Monday, November 24, 2014

The World Economy’s Shifting Challenges

NEW YORK – As 2013 comes to a close, efforts to revive growth in the world’s most influential economies – with the exception of the eurozone – are having a beneficial effect worldwide. All of the looming problems for the global economy are political in character.

After 25 years of stagnation, Japan is attempting to reinvigorate its economy by engaging in quantitative easing on an unprecedented scale. It is a risky experiment: faster growth could drive up interest rates, making debt-servicing costs unsustainable. But Prime Minister Shinzo Abe would rather take that risk than condemn Japan to a slow death. And, judging from the public’s enthusiastic support, so would ordinary Japanese.

By contrast, the European Union is heading toward the type of long-lasting stagnation from which Japan is desperate to escape. The stakes are high: Nation-states can survive a lost decade or more; but the EU, an incomplete association of nation-states, could easily be destroyed by it.

The euro’s design – which was modeled on the Deutsche Mark – has a fatal flaw. Creating a common central bank without a common treasury means that government debts are denominated in a currency that no single member country controls, making them subject to the risk of default. As a consequence of the crash of 2008, several member countries became over indebted, and risk premia made the eurozone’s division into creditor and debtor countries permanent.

This defect could have been corrected by replacing individual countries’ bonds with Eurobonds. Unfortunately, German Chancellor Angela Merkel, reflecting the radical change that Germans’ attitudes toward European integration have undergone, ruled that out. Prior to reunification, Germany was the main motor of integration; now, weighed down by reunification’s costs, German taxpayers are determined to avoid becoming European debtors’ deep pocket.

After the crash of 2008, Merkel insisted that each country should look after its own financial institutions and government debts should be paid in full. Without realizing it, Germany is repeating the tragic error of the French after World War I. Prime Minister Aristide Briand’s insistence on reparations led to the rise of Hitler; Angela Merkel’s policies are giving rise to extremist movements in the rest of Europe.

The current arrangements governing the euro are here to stay, because Germany will always do the bare minimum to preserve the common currency – and because the markets and the European authorities would punish any other country that challenged these arrangements. Nonetheless, the acute phase of the financial crisis is now over. The European financial authorities have tacitly recognized that austerity is counterproductive and have stopped imposing additional fiscal constraints. This has given the debtor countries some breathing room, and, even in the absence of any growth prospects, financial markets have stabilized.

Future crises will be political in origin. Indeed, this is already apparent, because the EU has become so inward-looking that it cannot adequately respond to external threats, be they in Syria or Ukraine. But the outlook is far from hopeless; the revival of a threat from Russia may reverse the prevailing trend toward European disintegration.

As a result, the crisis has transformed the EU from the “fantastic object” that inspired enthusiasm into something radically different. What was meant to be a voluntary association of equal states that sacrificed part of their sovereignty for the common good – the embodiment of the principles of an open society – has now been transformed by the euro crisis into a relationship between creditor and debtor countries that is neither voluntary nor equal. Indeed, the euro could destroy the EU altogether.

In contrast to Europe, the United States is emerging as the developed world’s strongest economy. Shale energy has given the US an important competitive advantage in manufacturing in general and in petrochemicals in particular. The banking and household sectors have made some progress in deleveraging. Quantitative easing has boosted asset values. And the housing market has improved, with construction lowering unemployment. The fiscal drag exerted by sequestration is also about to expire.

More surprising, the polarization of American politics shows signs of reversing. The two-party system worked reasonably well for two centuries, because both parties had to compete for the middle ground in general elections. Then the Republican Party was captured by a coalition of religious and market fundamentalists, later reinforced by neo-conservatives, that moved it to a far-right extreme. The Democrats tried to catch up in order to capture the middle ground, and both parties colluded in gerrymandering Congressional districts. As a consequence, activist-dominated party primaries took precedence over general elections.

