In for a bumpy ride: maybe a double-dip?

Poor political decisions pose the highest risk to global sustainability!

WHAT ARE WE TO DO?
By TAN SRI LIN SEE-YAN

THE World Bank’s Global Economic Prospect Summer 2010 Report carries both good and bad news. The good news: the global economy will grow faster than previously forecast at between 2.9% and 3.3% this year, up from January 2010 forecast of 2.7%.

Developing economies will spearhead recovery, growing three times as quickly as their high-income counterparts from now till 2012.

For developing countries in East Asia, World Bank projects growth of 8.7% this year before slowing next year and in 2012. China is projected to be the fastest growing economy, by 9.5% this year and 8.5% in 2011. But for the rebound to endure, high-income nations need to seize opportunities offered by stronger growth elsewhere.

A double dip?

The bad news: while markets have improved, reaction to a possible debt default and eventual contagion reflects fragility of the current situation. Indeed, “market nervousness concerning the fiscal position of several European high-income countries poses new challenge for the world economy.” Upheaval in Europe simply means a double-dip recession can’t be ruled out.

Recent efforts of the International Monetary Fund (IMF) and other European institutions are expected to stave off a major European sovereign debt default. In this scenario, World Bank expects high-income countries to grow just 2.1% to 2.3% this year – not enough to reverse last year’s 3.3% GDP (or gross domestic product) contraction.

However, global economic growth could stall sharply if the European sovereign debt crisis produces a debt default or spurs loss of market confidence. If bond yields rise by one percentage point, projected world growth could slow to 2% this year and 0.7% in 2011.

In the case of a full-fledged debt meltdown, high-income countries will expand by just 0.9% in 2010 and 0.6% in 2011. In this case, the GDP of France, Germany, Italy, Spain and Britain would fall sharply, causing a domino effect on exports to the rest of European Union and the world.

If Europe can avoid a debt crisis, signs of a steady recovery will continue. In the United States and Japan, the stimulus-led rebound is now being driven increasingly by more organic expansion, fuelled by investment and consumer demand. That signals a more self-sustaining recovery and diminishes the risk of a double-dip recession.

Historically, the only double-dip recession in modern times begun during 1980 when the US Federal Reserve (Fed) slashed federal funds rate to 9% that April from 17.5% in July 1979. Inflation returned, so the Fed reversed course and pushed the rate above 19% by January 1981.

Europe is a different story. With growth last year now undermined by debt anxieties, World Bank sees much weaker growth – possibly even no growth. Indeed, the fiscal situation in high-income countries in Europe and the United States is currently on an “unsustainable path, and there is a need for more rapid fiscal consolidation,” says World Bank.

This is not just to ensure sustainability of rich countries’ public finances, but also rapid cuts in public spending or tax hikes designed to return their debt ratio to 60% of GDP by 2030, would benefit poorer economies too. There will be a fall in export demand for sure, but this would be offset by improved financial positions, improved investment climate, and improved long-term interest rates.

Over the longer term, these same factors can be expected to kick-in a win-win situation.
Nevertheless, Wall Street is convinced fiscal tightening by European governments has dramatically shifted the macroeconomic environment for the worse over the past five weeks. The world’s leading hedge fund managers are already acting to re-position their funds for a double-dip recession. Many have begun to aggressively de-risk their portfolios. Others are closely monitoring, preparing for growth to be far less than what people now expect.

The deflation dilemma

Since the Greece debacle, financial markets have been sending mixed signals. We see falling yields on US Treasury bills, suggesting investors seem to worry more about economic stagnation and deflation. But we also see soaring gold prices, pointing to prospects of runaway inflation.

This is confusing. A fair assessment suggests that as of today, deflation is the bigger danger in the big, rich nations, whereas inflation is of immediate worry in many emerging economies, and potentially a longer-term danger for the richer ones.

Worries about consumer price deflation are resurfacing in the rich nations after weeks of market turmoil driven by Europe’s fiscal crisis. The fears are most pronounced in Europe where policymakers are under strong pressure to reduce unsustainable public debt before any durable recovery can emerge.

A combination of spending cuts and tax increases is likely to weigh down growth and feed in to deflation. In United States, eurozone and Japan, deflation is uncomfortably close by, despite near-zero interest rates and other central bank actions. Year to April 2010 core consumer prices rose by 0.9% in the United States (the lowest in four decades), by 0.7% in the eurozone, but fell by 1.5% in Japan, which has been battling falling prices for more than a decade.

Money and credit growth are virtually stagnant or shrinking in all three places. Unemployment (especially among youths) is high and large gaps remain between actual output and their potential. Eurozone’s austerity programmes will further sap domestic demand. The short-term consumer price outlook clearly points downwards.

Deflation makes it harder for consumers, businesses and government to pay off debts. Principal debt repayments are fixed but deflation is marked by falling incomes.

