Posted by:
Andrew Bell

1 February 2011

There is no shortage of potential disruptive factors for the global economy this year. In some cases, the unfolding nature of events makes forecasting problematic – political upheavals with gerontocratic governments in “denial” being a topical instance. In others, there is a dissonance between the authorities’ political and economic aims, with a resulting risk of contradictory communication and misunderstanding. It is important to know if a person asking if you want decking is a garden consultant or an urban troglodyte and in the same way politicians addressing economic problems can create damaging misunderstandings with unintended consequences.

Two recurrent examples over the past year are the management of sovereign debt strains in the Eurozone and the tensions over the banks: should they maximise (responsible) lending or create impregnable capital cushions?

In the case of Europe, there have been repeated statements from Germany that fiscally challenged governments should pay penal rates for European assistance, tighten fiscal policy and implement reforms to restore competitiveness. These have had the effect of increasing both the probability and cost of additional sovereign bailouts.

The current policy prescription is a good model for what should have been insisted upon before countries were allowed to join the Euro but a poor roadmap for dealing with consequences of having failed to do so. Countries that were led to believe that the Euro was a symbol of shared political allegiance as well as a way of importing the low interest rate fruits of Germany’s more disciplined economic culture have had a rude awakening. They have been allowed to swim in an alluring sea where the lifeguard failed to put up adequate warnings (Can you swim? Watch out for rip tides!) and now wants to charge for saving them from drowning. The policy mistakes are the responsibility of the countries on the geographic fringe of Europe (the “PIIGS”) but the institutional framework (the Euro itself) is also at fault, having switched from PollyAnna-ish liberality to draconian discipline when the economic divergences became too big to disguise (and the markets’ willingness to ignore them changed).

Europe’s failure to win markets’ confidence in managing its rolling sovereign debt crisis appears to have changed the debate. Chancellor Merkel’s new year TV address was reported in the Wall Street journal as saying “We have to strengthen the Euro, and...the Euro is more than just a currency. It is our good fortune that we Europeans are united. A united Europe is the guarantor of our peace and our freedom. The Euro is the basis of our economic wellbeing. Germany needs Europe and our common currency, for our own good and for coping with global challenges.” This could be Chancellor Kohl speaking (with his memories of a continent riven by war), or more likely Chancellor Merkel recognising that if the PIIGS dominoes fell, they would precipitate a German bank bailout and a recriminatory break-up of the Euro that would damage Germany, which would be seen to have caused it.

There are signs that the core European establishment is recoiling from this outcome. However, there may be further stumbles as Europe lives up to Churchill’s comment about Americans “You can always count on them to do the right thing – after they have exhausted all other possibilities”.

Europe aside, there remain contradictory attitudes towards the banks. Having stopped short of reintroducing the ducking stool for bankers there are some indications that official and public anger is morphing towards the more positive task of incentivising them to provide loans to fuel economic growth, balancing this against the desire for a stronger capital base. Immediately requiring dramatically higher capital ratios is likely either to increase the cost of capital for all companies or perversely encourage banks to shrink their loan books, as an alternative means of boosting their capital ratios. With much of the excessive leverage in the investment banking sector having been crunched out in 2007-9 and capital ratios already raised, the most readily available sources of further capital generation by the banks are reduced losses on existing loans and greater retained profits (relative to dividends). Higher bank profits can be taxed or used to fuel loan growth – winning fewer votes than putting the boot in but buttering more parsnips.  Has the time come for banks to moove from being scapegoats to milch cows?

With the western economies having moved from crisis to convalescence over the past two years, there is considerable unfinished business in the area of refinancing debts. This requires both clarity on western policy makers’ economic priorities (growth vs. inflation control) and policies consistent with that aim (loose policy in the short term but a credible commitment to bringing budget deficits under control and tightening monetary policy before inflation rises significantly).

Another major structural issue is the divergence of growth between mature and developing economies. Developed economies face problems of sustaining growth and preventing deflation. Emerging economies have the opposite problem of moderating growth and combating inflation. A slowdown, though desirable in the latter, would make debt management in the developed world more complicated – something which quantitative easing is designed to alleviate. Markets have shown signs of nerves in the past when China has been tightening, fearing that an attempted soft landing will result in policy overkill. As coming months unfold, it will be important to see whether this risk has again been avoided – will this be the Year of the Rabbit or of the Rabbit Pie?

Despite these lingering tactical risks, generally better news on economic growth suggests that the battle between structural headwinds and exceptional policy stimulus is resolving itself positively. Watchfulness will still be required, as 2011 could prove just as prone as 2010 was to tactical ambushes (from alternating growth and inflation scares).

Comments or feedback are always welcome at theblog@witan.co.uk

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