World economy

Fear returns

Governments were the solution to the economic crisis. Now they are the

problem

May 27th 2010

IT’S not quite a Lehman moment, but financial markets are more anxious today than

at any time since the global recovery took hold almost a year ago. The MSCI index of

global stocks has fallen by over 15% since mid-April. Treasury yields have tumbled

as investors have fled to the relative safety of American government bonds. The

three-month inter-bank borrowing rate is at a ten-month high. Gone is the

exuberance that greeted the return to growth. Investors are on edge.

What lies behind these jitters? New nervousness about geopolitical risk, with

tensions rising in the Korean peninsula, has not helped. But that comes on top of two

wider worries.

One is about the underlying health of the world economy. Fears are growing that the

global recovery will falter as Europe’s debt crisis spreads China’s property bubble

bursts and America’s stimulus-fuelled rebound peters out. The other concerns

government policy. From America’s overhaul of financial regulation to Germany’s

restrictions on short-selling, politicians are changing the rules in unpredictable ways.

And the scale of sovereign debts has left governments with less room to counter any

new downturn; indeed, many of them are being forced into austerity.

The danger is that these fears reinforce each other in a pernicious reversal of the

dynamics of 2008-09. Then, co-ordinated government action on a grand scale

stopped the global financial crisis from turning into a depression. Now, thanks to

incompetence and impotence, governments may become the problem that will drag

the world economy down.

Don’t panic

That is far from inevitable. Fears about the fragility of the global recovery are

exaggerated. Led by big emerging economies, the world’s output is probably growing

at an annual rate of more than 5%, far swifter than most seers expected.

This pace will, and should, slow, not least because the big emerging economies need

to tackle rising inflation and possible asset bubbles. China is in obvious danger,

which is why its government has tried to constrain loans and property prices.

Pricking asset bubbles is never easy, but there is scant evidence that its efforts are

too heavy-handed.

America’s growth may also slow as firms stop rebuilding their stocks and the

government’s stimulus tapers off. But the world’s biggest economy does not seem on

the verge of a second recession. For all their heavy debts, American consumers have

returned to the shops. Their confidence is rising as the economy is producing jobs

(albeit not enough of them). And Congress seems likely to slow the pace of fiscal

tightening with a new “mini-stimulus” of temporary spending.

Growth prospects look grimmest in Europe. Yet even there the likely immediate

outcome of the euro zone’s crisis is the enfeeblement of an already weak recovery,

rather than a sudden slump. The region’s profligate economies will struggle for

longer as austerity kicks in. But waning confidence will be mitigated by the boost

that exports receive from the euro’s plunge.

Look only at those probable short-term prospects and it is hard to see why financial

markets are suddenly in such a lather. The reason is that the risks of a far worse

outcome have risen, and those risks lie mainly with governments.

Grading the governments

The place with the wobbliest policy is Europe. For the euro to survive, Europeans

need to be prepared not just for painful fiscal adjustment but for profound structural

reform as well. Profligate governments, mostly in southern Europe, must become

more prudent. Uncompetitive economies must shake up their labour and product

markets. Countries that are running current-account surpluses, mainly in the north,

must help, by avoiding overzealous belt-tightening and introducing reforms to

encourage private spending. And the European Central Bank (ECB) should counter

the fiscal austerity with a looser monetary policy. Reducing real wages in Spain

would be easier if euro-zone inflation were higher.

Unfortunately, Germany’s government seems to be drawing exactly the opposite

conclusions, promising to set an example with tough cuts when it should be helping

to stimulate growth. The worry is that, under German pressure, the ECB will have

the same misguided tendency to toughness, condemning the euro area to years of

stagnation.

Governments outside the euro zone are also at risk of drawing flawed conclusions,

especially on exchange rates and fiscal policy. China seems to think that the euro’s

decline makes it less urgent to allow the yuan to appreciate. The opposite is true.

With its biggest export market in a funk, China needs to accelerate the rebalancing

of its economy towards domestic consumption, with the help of a stronger currency.

For much of the rich world, however, the most important consequences of Europe’s

mess will be fiscal. Governments must steer between imposing premature austerity

(in a bid to avoid becoming Greece) and allowing their public finances to deteriorate

for too long. In some countries with big deficits, the fear of a bond-market rout is

forcing rapid action. Britain’s new government spelled out useful initial spending cuts

this week. But the emergency budget promised for June 22nd will be trickier: it

needs to show resolve on the deficit without sending the country back into recession.

