Posted by:
Andrew Bell

7 June 2010

There is sufficient uncertainty over how the global economy manages itself out of the current imbalances and overhang of debt without having to worry about whether there is agreement on the route forward. While the financial system hung on a thread in late 2008, owing to the shrivelling up of credit markets, there was little time for disagreement, so broadly similar approaches were adopted in most countries (bank recapitalisation, monetary easing, fiscal boosts), albeit with variable willingness and timing. The slide in confidence was arrested, the slump in output turned around within a year and the self-reinforcing downward spiral of loan losses, restricted credit, falling asset prices, slumping output and further loan losses was reversed.

In 2010, attention has turned to the clean-up. Politicians want to tax, punish or regulate the banks to prevent a repetition of the recent implosion. Governments need to reduce borrowings, to avoid a rise in bond yields that could stifle the recovery and to prevent public sector debt ratcheting out of control. The boosts to consumption in countries that already have high levels of consumer borrowing (e.g. the UK and the US) have to give way to increased saving and a structural shift towards investment and exporting. In order for this increased prudence by some economies and most governments not to pitchfork the world back into recession, there needs to be an offset. This should partly come from loose monetary policy, to help borrowers cope with their debts and to prevent the undue deflation in asset prices (which underlie the security of most bank loans) that could result from higher taxes and public spending cuts. The other offset would naturally come from countries with trade surpluses boosting their domestic economies, to compensate for the headwind from deficit countries seeking to boost exports.

The recent meeting of the finance ministers of the G-20 industrialised countries showed disagreement over how this process would be handled. Although there was a stated commitment to “safeguarding” the recovery there were differences over the timing and extent of fiscal retrenchment and over what to do about the banks.

The fiscal disagreement might be portrayed by Germany as a division between procrastinating fiscal sinners wishing to avoid painful decisions and realists committed to financial stability. However, this does not answer the question over how demand growth will be sustained given the pace of retrenchment being demanded of the Mediterranean Euro members, let alone the UK and (as tax rises kick in from 2011) the US. The last German government passed a law to balance the budget by 2016 and the present government has announced more stringent cuts recently to offset the recession’s impact on the budget deficit. The US argued at the G-20 meeting for surplus countries (which include Germany, Japan and China) to do more to stimulate domestic growth as part of the necessary rebalancing of global growth. Instead Germany seems to be adopting the airlines’ oxygen supply advice: “please put your own mask on before helping others”.  The exposure of German and French banks to the debt of Greece, Spain and other countries under pressure to cut their deficits blurs the definition of who was being rescued in the Eurozone’s announced (but not yet implemented) €750bn rescue package. Germany’s self-righteousness would not survive another round of German bank rescues.

This G-20 policy disagreement is not as serious as that which ushered in the 1930s. Then, some countries kept monetary policy too tight for too long (by staying on the gold standard), others tightened fiscal policy as the recession boosted deficits and there was a general shift towards restricting trade and protectionism against imports. So far, the world appears to be disagreeing about one of these (fiscal policy) and flirting with another (protectionism). Monetary policy is generally loose where it needs to be, though central banks may have prematurely stopped their unconventional quantitative easing policies. Of the areas of possible policy error, protectionism is the most insidious and bears watching. Explicit use of tariffs is not widespread but everyone seems to be targeting export-led growth fuelled by currency weakness. It does not take a genius to fathom that not everyone can do this. So, either a “race to debase” gets underway, which would be very destabilising for economies and markets, or countries with surpluses will need to spend them. Although the G-20 communiqué said that “within their capacity countries will expand domestic sources of growth”, this appeared to be a fudge to paper over differences. It will probably take a greater crisis within the Eurozone, or a stalling of its own growth, to persuade Germany that its parochial interest lies in helping with global rebalancing. Economic isolation is not an option for an export-dependent economy.

The schizophrenia over the banks also highlights differences between rhetoric and reality. A mixture of more prudent regulation and greater capital reserves is likely to be needed to reduce the risk of a future banking crisis. It also seems fair for the profits of banks, once they are re-established, to be taxed more heavily in order to compensate for the public costs of rescuing the system in 2008. This levy or tax should ideally fall more heavily on those that were previously managed imprudently than those who simply benefited from the recovery ushered in by government guarantees. The problem with these banking questions is that politicians cannot agree on the answer and, even if they could, the wish to tax, regulate and de-gear the banking system is in conflict with the wish for the banks to ease lending conditions, in order to sustain economic recovery. Faced with the untimeliness of action, politicians are falling back on what many of them do best – talk. Even if valueless, talk is not costless, since banks without clarity over future regulation or taxes are likely to pursue self-help policies that reduce risk, even where the needs of the economy (and the available lending opportunities) argue for more expansive policies.

Although recent economic news has suggested that growth was taking firmer hold this spring, it is too soon to assess whether the Europe-centred financial crisis will hobble the recovery. Although the global authorities seem committed to sustaining the convalescence (since aggressive efforts to tackle budget deficits could be negated by a slip back into recession) there is a greater risk of a policy mistake than has been apparent for most of the crisis management underway since 2007. German insistence on fiscal consolidation NOW and reluctance to do their utmost to preserve the Euro might be more than short-term politics or turning the pressure on wayward governments and might instead be a sincerely-felt different analysis of the best way out of the current economic malaise (at least for Germany). Given the headwinds from consumer, government and bank sector deleveraging, early fiscal consolidation on the scale promoted by Germany looks set to be self-defeating, unless trade surplus countries rebalance their growth towards consumption and there is a powerful monetary offset to the fiscal brake. Eventually this may prove inflationary (a bigger topic for another day) but in the near-term the aura of deflation wafts from the robes of the zealots of fiscal wrecktitude. Real assets still look the investment of choice but the current debate is eroding confidence that reason will prevail.

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

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