The world economy

Be afraid

Unless politicians act more boldly, the world economy will keep heading towards a black hole

Oct 1st 2011
from the print edition


IN DARK days, people naturally seek glimmers of hope. So it was that financial markets, long battered by the ever-worsening euro crisis, rallied early this week amid speculation that Europe’s leaders had been bullied by the rest of the world into at last putting together a “big plan” to save the single currency. Investors ventured out from safe-haven bonds into riskier assets. Stock prices jumped: those of embattled French banks soared by almost 20% in just two days.

But those hopes are likely to fade, for three reasons. First, for all the breathless headlines from the IMF/World Bank meetings in Washington, DC, Europe’s leaders are a long way from a deal on how to save the euro. The best that can be said is that they now have a plan to have a plan, probably by early November. Second, even if a catastrophe in Europe is avoided, the prospects for the world economy are darkening, as the rich world’s fiscal austerity intensifies and slowing emerging economies provide less of a cushion for global growth. Third, America’s politicians are, once again, threatening to wreck the recovery with irresponsible fiscal brinkmanship. Together, these developments point to a perilous period ahead.

Most of the blame for this should be heaped on the leaders of the euro zone, still the biggest immediate danger. The doom-laden lectures from the Americans and others in Washington last week did achieve something: Europe’s policymakers now recognise that more must be done. They are, at last, focusing on the right priorities: building a firewall around illiquid but solvent countries like Italy; bolstering Europe’s banks; and dealing far more decisively with Greece. The idea is to have a plan in place by the Cannes summit of the G20 in early November.

That, however, is a long time to wait—and the Europeans still disagree vehemently about how to do any of this (see article ). Germany, for instance, thinks the main problem is fiscal profligacy and so is reluctant to boost Europe’s rescue fund; yet a far bigger fund is needed if a rescue is to be credible. The most urgent solutions, such as restructuring Greece’s debt or building a protective barrier around Italy, require the most political courage—something that Angela Merkel, Nicolas Sarkozy et al have yet to exhibit. The chances of a bold enough plan will shrink if markets stabilise. The less scared they are, the more likely Europe’s spineless policymakers are to jump yet again for a plan that does just enough to stave off catastrophe temporarily, but lets the underlying problem get worse.

Much of the world is now paying for their timidity: witness the increasingly dark economic backdrop. A slew of recent indicators suggests the euro area is slipping into recession, as Germany’s exports slow, the fiscal screws tighten, confidence slumps and the banks’ travails imply tighter credit. Even if the euro-zone crisis were to be solved tomorrow, the region’s GDP would probably shrink over the coming months.

America’s economy is still limping along, though the summer slump in share prices and consumer confidence suggest future spending will weaken further. The Federal Reserve is trying new ways of support, somewhat half-heartedly. Whatever it does, America is currently on course for the most stringent fiscal tightening of any big economy in 2012, as temporary tax cuts and unemployment insurance expire at the end of this year. That could change if Congress came to its senses, passed Barack Obama’s jobs plan and agreed on a medium-term deficit-reduction deal by November. If Democrats and Republicans fail to hash out a compromise on the deficit, draconian spending cuts will follow in 2013. For all the tirades against the Europeans, America’s economy risks being pushed into recession by its own fiscal policy—and by the fact that both parties are more interested in positioning themselves for the 2012 elections than in reaching the compromises needed to steer away from that hazardous course.

What about the cushion the emerging markets provide? That, too, is getting thinner. Their growth is slowing (as it needed to, since many economies were overheating). Recent falls in emerging-world currencies and stock prices show that financial panic can afflict the periphery too (see article ). Some emerging economies, including China, have less room to repeat their 2008-09 stimulus because of the debts that splurge left behind. Monetary policy can be loosened: several central banks have cut rates. But, overall, the emerging world will be less of a buoy to global growth than it has been hitherto.

Some of these constraints are unavoidable. Many governments have less room to support weak economies than they did in 2008. Some caution, too, is understandable from central bankers who have waded ever deeper into unconventional monetary policy. But governments are not just failing to act: they are exacerbating the mess.

Lacking conviction and courage

In the aftermath of the Lehman crisis, policymakers broadly did the right thing. The result was not a rapid return to prosperity in the West, but after such a big balance-sheet recession that was never going to happen. Now, more often than not, policymakers seem to be getting it wrong. Their mistakes vary, but two sorts stand out. One is an overwhelming emphasis on short-term fiscal austerity over growth. Fixing that means different things in different places: Germany could loosen fiscal policy, while in Britain the reins should merely be tightened more slowly. But the collective obsession with short-term austerity across the rich world is hurting.