So as deflation sets in, debt burden rises. Additionally, when prices fall, consumers put off purchasing in anticipation of still lower prices, driving the economy to a vicious cycle of weak spending and further sliding prices.

Indeed, deflation is harder to fight. With interest rates near zero, policymakers can’t use traditional rate cuts to spur growth and stop deflation. That’s an acute worry.

Japan’s ongoing fight against deflation suggests preventing prices from falling is less well understood; further budget belt-tightening suggests interest rates will remain low for some time. This causes problems for emerging nations in terms of unwelcome capital inflows, making it difficult for healthier economies to maintain financial stability. Many are already overheating, with rising consumer prices and asset bubbles.

The irony is governments were the solution to the recent great recession. Now they are the problem. The scale of sovereign debts has left rich-nation governments with less room to manoeuvre in any new downturn; so most of them are being forced into austerity. The real danger lies in these fears reinforcing each other in a pernicious reversal of the dynamics of 2008-09.

New conventional wisdom

After nearly two years of lockstep economic policy moves, the United States and Europe are going separate ways. Debt-wary Germany is pressing for austerity on public spending and tax hikes, while the United States preaches patience. This recent feud is best articulated by Nobel laureate Paul Krugman (supported by Nobel laureate Joseph Stigliz), calling it the “spread of a destructive idea”.

After less than a year of weak recovery from the worst slump since World War II, it is not timely for governments to switch from supporting the economy and helping the jobless, to start inflicting pain through fiscal austerity. Surely, not until the recovery is secure and self-sustainable. Lessons from the 1930s, when premature lifting of monetary and fiscal support led to a double-dip, must be applied. Germany’s old scar is hyperinflation.

What irked Krugman is the idea that nascent economies need even more suffering. The Organisation for Economic Cooperation and Development (OECD) has picked up on this and suggested in its latest report that policymakers should stop promoting economic recovery and instead bring on raising interest rates, slashing spending, and hiking taxes.

Ironically, this flies in the face of what the global economy now really needs. OECD justifies its stand on two grounds: (i) the need to head off inflation (certainly, inflationary expectations); yet, inflation is low and declining, and OECD’s own forecasts indicated no hint of an inflationary threat; (ii) the need to cut spending to guard against the “possibility that longer term inflationary expectations could become unanchored…”; yet, fiscal austerity at a time of high unemployment must be a lousy idea, not only does it deepen the downturn, it does little to improve the budget outlook.

On top of it all, OECD predicts that high unemployment will persist for years. It just doesn’t make sense.
Indeed, the battle has taken a higher profile. Next week, the Group of 20 Summit of world leaders (G-20) will meet in Toronto. Gone was an earlier pledge to maintain policy support until recovery is finally entrenched. In its place are statements stressing sustainable public finances and the need for some nations to accelerate the pace of consolidation.

One thing is clear: both the United States and Europe agree that current public debt levels are not sustainable. Their views differ on how and when to tackle them; quite obviously coloured by their memories of the 1930s – the US fear of pre-mature lifting of fiscal and monetary support (and a double-dip); and Europe, fearful of runaway inflation, emphasises fiscal restraint to restore confidence as a precondition for growth.

The rift goes beyond US-European politics – it’s also in academia, as evidenced by the divide between prominent economists four months ago in Britain: those who assert that budget cuts should be postponed until the economy is out of the liquidity trap, and those who insist on immediate cuts to achieve market credibility.
Here, Krugman has a point: currently, there is no evidence that the United States and Britain have any problems of access to markets. Based on experience, premature fiscal tightening is as big a danger as delayed tightening can be. It is not clear Europe is strong enough to absorb all that austerity. To be sure, a weaker Europe means a weaker global economy.

New political risks

Markets have been sending mixed signals. Much of the recent volatility of markets – rapid fall of the euro, tightening of bank rate spreads, tumbling stock indices, sharp swings in commodity markets – reflect new political risks.

These include (i) market perception that governments are unwilling or unable to reform their economies – the Greek crisis saw governments paralysed, where inaction and delay made the problem worse; (ii) market worries how soaring debts and budget deficits in the United States, Japan and Europe are being handled – no evidence they are prepared for large tax increases or severe spending cuts, resulting in potential soaring inflation and debt defaults; (iii) market concern over uncoordinated bank regulation reform – right now, the United States, the EU and Basle are all moving in different directions, at different speeds, and on different time lines.

Other potential political risks – inability of governments to politically borrow more in the face of another shock crisis; fiscal austerity could plunge economies into deflation, further raising unemployment and reviving recession; fear of competitive devaluations and global tariff war; and heightened sensitivity to connectivity among national and international economies.

So, the world is nervous for good reason. At this time, fundamentals are reasonably good. Unfortunately, political decisions are often unreasonably bad. Right now, that’s what poses the highest risk to global sustainability.

● Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email:
starbizweek@thestar.com.my.