Dark clouds over US and Europe

The world is adrift and it will continue to drift in the coming months or even years

Within the past couple of weeks, the world has changed. From a world so used to the United States playing a key leadership role in shaping global economic affairs to one going through a multi-speed recovery, with the emerging nations providing the source of growth and opportunity. This is a very rapid change indeed in historical time. What happened? First, the convergence of a series of events in Europe (contagion of the open ended debt crisis jolted France and spread to Italy and Spain, forcing the European Central Bank or ECB to buy their bonds) and in the US (last minute lifting of the debt ceiling exposed the dysfunctional US political system, and the Standard & Poor's downgrade of the US credit rating) have led to a loss of confidence by markets across the Atlantic in the effectiveness of the political leadership in resolving key problems confronting the developed world. Second, these events combined with the coming together of poor economic outcomes involving the fragilities of recovery have pushed the world into what the president of the World Bank called “a new danger zone,” with no fresh solutions in sight. Growth in leading world economies slowed for the fourth consecutive quarter, gaining just 0.2% in 2Q'11 (0.3% in 1Q'11) according to the Organisation for Economic Cooperation and Development. The slowdown was marked in the euro area. Germany slackened to 0.3% in 2Q'11 (1.3% in 1Q'1) and France stalled at zero after 0.9% in 1Q'11. The US picked up to 0.3% (0.1% in 1Q'11), while Japan contracted 0.3% in 2Q'11 (-0.9% in 1Q'11).

The US slides

Recent data disclosures and revisions showed that the 2008 recession was deeper than first thought, and the subsequent recovery flatter. The outcome: Gross domestic product (GDP) has yet to regain its pre-recession peak. Worse, the feeble recovery appears to be petering out. Over the past year, output has grown a mere 1.6%, well below what most economists consider to be the US's underlying growth rate, a pace that has been in the past almost always followed by a recession. Over the past six-months, the US has managed to eke out an annualised growth of only 0.8%. This was completely unexpected. For months, the Federal Reserve had dismissed the economy's poor performance as a transitory reaction to Japan's natural disaster and oil price increases driven by turmoil in the Middle East. They now admit much stiffer headwinds are restraining the recovery, enough to keep growth painfully slow. Recent sentiment surveys and business activity indicators are consistent with expectations of a marked slowdown in US growth. Fiscal austerity will now prove to be a drag on growth for years. Housing isn't coming back quickly. Households are still trying to rid themselves of debt in the face of eroding wealth. Old relationships that used to drive recoveries seem unlikely to have the pull they used to have. Historically, consumers' confidence had tended to rebound after unemployment peaked. This time, it didn't happen. Unemployment peaked in Oct 2009 at 10.1% but confidence kept on sinking. The University of Michigan's index fell in early August to its lowest level since 1980. Thrown in is concern about the impact of the wild stock market on consumer spending. Indeed, equity volatility is having a negative impact on consumer psychology at a time of already weakening spending.

Three main reasons underlie why the Fed made the recent commitment to keep short-term interest rates near zero through mid-2013: (i) cuts all round to US growth forecasts for 2H11 and 2012; (ii) drop in oil and commodity prices plus lower expectations on the pace of recovery led to growing confidence inflation will stabilise; and (iii) rise in downside risks to growth in the face of deep concern about Europe's ability to resolve its sovereign debt problems. The Fed's intention is at least to keep financial conditions easy for the next 18 months. Also, it helps to ensure the slowly growing economy would not lapse into recession, even though it's already too close to the line; any shock could knock it into negative territory.

The critical key

Productivity in the US has been weakening. In 2Q11, non-farm business labour productivity fell 0.3%, the second straight quarterly drop. It rose only 0.8% from 2Q10. Over the past year, hourly wages have risen faster than productivity. This keeps the labour market sluggish and threatens potential recovery. It also means an erosion of living standards over the long haul. But, these numbers overstate productivity growth because of four factors: (a) upward bias in the data - eg the US spends the most on health care per capita in the world, yet without superior outcomes; (b) government spending on military and domestic security have risen sharply, yet they don't deliver useful goods and services that raise living standards; (c) labour force participation has fallen for years. Taking lower-paying jobs out of the mix raises productivity but does not create higher value-added jobs; and (d) off-shoring by US companies to China for example, but they don't enhance American productivity. Overall, they just overstate productivity. So, the US, like Europe, needs to actually raise productivity at the ground level if they are to really grow and reduce debt over the long-term. The next wave of innovation will probably rely on the world's current pool of scientific leaders - most of whom is still US-based.

US deficit is too large

The US budget deficit is now 9.1% of GDP. That's high by any standard. According to the impartial US Congressional Budget Office (CBO), even after returning to full employment, the deficit will remain so large its debt to GDP will rise to 190% by 2035! What happened? This deficit was 3.2% in 2008; rose to 8.9% in 2010, pushing the debt/GDP ratio from 40% to 62% in 2010. This “5.7% of GDP” rise in the deficit came about because of (i) a fall of “2.6% of GDP” in revenue (from 17.5% to 14.9% of GDP), and (ii) a rise of “3.1% of GDP” in spending (from 20.7% to 23.8% of GDP). According to the CBO, less than one-half of the rise in deficit was caused by the downturn of 2008-2010. Because of this cyclical decline, revenue collections were lower and outlays, higher (due to higher unemployment benefits and transfers to help those adversely affected). They in turn raise total demand and thus, help to stabilise the economy. These are called “automatic stabilisers.” In addition, the budget deficit also worsened because, even at full-employment, revenues would still fall and spending rise. So, the great recession did its damage.