The second failure is one of honesty. Too many rich-world politicians have failed to tell voters the scale of the problem. In Germany, where the jobless rate is lower than in 2008, people tend to think the crisis is about lazy Greeks and Italians. Mrs Merkel needs to explain clearly that it also includes Germany’s own banks—and that Germany faces a choice between a costly solution and a ruinous one. In America the Republicans are guilty of outrageous obstructionism and misleading simplification, while Mr Obama has favoured class warfare over fiscal leadership. At a time of enormous problems, the politicians seem Lilliputian. That’s the real reason to be afraid.

The euro crisis

Is anyone in charge?

A look behind the drifting and squabbling to see who is really to blame, and what they’re thinking

Oct 1st 2011

IN THE Centennial Hall in Wroclaw, Poland, in early September, Jean-Claude Trichet, president of the European Central Bank, warned Europe’s finance ministers how grave the global financial crisis was. The euro area, he said, was currently its epicentre, and the consequences could be much worse than anything seen so far.

But since most citizens are not yet feeling the pain, politicians are struggling to act decisively. A lightning visit to Wroclaw by Tim Geithner, America’s treasury secretary, to express his alarm over the “catastrophic risk” of cascading sovereign defaults seemed to have little impact. The Europeans offered either excuses (decisions in a European Union of 27 countries are hard to reach) or hostility (America should sort out its own debt). After two days of talks, the euro-zone ministers came no closer to a solution.

One week later, at the annual meetings of the IMF and World Bank in Washington, the Americans and others, including China, berated the Europeans for threatening the world economy. In fact, there was some progress: the Europeans agreed that there must be a plan to ring-fence solvent but illiquid economies, beef up the main bail-out fund, the European Financial Stability Facility (EFSF), recapitalise Europe’s banks and, not least, deal with Greece, which may yet default chaotically. But there was no agreement on any of the details of such a plan.

The euro zone has the firepower to solve this crisis—its aggregate deficit and debt numbers compare favourably with America’s and Britain’s. But it is not a single entity, politically or economically. The currency is European, but treasuries are national and economies are only partially integrated. Each country wants to limit its liability for the debt of others and to curb the interference of peers in its economic policies. All 17 members have a veto on key decisions, which must then be ratified by unruly parliaments. Now the euro zone is trying to re-design itself even as it sinks—and every country is wondering whether to help others or save itself.

Half-step by half-step

By its own ponderous standards, the euro zone has changed course quite fast. It has bailed out three countries, created an embryonic rescue fund and, only this week, toughened up fiscal discipline with threats of early sanctions for miscreants. Yet each belated half-step exposes how much is left to do. A deal agreed in July, including a second bail-out for Greece with a “voluntarycontribution from creditors, recapitalisation of banks and more flexibility for the EFSF, is still struggling through national parliaments; and, in any case, these measures are already obsolete. Contagion has spread to Italy, and nobody pretends that the EFSF, even after July’s reforms, could save it without more money.

The euro zone may have only a few weeks to come up with a more credible plan; the informal deadline is the next G20 summit in Cannes in early November. Are Europe’s squabbling leaders up to it? To one despairing outsider, Austan Goolsbee, a former adviser to Barack Obama, Europeans are like the ineffective windbags in Monty Python’sLife of Brian”—“where, you know, the guy comes out and says, ‘We need to act,’ and the next one says, ‘You’re right, let’s draftno more talking…I second the motion. Let’s start doing something’.”

One could easily imagine Jean-Claude Trichet as the hapless Brian, left to rot on the cross as his comrades walk away. To many, Mr Trichet has been the saviour of the euro, freely breaking with orthodoxy and acting decisively to buy the bonds of vulnerable euro-zone governments while the politicians talk. Others, though, see him as the politicians’ lackey, and his purchase of sovereign bonds has driven two German colleagues to resign.

Mr Trichet works hard at being a paragon of charm and composure. But his self-control crumbled earlier this month when he was asked whether the ECB was now a Europeanbad bank”. “We have delivered price stability over the first 12-13 years of the euro! Impeccably! Impeccably!” he thundered, adding that he “would like very much to hear some congratulations” for delivering greater price stability in Germany than even the mighty Bundesbank ever managed.

Mr Trichet is clever enough to find justifications for his actions: the ECB, he claims, buys bonds not to bail out governments but to help the “transmission” of its interest rates to the market; and it accepts dubious Greek collateral on the ground that bailed-out countries are by definition solvent. He rightly warned the politicians that their campaign to make private bond-holders take a hit in future bail-outs would only spook the markets. But he may be wrong to oppose any kind of debt restructuring for Greece, which is patently bust.

