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Financial markets have rallied since July on the hope thatthe global economic and geopolitical outlook will not worsen, or, if it does,that central banks stand ready to backstopeconomies and markets with additional rounds of liquidity provision andquantitative easing. So, not only has good – or better-than-expected – economicnews boosted the markets, but even bad news has been good news, because itincreases the probability that central-banking firefighters like US FederalReserve Chairman Ben Bernanke and European Central Bank President Mario Draghiwill douse the markets with buckets of cash.
But markets that rise on bothgood and bad news are not stable markets. “Risk-off”episodes, in which investor sentiment sours,are likely to return if economic news worsens and confidence in policymakers’effectiveness drops.
In the eurozone, euphoria followed the ECB’s decision to providesupport with potentially unlimited purchases of distressed countries’ bonds.But the move is not a game changer; it only buys time for policymakers toimplement the tough measures needed to resolve the crisis. And the policychallenges are daunting: the eurozone’s recession is deepening as front-loaded fiscal consolidation and severecredit rationing continues. And, as eurozonebanks and public-debt markets become increasingly balkanized,establishing a banking union, a fiscal union, and an economic union whilepursuing macroeconomic policies that restore growth, external balance, andcompetitiveness will be extremely difficult.
Even the ECB’ssupport is not obvious. Monetary hawks – the Bundesbankand several other core central banks – who were worried about a new open-endedECB mandate pushed successfully for strict and effective conditionality for countries benefiting from thebond purchases. As a result, they can pull the plugon the program if its stringent criteria arenot met.
Moreover, Greece could exit the eurozone in 2013, before Spain and Italyare successfully ring-fenced; Spain – like Greece – is spiraling into depression, and may need a full-scale bailout bythe “troika” (the ECB, the EuropeanCommission, and the International Monetary Fund). Meanwhile, austerity fatiguein the eurozone periphery is increasingly clashing with bailout fatigue in thecore.
Small wonder, then,that Germany,politically unable to vote on more bailout resources, has outsourced that jobto the ECB, the only institution that can bypassdemocratically elected parliaments. But, again, liquidity provision alone –without policies to restore growth soon – would merely delay, not prevent, thebreakup of the monetary union, ultimately taking down the economic/trade unionand leading to the destruction of the single market.
In the United States,the latest economic data – including a weak labor market – confirm that growthis anemic, with output in the second half of2012 unlikely to be significantly stronger than the 1.6% annual gain recordedin January-June. And, given America’spolitical polarization and policy gridlock,we can expect more fights on the budget and the debt ceiling, another ratingdowngrade, and no agreement on a path toward medium-term fiscal consolidation and sustainability – regardless ofwhether President Barack Obama is reelected in November. On the contrary, weshould expect agreement only on the path of least political resistance:avoidance of tough fiscal choices until the bond vigilanteseventually wake up, spike long rates, andforce fiscal adjustment on the political system.
In China, a hard economic landinglooks increasingly likely as the investment bubble deflatesand net exports shrink. Meanwhile, the reforms necessary to reduce savings andincrease private consumption are being delayed. As in Europe and the US,the worst will be avoided in 2012 only by kickingthe can down the road with more monetary, fiscal, and credit stimulus.
Buta hard landing becomes more likely in 2013, as the stimulus fades,non-performing loans rise, the investment bustaccelerates, and the problem of rolling over the debts of provincialgovernments and their special investment vehicles can no longer be paperedover. And, given a new leadership’s caution as it establishes its power,reforms will occur at a snail’s pace, makingsocial and political unrest more likely.
Meanwhile, Brazil, India,Russia,and other emerging economies are playing the same game. Many have not adjustedas advanced economies’ weakness reduces the room for export-led growth; andmany delayed structural reforms needed to boost private-sector development andproductivity growth, while embracing a model of state capitalism that will soonreveal its limits. So the recent slowdown of growth in emerging markets is notjust cyclical, owing to weak growth oroutright recession in advanced economies; it is also structural.
Similar dithering is apparent at the geopolitical level aswell. The major global powers are still trying negotiations and sanctions toinduce Iranto abandon its efforts to develop nuclear weapons. But Iran is playing for time and hopingto reach a zone of immunity. By 2013, an Israel that –rightly or wrongly – perceives Iran’snuclear program to be an existential threat,and/or the US, which hasrejected containment of a nuclear Iran, may decide to strike, leadingto a war and a massive spike in oil prices.
Ineffectivegovernments with weak leadership are at the root of the problem. Indemocracies, repeated elections lead to short-term policy choices. In autocracies like Chinaand Russia,leaders resist the radical reforms that would reduce the power of entrenched lobbies and interests, thereby fuelingsocial unrest as resentment against corruption and rent-seeking boils over into protest.
But, as everyone kicks the can down the road, the can is gettingheavier and, in the major emerging markets and advanced economies alike, isapproaching a brick wall. Policymakers caneither crash into that wall, or they can show the leadership and vision neededto dismantle it safely.
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