Days of Reckoning in the Global Economy

July 01, 2011

You remember all of that rubbish back in 2009 about “green shoots” appearing to mark the beginning of the end of the global market crash? I recall dismissing this premature optimism, and saying instead that we had perhaps reached the end of the beginning. But I now realize I was wrong – only now are we reaching the end of the beginning. In fact, when our grandchildren look back at this horrid period, it may be this very week that is recalled as the watershed point from which the crisis was at last honestly faced, enabling the start of decisive remedial action.

In Europe on Wednesday, Greek’s political leaders were forced to the brink of default before finally agreeing to a US$28bn package of tax increases and spending cuts. Even now, Greek default seems inevitable – a matter of when, not whether. Even the IMF calculates the probability of Greek default at 75%. But it seems important to delay the inevitable for a single pragmatic reason: if it occurred now, it would almost inevitably haul Portugal, Ireland and Spain into the black hole with it - so by delaying Greece’s default Europe’s leaders buy some time for these countries to face brutal reality and take remedial action. This is no small matter: default by an economy that accounts for less than 2% of the EU’s GDP may be traumatic (n particular for the German and French banks with massive exposures there) but not half as traumatic as economies accounting for almost 15%.

Even if formal defaults are avoided, Europe’s economies in general face a grim few years ahead. Jobless numbers are still rising (nearly 21% in Spain), property prices are still heading down, government services are being cut, taxes are being increased – and the pain from all of these developments has barely yet been felt – for most of Europe’s economies, the bulk of politically-tough austerity measures are only now in the process of being promulgated. Even the mere thought of the pain has taken political protest to boiling point – heaven knows how politicians will deal with the tough tasks ahead in the teeth of protest driven by real pain.

In the US, today is the day the life-support system provided by QE2 comes to an end. For the first time since the 2008 crash we will discover how the US economy can cope without life support. The auguries are nail-bitingly awful: the housing market is still falling, with 7m homes in foreclosure, and a further 2m expected to be passed into bank hands by the end of the year. Few banks carrying these homes and their mortgages on their books have yet written them down to current (still falling) price levels – and would probably be insolvent if they did. Jobless numbers are still rising. Even though Wal-Mart has seen eight consecutive quarters of falling sales, US consumer spending still sits at 120% of average household earnings – 10% down from the spending peaks reached before 2008, but still far above the 90% level that prevailed in the 1990s. Clearly, US consumers still have a lot of belt tightening to do.

The political challenge of mixing a cocktail of spending cuts and tax increases has become entangled in party wrangling focused on Presidential elections still 18 months away. But with public debt up above 100% of GDP, and the US administration set to crunch into debt limits on August 2, the day of reckoning on managing debt is upon us. Incredibly, there is now serious discussion of the possibility of US default. Spreads on US 1-year sovereign debt have jumped from 20 points to more than 45 points since the beginning of May – worse than either Brazil or France.

Just as the US’s QE2 life-support system has been switched off, so by unhappy coincidence is the Japanese government unwinding its massive liquidity injections made after the Sendai earthquake. As one FT correspondent noted anxiously: “There are monetary experiments under way on every front.”

And of course, in this group we must include Beijing, which has also had to curb its own QE2 equivalent in response to alarming signs of property bubbles, debt-fuelled speculation and corruption, and gathering inflation. As those on intensive care in the US and Europe turn pleadingly to China to keep its party rolling in order to provide some stimulus to an otherwise limp global economy, speculation has arisen over whether China can curb these excesses without creating its own hard landing.

Regardless of the capacity of China’s leaders to rein in on domestic excesses without clobbering growth, one needs to provide a reality check for those looking to China to provide a helping hand. China’s GDP amounts to US$7.6 trillion – about half the size of the US’s US$15 trillion economy, and a third the size of the EU’s US$22 trillion economy. It is clear that consumer spending inside China cannot provide the sort of locomotive momentum Europeans or Americans seek to remedy their ills.

On the contrary, it must surely only be a matter of time before the protracted slump of the world’s two main consuming regions takes its toll on the traditionally export-oriented economies of Asia – China included. And if this enfeeblement of consumer demand in the US and Europe occurs while China’s leaders are engaged in delicate maneuvers to choke their own inflationary pressures, then the danger of a Chinese “hard landing” cannot be dismissed out of hand.

For China, an additional wild card in managing its internal economic challenges is the increasingly apparent political face-off between conservative and liberalizing elements in the leadership ahead of the leadership changes in 2012. With the liberalizing policies of recent years being blamed by conservatives for rising inequality and widespread corruption, there is pressure to rein in sharply on bank lending. If this results in a sharp economic slowdown, then the liberal voices in the leadership will be under even further pressure. This difficult political context can only get more troubling over the coming 12 months, and must raise real questions about China’s ability to perform the stimulative economic role being begged of it by many in the west.

It must surely be good news that we are at last at the end of the beginning. Bad news, however, that it is likely to take several years for glimmers of good health to reappear in the global economy. And even more challenging to realize that the coming couple of months are going to be critical. As one leading economist noted last week: “If there was ever a moment in the calendar when it seems foolish to embark on market gambles, August is surely that point… Better check that the Blackberry works on the beach if you plan any summer holiday. If financial history is any guide, you will need it.”


* The translated Chinese version was published in Ming Pao on July 1, 2011.


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