in consumption has been one of the main demand side causes of the global slowdown.

Economists like Richard Koo and Ken Rogoff talk of “balance sheet recessions” and a “second great contraction” as if they are entirely unfamiliar developments. They certainly are different from the recessions we have seen outside of Japan in the post-war period, but they could equally be described as a chronic and persistent shortage of demand.

Given the prevailing political mood in both Europe and America, that could prove to be a surprisingly difficult problem to solve.

Jeffrey Sachs, “Tripped Up by Globalisation”

I’ve watched dozens of financial crises up close, and know that success means showing the public a way out that is bold, technically sound and built on social values. Transatlantic leadership is falling short on all counts. Neither the US nor Europe has even properly diagnosed the core problem, namely that both regions are being whipsawed by globalisation.

[...] The path to recovery now lies not in a new housing bubble, but in upgraded skills, increased exports and public investments in infrastructure and low-carbon energy. Instead, the US and Europe have veered between dead-end, consumption-oriented stimulus packages and austerity without a vision for investment.Macroeconomic policy has not only failed to create jobs, but also to respond to basic social values too. Let me be clear: good social policy does not mean running big deficits. Public debts are already too large in both Europe and the US. But it does mean a completely different balance between cuts to social services and tax increases on the rich.

The simple fact is that globalisation has not only hit the unskilled hard but has also proved a bonanza for the global super-rich. They have been able to invest in new and highly profitable projects in emerging economies. Meanwhile, as Warren Buffett argued this week, they have been able to convince their home governments to cut tax rates on profits and high incomes in the name of global tax competition. Tax havens have proliferated even as the politicians have occasionally railed against them. In the end the poor are doubly hit, first by global market forces, then by the ability of the rich to park money at low taxes in hideaways around the world.

An improved fiscal policy in the transatlantic economies would therefore be based on three realities. First, it would expand investments in human and infrastructure capital. Second, it would cut wasteful spending, for instance in misguided military engagements in places such as Iraq, Afghanistan, and Yemen. Third, it would balance budgets in the medium term, in no small part through tax increases on high personal incomes and international corporate profits that are shielded by loopholes and overseas tax havens.

Infrastructure investment also need not increase deficits if any new projects pay their own way. Even if they require upfront borrowing, projects will not add to net financial liabilities if they are repaid through future revenues. Currently, budget accounting in the US and Europe generally fails to distinguish between these self-financing capital projects – such as bridges, which earn revenue through future tolls – and those financed by general revenues.

Export-led growth is the other under-explored channel of recovery. Part of this must be earned through better skills and technologies – another reason not to cut education. But another part can be earned through better financial policies. China, realising this, has sold Africa many billions of dollars per year of infrastructure export projects, financed by long-term Chinese loans. Yet the US and Europe have virtually ceded that market to China by the lack of financing to African and other fast-growing economies.

The last missing piece for any recovery, however, is clarity of purpose from the political class. In Europe, a coherent response led by the European Union has been sidelined to policymaking by national governments – the pact between France and Germany being only the latest example. For months, Europe’s fate has been decided by German state elections and small Finnish parties. The European Central Bank has been so divided that it too has neglected core functions of stabilising panicked markets. There is no way the euro can survive if European-wide institutions continue to be so weak, slow and divided.

The US has similarly devolved into a mélange of sector, class, and regional interests. President Barack Obama is the incredibly shrinking leader, waiting to see whether Congressional power barons will call. More generally, the US cannot prosper while its politicians go hat in hand to the vested interests that finance their nonstop campaigning.

The recent swoon in financial markets and the stalled recovery in the US and Europe reflect these fundamental shortcomings. There is no growth strategy, only the hope that scared and debt-burdened consumers will return to buying houses they don’t need and can’t afford. Sadly, these global economic currents will continue to claim jobs and drain capital until there is a revival of bold, concerted leadership. In the meantime, the markets will gyrate in pangs of uncertainty.

Mark Leonard, “Breaking Europe’s Cycle of Enfeeblement”

It is time to face facts: markets are not just betting against the euro but testing the European project itself. Tuesday’s Franco-German summit showed that the more leaders repeat outdated nostrums – such as the impossibility of eurobonds – the less they are believed. The Merkel-Sarkozy proposals were an attempt to paper over differences (with Germanic prudence on eurobonds and debt ceilings balancing Gallic pressure for economic governance) and buy time, but the past few months have shown that this piecemeal approach will simply increase the cost of a long-term solution. To save itself, the European Union must stop seeking loopholes and attacking symptoms, and instead grapple seriously with its fundamental design faults.

