World economy: Vulnerable to vertigo
By Chris Giles
Published: July 27 2010 23:00 | Last updated: July 27 2010 23:00
Double dip. It is the phrase on everyone’s lips – and it makes many of those lips tremble. With the shock of 2008 fading into memory, the moment of reckoning for the global economy has arrived. Will the bounce back from the nadir become established as a return to sustainable expansion – or will initial relief mutate into the despair of a renewed slowdown?
There is no doubt that the mood has soured since spring as Europe’s authorities flapped in the face of a sovereign debt crisis, thus intensifying its effects. Just take a – however unscientific – survey of English-language media over the past six months: while mentions of a V-shaped recovery have remained constant, references to a double dip have soared. They were almost four times as high in July as in May.
Such talk is fuelling the doom-mongers. Chief among them, Nouriel Roubini, chairman of Roubini Global Economics, argued last week that a downturn in the global economy “will accelerate in the second half of the year”. For Europe and Japan, “avoiding double-dip recession will be difficult”, he said. Indeed, right on cue, manufacturing activity indicators weakened in June for China, South Korea, Taiwan, India and Australia.
Gloom has spread to policymakers in the world’s largest economy. Revising forecasts down for the first time since 2009, Ben Bernanke, Federal Reserve chairman, told Congress last week that the US outlook was “unusually uncertain”. America’s central bank chief added: “We are ready and we will act if the economy does not continue to improve, if we do not see the kind of improvements in the labour market that we are hoping for and expecting.”
Lawrence Summers, chief economic adviser to President Barack Obama, described the world’s leading economies as “in or near liquidity trap conditions”, which translates as implying that they are so weak that lower interest rates and other monetary policy tools are ineffective stimulants. No matter how much money is thrown into the system, people are so nervous that they just hoard it.
But dwelling on the negative does not tell the whole story. Although fears have grown, the data do not point ominously downward. Instead, led by a remarkable expansion in emerging economies, the world economy has surprised almost everyone by growing as fast in 2010 as it was before the financial crisis.
While the International Monetary Fund’s forecast for this year languished at 1.9 per cent in April 2009, it has subsequently been revised five times, every time higher, so it now stands at 4.6 per cent. World trade is rising at double-digit rates and, even in the advanced world, upgrades in growth forecasts have outweighed downgrades. Germany’s economy is now expected to have grown by more than 1 per cent in the second quarter; Britain’s statistical office recorded growth of 1.1 per cent for the same period, the fastest rate for four years.
These positive straws in the wind have led some European policymakers to make more strident calls for fiscal tightening than they would have dared to a year ago. Jean-Claude Trichet, European Central Bank president, last week called for tightening everywhere. “With hindsight, we see how unfortunate was the oversimplified message of fiscal stimulus given to all industrial economies under the motto: ‘stimulate’, ‘activate’, ‘spend’!” he wrote in the Financial Times.
In spite of concerns about a double dip, the vast majority of economists still predict continued recovery, even if they reckon the global economy will slow in the second half of 2010. Willem Buiter, chief economist at Citigroup, expects no huge shock from Europe. “It’s a pathetic recovery, but no more pathetic than expected before the sovereign debt crisis.”
Of course, Mr Trichet knows the future no better than Mr Bernanke, Mr Roubini or Mr Buiter. And apart from in the very short term, economic forecasts impart little valuable information. Using past forecast errors as a guide, the new UK Office for Budget Responsibility sees an 80 per cent chance that the British economy will grow between a negative 0.4 per cent and a positive 4.7 per cent in 2011, a range so wide it encompasses both boom and bust. Not much more helpful in divining the future is its calculation that there is a 50:50 chance that 2011 growth will either be below 1.2 per cent or above 3.9 per cent.
What is true for the UK also applies to the global economy, according to Michael Dicks of Barclays Wealth. Uncertainties over the US consumer, European monetary union survival and Asian inflation mean “macroeconomic forecast needs to be scenario-based currently, rather than the more usual ‘best-guess’ variety”.
So what could cause a global double dip? There are four big risks: a general slide in confidence, the unwinding of temporary boosts to growth, a sudden financial implosion, and a bad reaction to fiscal austerity.
First among the causes for concern is the effect of falling business and household confidence, the glue holding the global recovery together. The initial sign came in May when the global purchasing managers’ index for both manufacturing and services fell from the April peak as activity and new orders dropped.
The declines continued in June, fuelling fears that the rapid phase of the recovery could be short-lived. But July’s results for Europe – the main cause for concern in the spring – were much more encouraging. “This suggests that hardly any of the strong growth momentum of the second quarter of 2010 has been lost so far,” says Greg Fuzesi of JPMorgan, with gross domestic product “still appearing to be growing comfortably above a 2.5 per cent annualised pace at the start of the third quarter”.
Households have also shown few signs of a slide back into a fear of spending. Though in most recession-hit countries they have been saving much more than before the crisis, savings rates have stopped rising. At current rates, households will be able to reduce debt without detracting further from economic growth.
Temporary boosts end
A second concern is that the recovery has been driven far too much by temporary features of post-recession economies – such as companies rebuilding stock levels. Given the US reliance on changes in inventories for the majority of its growth in the past two quarters, Mr Bernanke for one is worried. In his semi-annual report he told Congress this month that “fiscal policy and inventory restocking will likely be providing less impetus to the recovery than they have in recent quarters”.
But even many traditionally gloomy forecasters agree there is still sufficient momentum in these economies to prevent a double dip resulting from an end to the inventory cycle alone.