That completed the polarization of American politics. Eventually, the Republican Party’s Tea Party wing overplayed its hand. After the recent debacle of the government shutdown, what remains of the Republican establishment has begun fighting back, and this should lead to a revival of the two-party system.

The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam.

That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing.

There are some eerie resemblances with the financial conditions that prevailed in the US in the years preceding the crash of 2008. But there is a significant difference, too. In the US, financial markets tend to dominate politics; in China, the state owns the banks and the bulk of the economy, and the Communist Party controls the state-owned enterprises.

Aware of the dangers, the People’s Bank of China took steps starting in 2012 to curb the growth of debt; but when the slowdown started to cause real distress in the economy, the Party asserted its supremacy. In July 2013, the leadership ordered the steel industry to restart the furnaces and the PBOC to ease credit. The economy turned around on a dime. In November, the Third Plenum of the 18th Central Committee announced far-reaching reforms. These developments are largely responsible for the recent improvement in the global outlook.

The Chinese leadership was right to give precedence to economic growth over structural reforms, because structural reforms, when combined with fiscal austerity, push economies into a deflationary tailspin. But there is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.

How and when this contradiction will be resolved will have profound consequences for China and the world. A successful transition in China will most likely entail political as well as economic reforms, while failure would undermine still-widespread trust in the country’s political leadership, resulting in repression at home and military confrontation abroad.

The other great unresolved problem is the absence of proper global governance. The lack of agreement among the United Nations Security Council’s five permanent members is exacerbating humanitarian catastrophes in countries like Syria – not to mention allowing global warming to proceed largely unhindered. But, in contrast to the Chinese conundrum, which will come to a head in the next few years, the absence of global governance may continue indefinitely.

Read more from "2013: Reversing Gears" here, or on Kindle and iBooks.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (16)

    Please login or register to post a comment

    1. CommentedCarol Maczinsky

      Democratic nations are responsible for themselves and for what they signed up to. It is nonsensical to argue that "Angela Merkel’s policies are giving rise to extremist movements", in fact Merkel's policy is to bankroll these nations against the spirit of Maastricht, I don't agree with Soros' gloomy Euro outlook and I don't believe in a Japanese recovery. Eurobonds are suicidal with partners that don't keep discipline.

    2. CommentedJoshua Ioji Konov

      Can the Global Investment and Productivity Steer Growth

      In the ways the Global economy works, the expectations for the investment and productivity as fundamental economic agents for growth vary in different countries:
      Whereas in European Union relies generally on such to prompt and maintain economic growth, in the United States the market interference was much bigger through Quantitative Easing and Stimulus Packages, it when farther in Japan, and even farther in China whereas the market interference is basically running the whole economy through targeted stimulus packages, establishing tax free regions, using the state owned businesses to raise salaries. Income and internal consumption. Until, in the US whereas the politics interfere with the government policies: in Japan and China such policies are roaming free. The “as it comes: as it goes”’s Economics of 21st Century has arrived and whoever understood it right gas started using it indiscriminately from political views and ideas. The winners clearly are these the last one. To rely on the Investment and Productivity to stear the markets into growth and possible employment has become a dream for a few economists in the West that excuses them from the failure to oversee and overcome the 2007-9 Recession that almost crushed the Global economy. What the Chinese took off from the Recession was the practical ideas that relying only on the National and International Investment and the rising Productivity, which relies on the simple ideas of lower taxation and weak regulations to prompt economic growth causa finita est, therefor, they started targeted market interference by watching the Inflation and possible Bubbles, so the system has worked much better than everywhere else. The Social and Infrastructural Policies have been positive economic tools, too. What the Chinese discovered, followed by Japan, was that by using the “invisible hand” was much more effective than waiting for some investors to decide to boost their economies.