Since the French and Dutch “no” votes in 2005, pro-Europeans have acted like the mythical boy with his finger in the dyke; unwilling to give ground for fear of a eurosceptic flood. As a result they have defended the unsatisfactory and unsustainable status quo: a currency not backed by a treasury; joint borders without a common migration policy; and a technocratic foreign policy divorced from national sources of power.

The only way to stop a tide of disintegration spreading beyond the euro to the EU itself is to tackle these problems head on. Doing so, however, means first giving up the dream of a one-speed Europe. EU nations have long travelled at different speeds, but now they need an institutional framework for a multi-speed future.

Rather than hiding this division, the EU now needs a model in which fast-lane nations act as pioneers who endow the whole project with new purpose. Yet even a multispeed Europe needs bigger fiscal transfers – the best option being an explicit deal between creditor and debtor nations. As well as reconciling austerity with debt support, this could develop a vision that balanced economic liberalisation with social protection.

Most importantly, Europe’s leaders must stop stripping the politics out of European integration. Instead of shrouding discussions in legalese, they must engage voters in a debate to reinvent the three big integration projects of the past 20 years: the euro, Schengen freedom of movement and a united foreign policy.

On the euro – the most existential of the crises – leaders have tried unsuccessfully to stem market panic but not dealt with deeper problems. Even after the latest summit, the policies fall short of the eurobonds, European banking regulation and pan-European deposit insurance schemes that are needed. New rules at the European financial stability facility – allowing it to support banks by buying Greek bonds, and even to recapitalise banks directly – marks a changed German position, whose logic backs new eurobonds. This must now be made explicit, and backed by a big EFSF expansion.

[...] The eurozone’s debt and deficits are also far lower than in the US, Japan or even the UK. Yet the EU’s failure to govern itself is fuelling global perceptions of decline, in turn making Europe’s citizens even more short-sighted, as they try to protect their slice of a shrinking cake. EU leaders’ attempts to defend the status quo only reinforce a vicious circle of enfeeblement. Conservatism will not break this cycle of decline. To save Europe, we must reinvent it.

Unfortunately, the world is moving in the general direction I’ve discussed in previous posts. In a nutshell, markets are crashing because fiscal austerity programs are being implemented at the very moment that economic growth has disappeared, and the effect of fiscal rectitude will be to worsen both budget deficits and debt-to-GDP ratios. My view continues to be that this disastrous sequence of events will eventually terminate with a bang: the breakup of the eurozone.

Morgan Stanley has taken another baby-step in the direction of reality recognition. Here’s the full text of its revised but still overly optimistic economic forecast:

Ever more BBB: We are cutting our global GDP growth forecasts by a combined full percentage point in 2011-12, to 3.9% from 4.2% in 2011, and to 3.8% from 4.5% in 2012. We now see growth in the developed market economies averaging only 1.5% this year and next (down from 1.9% and 2.4% previously) – markedly more sluggish than the 20-year trend growth rate in DM of 2.3%, and more than a full percentage point below the 2.6% rate in 2010 as the world rebounded from the Great Recession. While we had been calling for a BBB recovery in DM all along, the path now looks even more bumpy, below-par and brittle.

EM isn’t immune, but generating 80% of global growth: The great EM-DM growth divide continues, but EM economies won’t be immune to the DM slowdown, in our view. We now see EM growth decelerating from 7.8% in 2010 to 6.4% this year (6.6% previously), and further to 6.1% (6.7%) in 2012. While this keeps EM GDP cruising above its 20-year trend rate of 5%, it implies significant further cooling of growth compared to last year’s bonanza. Remarkably, despite slowing growth, EM economies – which now account for half of global GDP (using PPP weights) – will generate fully 80% of global GDP growth we are forecasting for 2011-12.

A policy-induced slowdown: There are three main reasons for our downgrade. First, the recent incoming data, especially in the US and the euro area, have been disappointing, suggesting less momentum into 2H11 and pushing down full-year 2011 estimates. Second, recent policy errors – especially Europe’s slow and insufficient response to the sovereign crisis and the drama around lifting the US debt ceiling – have weighed down on financial markets and eroded business and consumer confidence. A negative feedback loop between weak growth and soggy asset markets now appears to be in the making in Europe and the US. This should be aggravated by the prospect of fiscal tightening in the US and Europe.