In America, paradoxically, the Greek crisis has, if anything, removed the pressure for

deficit reduction, by reducing bond yields. America’s structural budget deficit will

soon be bigger than that of any other OECD member, and the country badly needs a
plan to deal with it. But for now, lower bond yields and a stronger dollar are the

route through which American spending will rise to counter European austerity.

Thanks to its population growth and the dollar’s role as a global currency, America

has more fiscal room than any other big-deficit country. It has been right to use it.

The world is nervous for good reason. Although the fundamentals are reasonably

good, the judgment of politicians is often unreasonably bad. Right now that is what

poses the biggest risk to the world economy.

http://www.economist.com/node/16216363?story_id=16216363

The euro-zone crisis

Europe's three great delusions

The continent’s leaders have still not grasped how much they need to do

to save the euro

May 20th 2010

IT HAS been another turbulent week for the euro. Investors have pondered the €750

billion ($950 billion) rescue plan devised by euro-zone finance ministers—and remain

nervous. The euro has fallen sharply. Fears that the rescue plan will not be

implemented may grow. But the real worry is that the time the plan should buy may

be wasted as a result of three delusions which have overtaken European leaders.

Too The first is shoot-the-messenger syndrome. many European politicians lay all the

blame on speculators, hedge funds, rating agencies and the rest for “unwarranted”

attacks on the euro. Such thinking has informed Germany’s decision to ban “naked”

short-selling of government bonds. The German regulator itself admits that this

practice played little part in the Greek mess. The ban will apply only in Germany,

whereas most short-selling happens in London. If it has any impact at all, it will

merely make it harder to sell government bonds.

The decision in Brussels to push through tough rules on hedge funds and private

equity reflects an equally gormless view that such firms caused the financial crisis.

Nobody can deny that financial regulation needs to be improved. But to attribute the

woes of euro-zone government-bond markets solely to evil speculators is

dangerously misguided. In fact, investors everywhere (not least at home) have

woken up, belatedly, to the extreme fiscal vulnerability of some euro-zone countries

—and are now forcing budget cuts.

The second delusion might be termed excessive faith in shock-and-awe. Although the

euro’s rescue plan took weeks to devise, €750 billion is an undeniably big number.

The European Commission’s president, José Manuel Barroso, claimed it showed the

euro zone would do “whatever it takes” to defend itself. Even less troubled euro-zone

countries like Italy are pushing new fiscal austerity. Yet for Greece, faith in shock-

and-awe seems misplaced. Even if it does everything it has promised (and it may

well not), Greece will end up with public debt over 150% of GDP and at best meagre

growth prospects. In truth, Greece’s debt problem is one of insolvency, not illiquidity

—and insolvency cannot be rectified by piling on more debt, however shocking and

awesome the amount. Instead, euro-zone governments and regulators should start

planning now for an orderly debt restructuring, including the imposition of losses

(“haircuts”) on banks that hold Greek debt.

Burying Greek busts

The third and most disturbing delusion is that deeper structural reform is not

necessary; everything will be fine if only Greece and other euro-zone laggards cut

their budget deficits. Several notorious fiscal reprobates are promising Angela Merkel

that they will whip themselves into line. This is both masochistic and cowardly. On

the one hand, sharply reducing demand in economies that are recovering only

weakly from recession may cause much unnecessary pain. But an obsession with

fiscal discipline may also be an excuse for politicians to run away from tackling

Europe’s chronic imbalances and the loss of competitiveness in southern Europe.

Greece, Spain and Italy all made strenuous efforts to qualify for the euro. But once

in, they relaxed and gave up the tiresome business of pushing through reforms to

enhance competition, hold down labour costs and boost productivity. In fact their

loss of monetary and exchange-rate flexibility makes these reforms more pressing—

as the euro crisis has underlined. It also makes it imperative that Germany do more

to boost domestic demand. How sad that most euro-zone governments still do not

seem to get it; how pathetic that they cover their ignorance by blaming hedge-fund

managers in London.

http://www.economist.com/node/16163376?story_id=16163376