Sunday, October 26, 2014
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Decision Time for the Global Economy

MILAN – In the dog days of summer, Milan is quieter than many European cities. The locals are away, and, unlike Paris or Rome, tourists do not take their place. Here and elsewhere, people, businesses, governments, and markets take a break, decompress, and reflect. Europe’s economic problems will still be here, waiting for us, in September.

And when summer ends, uncertainty about key issues will be the order of the day – and not only in Europe. Largely unanticipated protest movements in Turkey and Brazil have raised questions about the economic and social sustainability of emerging-market growth. The fires in Bangladeshi garment factories have raised new questions about the governance of global supply chains.

In the United States, the Federal Reserve hinted at “tapering” its quantitative-easing policy later in the year, and a kind of global carry trade based on monetary conditions in advanced countries started to unwind as a result, causing credit tightening and market turbulence in emerging economies. This is probably only a preview of the complexity of the exit from the post-crisis assisted-growth model that has prevailed in the US, Europe, and now Japan. A possible political impasse in the US in September over the budget and debt ceiling complicates the outlook further.

And yet much of the current uncertainty is set to dissipate. In the coming months, highly consequential policy decisions (or their absence) in systemically critical parts of the global economy will be revealed, with significant effects on growth rates, asset prices, and overall confidence.

For starters, China’s new leadership has moved away from outsize fiscal and monetary stimulus and accepted an economic slowdown, betting on structural change, systemic reform, and sustainable longer-term growth. The key signals will come from the Chinese Communist Party’s plenary meeting in the early fall.

China’s reforms will either support the economic shift, boosting sentiment and lifting growth forecasts, or they will fall short and disappoint, with attention most likely to be focused on the size and nature of state intervention in markets. Either way, with the future of the global economy’s principal growth engine at stake, the effects will be felt worldwide.

In the US, economic deleveraging has proceeded significantly further than it has in Europe. The US is adjusting structurally and generating real (inflation-adjusted) GDP growth (though well below its potential annual rate of 3-3.5%). The tradable sector is expanding and is not dependent on leverage to generate aggregate demand.

One can think of the US economy as an 8-cylinder engine running on five, owing to residual deleveraging, fiscal consolidation and drag, public-sector investment shortfalls, and questions about the financial health and security of middle-income households (the backbone of domestic aggregate demand). Part-time employment is spreading and may become the labor market’s new normal.

Then there is the question of the Fed’s assisted-growth model. Is the US economy ready to grow without abnormal policy support? It seems clear that tapering the Fed’s monthly purchases of long-term securities later this year would cause a realignment of asset values in financial markets. How this spills over into the real economy is yet another source of uncertainty.

But, despite some transitional market turbulence, the overall effect will likely be positive. The beneficial effect on the risk-return options available to investors/savers (including pension funds) will outweigh the higher cost of debt; indeed, an important subset of growth engines in the tradable sector is not dependent on low-cost debt.

The same cannot be said of Europe, where Germany’s general election in September is viewed as a key barometer of continuing commitment to the euro. The European Central Bank’s “outright monetary transactions” program – though conditional, limited to short-term government debt, and so far unused – appears to have stabilized eurozone sovereign-debt markets, albeit in a low- or zero-growth environment. But the OMT program is dependent on German support. The question is how long this can last, given southern Europe’s growth and employment challenges (and an apparent lack of understanding among policymakers and the public that there are no short-term solutions).

In Italy, the debate centers on taxes in general, and the rather miniscule property tax in particular. The income tax (and thus the tax on employment) is high. But the country is relatively wealthy, especially in terms of property assets on household balance sheets. So higher taxes on property and lower taxes on income would contribute to the creation of a more dynamic, competitive economy.

But that is far from the current focus of public debate. The key liberalizing reforms that would enhance the economy’s flexibility and pace of adjustment are simply not on the agenda (owing to an underlying lack of trust among voters).

This is important because the private sector in Italy (and in Spain) cannot match the structural flexibility found in the US (and in Germany since its reforms in 2003-2006). Think now of an 8-cylinder engine running not on five cylinders, but on two or three at best. (Admittedly, the Spanish labor market reforms enacted earlier this year may start to lift employment and improve competitiveness and growth on the economy’s tradable side, which is constrained largely by low productivity, not weak demand.)

But the default option in the context of political gridlock – a halting, slow-growth strategy, focused excessively on fiscal austerity and featuring high unemployment (especially for the young) – is unlikely to remain workable for long. At some point, the political agenda will either shift toward real reform, or sentiment will shift substantially against the euro.

Fortunately, this uncomfortable uncertainty will not last much longer – in Europe or elsewhere. China’s leaders will make their choices, as will German voters. The Fed will clarify the direction of US monetary policy. Markets will adjust and settle down. Distortions will begin to unwind.

Without dismissing the downside risks, I remain cautiously optimistic about the global economy’s prospects. With greater clarity in terms of Chinese and US policy, both economies should gain momentum. That will give developing countries (many of which face difficult domestic policy choices) a tailwind, while making the substantial challenges in Europe and Japan easier to address.