Mr Trichet could, in theory, solve the immediate problem single-handedly by announcing that the ECB would buy unlimited amounts of sovereign bonds if a solvent country came under attack. There are signs that it is ready to provide longer-term liquidity (up to one year) to banks and to ease interest rates. But Mr Trichet is the first to declare that the ECB cannot alone hold the breach in the bond markets.

In any case, time is running out for a grand move. Mr Trichet will step down at the end of October, making way for Italy’s Mario Draghi. The change makes many nervous. The Italian central banker is impeccably orthodox in his economic thinking. Moreover he may find it hard, as an Italian, to expand the ECB’s bond-buying when Italy is especially vulnerable.

It’s all up to Angela and Wolfgang

In the end, the future of the euro will be decided largely in Germany. It has the deepest pockets, and its post-war renaissance is intimately bound up with European integration. If Europe takes decisions slowly, it is partly because of Germany’s complex federal structure and messy coalition politics. And for all the criticism, it is easy to understand Germany’s hesitation. It faces an agonising choice: to back the euro with almost unlimited taxpayers’ funds, or risk the break-up of the single currency. The government has tried to steer away from both horrors. Many Germans think it is already going too far, too fast towards a “transfer union”.

Germany’s slow response also has something to do with the personality of the chancellor, Angela Merkel. She is a physicist by training, methodical to a fault and ultra-cautious; faced with conflicting advice, her instinct is always to put off a decision. She may be fully committed to the project, but for her Europe is a cost-benefit calculation rather than historical destiny.

Not so her finance minister and one-time rival, Wolfgang Schäuble, a disciple of the ex-chancellor, Helmut Kohl. Mr Schäuble, who is wheelchair-bound since an assassination attempt in 1990, does not demur when interviewers describe him as the cabinet’slast European”. His relations with Mrs Merkel have not always been easy. She became chairman of her Christian Democratic Union in 2000 after Mr Schäuble was forced out of the job over his involvement in a party-financing scandal. These days the Merkel-Schäuble dynamic is watched as closely as bond spreads. At least once, the chancellor has countermanded a deal struck by her finance minister. Mr Schäuble is hawkish on the need for fiscal discipline and may be readier than Mrs Merkel to push Greece into a default, yet he is also more prepared for greater integration in the future, including joint Eurobonds, which the chancellor opposes.

Mrs Merkel may be lacking high-quality advice. Her newish economic adviser is Lars-Hendrik Röller, known for his writings on competition rather than high finance. He replaced Jens Weidmann, a long-serving adviser with an economics PhD who took over at the Bundesbank in May. Mr Schäuble, for his part, has Jörg Asmussen as his Europe man, a Social Democrat kept on for his experience of financial fire-fighting. But Mr Asmussen is heading for the ECB, where he and Mr Weidmann—it is hopedmay be more flexible than their predecessors, Juergen Stark and Axel Weber. His replacement, Thomas Steffen, was the chief insurance regulator.

Yet personalities have less influence on policymaking in Germany than elsewhere. Powerful institutions such as the Bundesbank, the trusted guardian of economic stability, and the constitutional court, which has said Germany is close to the limit of how much power can be surrendered to the EU, do much to set the boundaries of the euro debate. Public opinion is ambiguous: voters tell pollsters they dislike bail-outs, but do not want to see the euro destroyed.

The strange silence of Nicolas

Though pre-eminent, Germany still needs the support of France to get its way. In contrast with Germany’s dispersed power, economic policymaking in France is concentrated in Nicolas Sarkozy’s Elysée Palace. François Baroin, an inexperienced and floppy-haired political hack who took over from Christine Lagarde as finance minister when she went to the IMF in July, attends formal meetings with Mr Schäuble. But France’s real finance minister”, says one insider, is Xavier Musca, the presidential chief of staff. Mr Musca cut his teeth at the French treasury, working for Mr Trichet during the talks that led to the 1992 Maastricht treaty, the foundation of the euro. He is backed by Ramon Fernandez, head of the treasury, and Emmanuel Moulin, Mr Sarkozy’s economic adviser. None is a trained economist.

Although unpopular, the mercurial Mr Sarkozy faces none of Mrs Merkel’s problems of public opposition to bail-outs. And he is never shy of a bold plan, particularly in the run-up to a tight election next spring. Curiously, though, French ideas have been modest of late. Mr Sarkozy tends to propose only what he knows Mrs Merkel will accept, such as the idea of a European tax on financial transactions. French officials may be keen on Eurobonds, but dare not speak of them in public. Perhaps this caution stems from Mr Sarkozy’s worries about whether France is a creditor or a soon-to-be supplicant. French banks, heavily exposed to the troubled Mediterranean periphery, are wobbly. And as the most highly indebted of the euro zone’s AAA-rated countries, France fears losing its place in the top tier.