Julian Jessop of Capital Economics says the “recoveries in the US and China appear to be slowing to a more sustainable pace rather than coming to a complete halt”. Incoming data on investment and consumer spending have been quite good, he says. “Growth was always likely to slow once these boosts began to fade. However, this slowdown need not develop into a double dip.” In China, where annual growth slowed to 10.3 per cent in the second quarter from 11.9 per cent in the first, the slowing helps “avoid overheating and assist in the transformation of our economic model”, reckons Sheng Laiyun of the National Bureau of Statistics.
A crisis returns
The third fear is that it is just a matter of time until another crisis strikes, in Europe’s sovereign debt market. As with the collapse of Lehman Brothers in 2008, a sudden fissure would wreck all analysis based on recent trends.
Recognising this risk, the IMF says recent market turbulence “has cast a cloud over the outlook” and if confidence and growth did implode in Europe, “the negative growth spill-overs to other countries and regions could be substantial because of financial and trade linkages”. In a test model of a similar disaster in Europe to the end of 2008, world growth would fall by 1.5 points in 2011, the IMF estimated, and the eurozone would suffer a serious double dip.
Luckily for the world, the signs this spring that implosion was imminent, and the faltering response of European governments in putting bail-out plans in place, never quite became a wider crisis. As Holger Schmieding at Bank of America Merrill Lynch says: “Greece is staging an impressive fiscal turnround; Spain has come through its July peak funding season with flying colours. The risk that Spain may fall noisily into the safety net soon has receded.”
The longer Europe muddles along without a new crisis, the more remote the risk of a sudden implosion becomes. According to Mr Buiter, “the disaster scenario of sovereign defaults is no longer on the table except as a tail risk”. Last week’s European bank stress tests might represent another small step away from the brink.
Fourth, if the financial crisis risk is very real, but diminishing, the risks to the global economy from fiscal austerity have without doubt risen. Government budgets have been tightened around the world since Europe’s crisis in May, providing an additional headwind at a time when there is a natural tendency for economies to slow.
Economists agree fiscal policy needs to tighten but disagree over the timing of tax increases and spending cuts and the speed of deficit reduction. Even the IMF is nervous. “Most advanced economies do not need to tighten before 2011 because tightening sooner could undermine the fledgling recovery, but they should not add further stimulus,” it says.
But the heat generated by the theoretical economic debate on fiscal austerity can exaggerate the economic significance of the budgetary policies actually planned. Neither extreme tightening nor extreme stimulus are on the table in any significantly sized advanced or emerging economy. On average, to cut deficits the advanced members of the Group of 20 leading economies plan spending and tax measures worth 1.25 per cent of national income in 2011, up from 1.1 per cent before Europe’s debt crisis. Emerging markets are tightening budgets by 0.85 per cent of national income, up from 0.65 per cent in April.
The extra tightening is not big enough to push the world back into recession if the IMF’s baseline forecasts of an expansion of 4.3 per cent globally and 2.4 per cent in advanced economies are reasonable.
. . .
So with each of the four big risks becoming less dangerous – or unlikely on its own to push things back over the edge – and with confidence holding up, the vast majority of economists simply expect something of a grind in the years ahead. The picture is one of slow underlying growth coupled with austerity in the public sector in advanced economies and much faster growth in the emerging world.
We can expect “an extended period of relatively sluggish industrial country growth over the next few years, capped by poor credit availability, fiscal consolidation and high private debts”, says Michael Saunders of Citi.
But equally, no one can be sure that the current, just about benign, trends will last and it is safe to sound the all clear. Lord Stern, former chief economist of the World Bank and academic at the London School of Economics, says the uncertainties spoken about by Mr Bernanke are all too real. “We do not know what may happen to consumer and investor confidence; it is absurd to pretend otherwise.”
THE AMERICAN EXPERIENCE
Even the toughest stress tests cannot ensure a revival of bank lending
Hopes were initially high that last Friday’s stress tests of 91 European banks would improve the resilience of the financial system and its ability to support the recovery. Earlier this month, Jean-Claude Trichet, European Central Bank president, spoke about the process “laying the foundations for sustainable growth, job creation and financial stability”. The authorities expect the results of the tests – failed by only seven institutions – to remove one reason at least to doubt the sustainability of the recovery.
Publication of the results was intended to alleviate the problem of “incomplete information”. Because providers of funds to banks cannot be certain of the quality of the assets on their balance sheets, they require a premium to lend. At times of financial turmoil, as in the 2008 credit crunch, the premium grows so large that the bank funding market dries up, inhibiting lending and slowing the economy.
To stop such a vicious circle taking hold, says Peter Westaway of Japanese investment bank Nomura, tests should be designed to “free up the information logjam”. He says: “A successful set of bank stress tests can set in train the virtuous circle whereby the banking system again facilitates the conditions for economic recovery in Europe.” With most analysts dismissing last week’s tests as too easy, that looks unlikely.
A deeper problem, however, is that an increase in the quantity and quality of information cannot guarantee looser credit conditions and faster growth. The more stringent US stress tests of spring 2009 – failed by 10 out of 19 banks and generally held to be successful – set a worrying precedent.
Ben Bernanke, Federal Reserve chairman, said in May that, “by setting reasonably ambitious capital targets, we hoped also to hasten the return to a better lending environment. Clearly that objective has not yet been realised, as bank lending continues to contract and terms and conditions remain tight.”
This suggests the European version is unlikely to be the catalyst to a faster recovery on the continent. “The stress tests alone will not encourage lending,” says Michael Hanson of Bank of America Merrill Lynch. “They will not jump-start the economy and they will not resolve fiscal crises.”