Looking ahead, the Obama administration's budget proposals would add (according to CBO) US$3.8 trillion to the national debt between 2010 and 2020. This would raise the debt/GDP ratio to 90% reflecting limited higher spending, weaker revenues from middle and lower income taxpayers, offset in part by higher taxes on the rich. Even so, these are based on conservative assumptions regarding military spending, no new programmes and lower discretionary spending in “real” terms. No doubt, actual fiscal consolidation would imply much more spending cuts and higher revenues. According to Harvard's Prof M. Feldstein, increased revenues can only come about, without raising marginal tax rates, through what he calls cuts in “tax expenditures,” that is, reforming tax deductions (eg cutting farm subsidies, eliminating deductions for ethanol production, etc). Such a “balanced approach” to resolve the growing fiscal deficit will be hard to come-by given the political paralysis in Washington. Worse, the poisonous politics of the past two months have created a new sort of uncertainty. The tea partiers' refusal to compromise can, at worse, kill off the recovery. The only institution with power to avert danger is the Fed. But printing money can be counter-productive. Fiscal measures are the preferred way to go at this time. Even so, the US fiscal problems will mount beyond 2020 because of the rising cost of social security and medicare benefits. No doubt, fundamental reform is still needed for the long-term health of the US economy.

Eurozone stumbles

Looming large as a risk factor is Europe's long running sovereign debt saga, which is pummelling US and European financial markets and business confidence. So far, Europe's woes and the market turmoil it stirred are worrisome. The S&P 500 fell close to 5% last week extending losses of 15.4% over the previous three weeks, its worse streak of that length in 2 years, and down 17.6% from its 2011 high. The situation in Europe has been dictating much of the global markets' recent movements. The eurozone's dominant service sector was effectively stagnant in August after two years of growth, while manufacturing activity, which drove much of the recovery in the bloc shrank for the first time since September 2009. Latest indicators add to signs the slowdown is spreading beyond the periphery and taking root in its core members, including Germany. The Flash Markit Eurozone Services Purchasing Managers' Index (PMI) fell to 51.5 in August (51.6 in July), its lowest level since September 2009. The PMI, which measures activity ranging from restaurants to banks, is still above “50”, the mark dividing growth from contraction. However, PMI for manufacturing slid to 49.7 the first sub-50 reading since September 2009. Both services and manufacturing are struggling.

Going forward, poor data show neither Germany nor France (together making- up one-half the bloc's GDP) is going to be the locomotive. Indeed, the risks of “pushing” the region over the edge are significant. Germany faces an obvious slowdown and a possible lengthy stagnation.

European financial markets just came off a turbulent two weeks, with investors fearing the debt crisis could spread further if Europe's policy makers fail to implement institutional change and new structural supports for the currency bloc's finances. In the interim, the ECB has been picking up Italian and Spanish bonds to keep borrowing costs from soaring. The action has worked so far, but the ECB is only buying time and can't support markets indefinitely. So far, the rescue bill included 365 billion euros in official loans to Greece, Portugal and Ireland; the creation of a 440 billion euros rescue fund; and 96 billion euros in bond buying by the ECB. Despite this, market volatility and uncertainty prevail. Europe is being forced into an end-game with three possible outcomes: (a) disorderly break-up - possible if the peripherals fail in their fiscal reform or can no longer withstand stagnation arising from austerity; (b) greater fiscal union in return for strict national fiscal discipline; and (c) creation of a more compact and more economically coherent eurozone against contagion; this implies some weaker members will take “sabbatical” from the euro. My own sense is that the end-game will be neither simple nor orderly. Politicians will likely opt for a weak variant of fiscal union. After more pain, a smaller and more robust euro could emerge and avoid the euro's demise. Nobel Laureate Paul Krugman gives a “50% chance Greece would leave and a 10% odds of Italy following.”

Leaderless world

The crisis we now face is one of confidence. Starting with the markets across both sides of the Atlantic and in Japan. This lack of confidence reflected an accumulation of discouraging news, including feeble economic data in the US and Europe, and signs European banks are not so stable. The global rout seems to have its roots in free-floating anxiety about US dysfunctional politics and about euroland's economic and financial stability. Confidence is indeed shaky, already spreading to businesses and consumers, raising risks any fresh shock could be enough to push the US and European economies into recession. Business optimism, at best, is “softish.” Consumers are still deleveraging. Unfortunately, this general lack of confidence in global economic prospects could become a self-fulfilling prophecy. In the end, it's all about politics. The French philosopher Blaise Pascal contends politics have incentives that economics cannot understand. To act, politicians need consensus, which often does not emerge until the costs of inaction become highly visible. By then, it is often too late to avoid a much worse outcome. So, the demand for global leadership has never been greater. But, none is forthcoming not for the US, not from Europe; certainly not from Germany and France, or Britain.

The world is adrift. Unfortunately, it will continue to drift in the coming months, even years. Voters on both sides of the Atlantic need to demand more from their leaders than “continued austerity on autopilot.” After all, in politics, leadership is the art of making the impossible possible.