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  1. CommentedPaul A. Myers

    My takeaway is that as world growth starts to get going, the US, Germany, China, and some other countries will grow faster, that is "win," because of better structural flexibility while others will lag behind due to an inability to address the political choices necessary to support a higher rate of growth.

    My expectation would be that in two or three years time, we will see articles about winners and losers in the next growth phase of the world economy.

  2. CommentedNitin Agrawal


    The fires in Bangladeshi garment factories have raised new questions about the governance of global supply chains?!

    Are you kidding me? Who gave this guy a Nobel price?

  3. CommentedLuca Gemmi

    The reason why italian government wants with urgency to delete this property tax (called Imu) is merely political and electoral. Imu has been assumed as symbol of austerity and european technocratic power by the people, and some political party accommodates this view to gain vote and consensus. We suffer from the lack of a serious debate on this tax.

  4. Portrait of Pingfan Hong

    CommentedPingfan Hong

    The list of the global issues mentioned in the article would be more complete if the challenges facing India and Japan are added.

    The currency crisis (defined as depreciation of a currency by 20% or more in a short period of time) in India, compounnding by its twin deficit, if not contained, could trigger a new round of economic crisis in emerging economies.

    In Japan, the new stimulus policies are running out of steam, while the public debt continues to pile up.

  5. CommentedFrank Hollenbeck

    China’s reforms will either support the economic shift, boosting sentiment and lifting growth forecasts, or they will fall short and disappoint, WOW what insight! it may or may not!

  6. CommentedFrank Hollenbeck

    Someone need to say something about these "no content articles". I assume these "Nobel" economists get paid by the word and not the content of their articles. This one is no different. What does the author tell us? Nothing! absolutely nothing,that an average intelligent person could have read anywhere else. China and Europe may have troubles ahead. WOW, talk about insightful!

  7. CommentedTamara van Halm

    I do hope Michael will print this article, frame it, hang it on a wall and read it again after a couple of years and of course....reflect.

    Indeed aggregate demand is a key word, but his 'sight' remains limited to old economics. Holding on to the idea that we need to compete, clinging on to governments and nation states for solutions. As economies continue to evolve into the sphere of intellectual property and digital creation and production, the concept of nation states will be transformed not from competing to collaborating.

      CommentedFrank Hollenbeck

      Aggregate demand is NOT the answer. Aggregate demand is the poison eating at the heart of economic theory as Ricardo said, " men err in their production, there is no deficiency of demand". What nonsense!

      CommentedFrank Hollenbeck

      Aggregate demand is NOT the answer. Aggregate demand is the poison eating at the heart of economic theory as Ricardo said, " men err in their production, there is no deficiency of demand". What nonsense!

      CommentedFrank Hollenbeck

      Aggregate demand is NOT the answer. Aggregate demand is the poison eating at the heart of economic theory as Ricardo said, " men err in their production, there is no deficiency of demand". What nonsense!

      CommentedFrank Hollenbeck

      Aggregate demand is NOT the answer. Aggregate demand is the poison eating at the heart of economic theory as Ricardo said, " men err in their production, there is no deficiency of demand". What nonsense!

  8. CommentedZsolt Hermann

    I think the global economy, the global world first of all have to do a single task: to understand and start implementing what global means.
    Global means integral, integral means interconnected and fully interdependent.
    Today even if people agree with all the above they seem to think it relates to everybody else but themselves, and they continue thinking and acting as we lived in the previous fragmented, polarized, broken up world where individuals and nations could seemingly do whatever they wanted, calculating, planning and acting by their own accord.
    In a global, integral system when somebody moves a finger it affects the whole system in a fundamental manner.
    Every thought, or action that happens without first considering the well-being of the whole system is by default harmful and will fail, and the negative effect will go back to the initiator as a boomerang with multiple force.
    Thus the present "running around as headless chicken" attitude is depleting remaining, already depleted resources, undermining the leftover foundations before the inevitable restart.
    Leaders and the public alike would need to pause, stop the further destruction and start examining and understanding the system we evolved into and how we could adapt to it in a way that we could mutually build something robust and sustainable.
    We simply need to wake up, we are not in a Hollywood movie with guaranteed happy ending, but at least this ending is still in our own hands, provided we understand where we are and how we need to proceed.

  9. CommentedJohn Sullivan

    Yawn. Must have been a slow day.

    As far as one might think from this article is that economies are all now centrally planned. Just what are the global governments going to do?

    Of course, the statistically measured results of the coming interventionism will be measured against some standard in the past, based on the interventions that took place then. Success can be claimed if the data is interpreted as such.

    Unfortunately, what the results of interventionism can't be measured against is the state of affairs that would exist absent the interventions, the manipulations, the cronyism, and so forth., past, present and future. 5% unemployment will be heralded as a victory when no one can cite an economy with full employment to compare it with.

    I am the best looking person I see when I look in the mirror. And so are you.

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