The French president, though, may be about to secure a prize that France has long wanted and Germany has long resisted: Europeaneconomic government”. For Mr Sarkozy, this means the 17 leaders of the euro zone meeting separately from the ten non-euro EU members (including Britain) to co-ordinate economic policies. Over time, this might lead to a new bureaucracy separate from the European Commission. In a smaller-core Europe, Mr Sarkozy thinks, France’s voice will be louder. Yet to get this French-inspired institutional structure, Mr Sarkozy has to accept German ideas: peer pressure to promote fiscal discipline and economic competitiveness.

Other countries in the euro zone matter less than France and Germany. The fate of Greece is being negotiated over the heads of its prime minister, George Papandreou, and his bruiser of a finance minister, Evangelos Venizelos. Italy’s experienced fiscal hawk, Giulio Tremonti, has been weakened by scandal at home and a row with his prime minister, Silvio Berlusconi. Spain’s Elena Salgado has generally deferred to her leader, José Luis Rodríguez Zapatero; in any case, her Socialists are heading for defeat in an election in November. The Dutch and Finns, under pressure from Eurosceptic parties, are increasingly obstructive, as is Slovakia. But in the end it is still France and Germany that count.

To organise things, they rely on their political fixer, Herman Van Rompuy, the president of the European Council. This former Belgian prime minister blends the austere demeanour of a monk (he famously writes Japanese haiku verses) with the wiliness of a French cardinal. He operates in the background, almost in the confessional, finding a point of balance between Paris and Berlin and then selling their ideas to leaders in other capitals. He will deliver proposals for economic governance to a European summit in mid-October; if adopted, these will undoubtedly shift power and influence within the euro zone.

First, they will enhance the role of leaders at the expense of finance ministers, so giving Mr Van Rompuy a greater role as “Mr Euro” than Jean-Claude Juncker, Luxembourg’s prime minister and finance minister, who chairs that group in the euro-zone. Mr Juncker has lived through all the single currency’s vicissitudes, but these days gives a mumbling, wayward performance, admitting earlier this year that he has sometimes lied about the state of policy discussions. Having upset both France and Germany over the years, the hard-puffing Mr Juncker should have realised his days were numbered in March when smoking was banned from all summit meetings.
           Juncker to Trichet: Any ideas?

A second power shift is likely to be from the European Commission to national leaders. Though the commission is the traditional guardian of the European ideal, it is regarded with some disdain by the Germans and French. Even its friends despair of the timidity of its president, José Manuel Barroso, once Portugal’s prime minister. It is hard to imagine Jacques Delors, one of his most energetic predecessors, lying so low with the euro in such a state.

Even so, the commission retains the bureaucratic power. Mr Van Rompuy often finds himself working with its ideas, and national leaders often end up endorsing its plans. Olli Rehn, the Finnish commissioner for economic policy (and a former professional footballer) is more capable than his stiff public persona suggests. And Michel Barnier, the French commissioner for the single market, is moving systematically to regulate the financial sector, often pushing Britain into rearguard actions to defend the interests of the City of London.

The shift to inter-governmentalism, Mr Barroso declared this week, could spell “the death of the united Europe that we seek”. Striving to regain the initiative, the commission will soon push for Eurobonds and greater decision-making autonomy in its rescue fund.

It’s My Friend (or Foe?)

These days, the IMF has a big voice in the euro zone. Its quarterly judgments about Greece’s performance will decide whether the country remains on life-support. And it is speaking more bluntly under its new managing director, Ms Lagarde. She infuriated her former European colleagues in August with a hard-hitting call for recapitalising Europe’s banks. More recently her chief economist reinforced the mood of panic by warning that the world economy was entering a “dangerous new phase”.

Ms Lagarde’s tough tone may reflect the views of David Lipton, her new deputy, recently an adviser in the White House on international economics. Mr Lipton was a senior figure in the Clinton administration during the 1990s emerging-market crash. His priorities, notably boosting bank capital, also reflect official assessments of what worked in America in the earlier phases of its own crisis. He is be
coming one of the most important non-European voices in the sovereign-debt debacle.

European leaders such as Mr Barroso may well feel wounded” by the patronising lectures of outsiders. But unless the euro zone’s countries listen to good advice, and quickly act on it, they will face not just humiliation but economic catastrophe.