US and Europe dangerously close to recession: Our revised forecasts show the US and the euro area hovering dangerously close to a recession – defined as two consecutive quarters of contraction – over the next 6-12 months. The US growth disappointment in 1H11, when GDP advanced by an annual average rate of less than 1%, illustrates the brittleness of the US recovery in the face of external shocks (oil, Japan earthquake), despite ongoing QE2 and fiscal stimulus at the time. While the current quarter should still show some rebound in growth to around 3% from the very low bar in 1H, much of this rebound is likely due to temporary factors such as the ramping up of auto production as supply disruptions ease. The most critical period for the US economy will likely be 4Q11, when we may see some fallout from the heightened volatility of risk markets, and 1Q12, when we get an automatic tightening of fiscal policy if, as our US team currently assumes, this year’s fiscal stimulus measures expire.

Europe’s woes to continue: The ECB’s past rate hikes and, more so, the sovereign crisis and the additional fiscal policy tightening as well as the banking sector funding stress it produces, will take an additional toll on growth, in our view. Our European team now sees euro area GDP broadly stagnating later this year and in early 2012. Thus, it won’t take much to tip the balance towards recession, especially as a final resolution of the debt crisis (in the form of fiscal transfers or common bond issuance) is likely to be very slow in coming. Our European team has slashed its already below-consensus 2012 euro area GDP forecast from 1.2% to a mere 0.5%. In our view, despite the problems in the US, the euro area is clearly the weakest link in the global chain.

Dangerously close to recession, but not our base case: While we think that the US and the euro area will be dangerously close to recession over the next several quarters, we are not making recession our base case, for three reasons. First, companies are sitting on a pile of cash and display healthy profit margins. Second, the decline in oil prices from the peaks earlier this year should act as a partial stabiliser, lowering headline inflation over the next 6-12 months and supporting household real disposable incomes. Third, we expect the major central banks to lend additional support, with both the ECB and the Fed cutting interest rates and possibly implementing additional non-standard easing measures.

Why this is not 2008: Initial conditions are better now. Back then, household, corporate and bank balance sheets were much weaker, employment in the US was already falling and unemployment rising, monetary policy was tight, and the Lehman collapse meant that the financial system, including trade finance, totally seized up. Against this, fiscal and monetary policy have less (though not zero) room for manoeuvre now. So, while a freefall of the economy similar to 2008 looks very unlikely, policy also has less potential for a shock-and-awe response, if needed. Surely, we should not take too much comfort from saying that this is not 2008 – after all, the recession that followed was the deepest since the Great Depression. However, a plausible recession scenario in 2011-12 would be much shallower than the 2008-09 experience. To get a 2008-type recession, one would have to assume a major Lehman-type policy error, such as the default of a European sovereign, which could bring the whole financial system down. While not impossible, we currently attach a very low probability to such an outcome. We will elaborate more on bear and bull scenarios in the coming weeks.

EM policy-makers to cushion the blow: The current slowdown in EM growth now looks set to be prolonged into 2012 by the weaker DM outlook. But with inflation at or close to a temporary peak, some policy easing in EM looks likely to provide a cushion for growth. EM policy-makers should be able and willing to help their own economies avoid a hard landing, but they won’t be able to bail out the world, in our view. Absent the kind of tail risks that were present in the world in 2008, and having barely emerged from a battle with inflation and overheating, EM policy-makers at this point will likely signal that they want to use just enough policy stimulus to help their own economies. In fact, given the constraints on DM policy-makers, EM policy-makers should really be ready to act relatively more aggressively, but this is unlikely given lingering inflation risks. If neither aggressive nor pre-emptive action is forthcoming, then a DM shock to growth could slow down EM economies significantly. Any policy action would then have to be aggressive. The good news? We believe weaker DM growth will reinforce many EM policy-makers’ resolve to support the rebalancing towards domestically led EM growth and allow more rapid exchange rate appreciation.

The early signs are encouraging if the recent moves in the renminbi are anything to go by, and they will be welcome relief for a slowing EM economy. Our AXJ team now expects further downside, particularly in 2012, to its below-consensus growth forecast. Latin America and CEEMEA growth is now forecast to be 1% and 0.6% lower than previously expected. Regional giants China, India and Russia all show better resilience than their respective regions, with growth now lower by 0.3%, 0.4% and 0.3%, respectively, than previously expected. Growth in Brazil, however, has been marked down from 4.6% to 3.5% in 2012, a little lower than the downgrade for the region as a whole.

Inflation, not deflation: While near-term inflation expectationshave eased, reflecting weaker growth and lower commodity prices, longer-dated forward measures of inflation expectations (such as five-year five-year-forward breakevens) have remained elevated during the recent turmoil. This suggests that a Japan-type negative feedback loop between weaker growth and deflation expectations can most likely be avoided. The difference to Japan, despite other similarities, is that monetary policy has acted much more aggressively much earlier in this crisis, thus nurturing expectations of positive inflation and pushing real interest rates into negative territory.