Emerging markets

One more such victory

The emerging economies are winning the currency war. No one is celebrating

Oct 1st 2011
from the print edition

A YEAR ago Brazil’s finance minister, Guido Mantega, declared that the world had entered into a “currency war”. He worried that in a depressed global economy, without enough spending to go around, countries would sally forth and grab a bit of extra demand for themselves by weakening their currencies. The dollar, for example, fell by 11% against Brazil’s real in the year to August 2011, much to the chagrin of Brazil’s manufacturers. Like other emerging economies it fought back by imposing taxes and other restrictions on foreign purchases of local securities.

But the invasion of foreign capital that so worried Mr Mantega has now turned into a shambolic retreat. The outflows have dragged down the exchange rates of almost every emerging economy since the beginning of August (see chart 1). Having spent much of the past year fretting about their currencies’ rise, central banks across the emerging world have now intervened in the markets to slow their currencies’ fall. In a currency war, where each side fights to gain competitiveness against the others, these tumbling exchange rates presumably count as victories. But they are Pyrrhic.

That term originates with the GreeksPyrrhus was a Hellenistic general whose victories against Rome came at a grievous cost to his own side. The Greeks are also partly responsible for more recent reversals. As the government in Athens teeters on the brink of default, investors have begun to doubt the creditworthiness of other euro-zone governments, as well as the banks that lent to them. The gathering unease has left global investors less willing to tolerate the risks associated with volatile emerging economies.

Indeed, some are unwilling to tolerate risks of any kind (see Buttonwood ). They are accumulating cash by selling other assets, from gold to Thai equities, more or less indiscriminately. An index of emerging stockmarkets prepared by MSCI has fallen by over 20% since August 1st, despite a rally on September 27th. The worry now is that bonds will follow suit. Foreign investors hold a third of the local-currency debt issued by Indonesia, Korea, Malaysia, Mexico, Poland and Turkey. In a conference call, Bhanu Baweja of UBS worried that the stomach-churning developments in Europe and America might prompt these investors to “pukeup their bondholdings.

A cheaper real, zloty and rupee will help emerging economies win a bigger share of global spending. But that is small consolation if global spending declines. The volume of exports from Latin America and Asia did not surpass its pre-crisis peak until the first quarter of this year, according to the Netherlands Bureau for Economic Policy Analysis. And foreign sales are bound to fall again as America stagnates and a two-speed Europe converges on a single, slower pace.

Falling export orders was one of the complaints voiced by Chinese manufacturers in a preliminary survey of purchasing managers published by HSBC last week. The survey showed manufacturing shrinking from the month before (see chart 2), adding to the gloom on world markets. But HSBC’s China economist, Qu Hongbin, believes GDP will still grow at an annual pace of 8.5-9% in the second half of this year. China’s economy is not as dependent on exports as it was, he points out. International trade (exports minus imports) contributed a little less than nothing to the country’s growth in the first half of this year. And imports have remained strong: in the traumatic month of August, China imported 30% more (in dollar terms) than it bought a year before.

These imports included iron ore and other materials destined ultimately for China’s construction industry, which has become a mainstay of the economy’s growth, but also a headache for its policymakers. To quell property prices, the government is trying to starve real-estate developers of financing. First, it restricted bank lending; now it is removing trust-company financing from the menu. But even as it curbs the top end of the property market, the government is urging local authorities to build affordable housing. Bricks are still being laid, even if less profit is being made. Homebuilding is surprisingly buoyant (housing starts increased by 32% in the year to August), even as home builders take a battering on markets.

If the world economy were to collapse, emerging economies have scope to ease policy. Michael Buchanan and his colleagues at Goldman Sachs calculate that emerging Asia could offset a growth shock of up to 5.1 percentage points, if they allowed their interest and exchange rates to fall to their lowest points in the crisis, and their budget balances to deteriorate as far as they did in 2009.

In Israel, where inflation expectations have fallen, and Brazil, where they have not, central banks have already started cutting rates, even though inflation in both countries remains above the official target. Thailand’s new government is beginning a fiscal splurge, including generous purchases of rice from the country’s farmers, that may prove better timed than it seemed when it was promised.

But other emerging economies will be more reluctant to stimulate, precisely because they have done so before. India’s central bank is still preoccupied with the inflation that quickly ensued after the financial crisis abated. As recently as September 16th, it raised interest rates for the 12th time in 18 months. And China is only now coming to terms with the bad debts amassed by local governments during the stimulus lending of 2009 and 2010. Loans worth perhaps 2 trillion-3 trillion yuan ($310 billion-630 billion) may have already turned sour, according to China’s banking regulator. It is now scolding banks for the recklessness that was urged upon them during the crisis. If the central government decides that another stimulus onslaught is necessary, it may find the banks are less willing footsoldiers. Even successful battles leave casualties in their wake.