      What the EU and now the US are doing is digging themselves into a perpetual circle of unemployment and underemployment that consequently will push them to start using so called unorthodox economic agent and tools to prompt long term economic growth. The Investment and Productivity always follow the winners, and guest who will be the winners if a long term economic policies are not undertaken.
      Joshua Ioji Konov 2014

    3. CommentedEmilio Perez

      The International Pipe dream is to predict China's demise. Well, stop dreaming as this will not be in the near future. Think about it, just a couple of years ago the nation with the highest population decided to create a middle class. This means investment in infrastructure, increasing the quality and rates of employment, rent as means of real estate value, etc. Do you think that this can be done overnight? And to make matters worse for the rest of the World, they control their own currency rate. That is the key, the only way that you can really slow their growth is by pushing them (like in the opium wars of 1864) to have their currency valued in the International market.

        CommentedAndrew Purdy

        China isn't going to have a demise, but eventually supply constraints, particularly for energy, will have a major drag on their growth.

    4. CommentedBoon Tee

      Beijing is well aware of the domestic debt growth (albeit not exponentially as exaggerated) which is under control. China has been more concerned with corruption and environmental deterioration than pure economic growth that can be sustained at 7 to 8%. (btt1943)

    5. CommentedPaul A. Myers

      For the euro to stay, there must be adaptations in the Southern countries in the near and intermediate term that are not at this time visible. If this situation is still going sidewise after the May elections, one would presume that politics will drive some very new thinking.

        CommentedEmilio Perez

        Paul, I think that the problem in the Eurozone is not with the lower countries but with Germany. First of all, the currency is way over valued in order for Germany to buy raw materials at a great price and later be able to sell their products at competitive international profits. Also, Germany, for alterior reasons, is not allowing the lower countries to devalue their services in order to attract investment. This is a huge mistake. The economic problems in the eurozone are easily solved but the problem is that Germany would be the one to suffer and since they are the ones "running the show", they will never allow it. This is Germany's moment to show leadership but do not forget that the eurozone is an economic entity run by political Islands.

    6. CommentedArmen Papazian

      The looming problem of the global economy is debt-based money mechanics, which is the ultimate challenge facing all these countries and the Euro. Interesting that there is no reference to space either. This is the Solar century, and if one is to address the shifting challenges of the global economy, one must address the global economy not as a political map, but as a floating planet in cosmos.

    7. CommentedProcyon Mukherjee

      Policies in the EU is centered around politics of parties, not around self-interest of countries or governments if we take the EU parliament as an example. There are currently 7 political parties in the EU Parliament– EPP, S&D, ALDE/ALDE, Greens/EFA, ECR, GUE/NGL, and EFD. The largest party has 265 members and the smallest has 32 members. Each party is made up of MEPs from various different EU countries and the MEPs are grouped in Parliament according to their political inclinations and not their nationality. Hence, there is a high possibility of a situation where two German MEPs are part of two parties that diverged completely on the political spectrum. Given this arrangement I find it odd that we could actually pin-point Germany and its Chancellor for orchestrating the policy instruments, like preserving the Euro, an example cited by Soros.

      Politics of parties as opposed to politics of countries is a significantly different ball game in the EU.

        CommentedAndrew Purdy

        The EU Parliament has almost no power. The power lies with the Commission and the Council.

        CommentedMK Anon

        Procyon: national vote are stil very important in the parliament, For example, the vote to give the mandate to the commission to negociate the TTIP was very much nationaly driven, with most germans being for it, while most french were against it, regardless of their parties's position on the matter

    8. CommentedFabio Souza

      "In the US, financial markets tend to dominate politics, in China, the state owns the banks and the bulk of the economy". In both cases money talks first in politics, let's not be naive! State Owned Entrepreses, Private Capital or Mixed are always leeding politics everywhere. With more or less corruption!

    9. CommentedFabio Souza

      "The fiscal drag exerted by sequestration is also about to expire." Something to look at, it's a political issue that may hurt Democrats.

    10. CommentedFabio Souza

      It's about housing worldwide It's been an increase, but with possible bubble in China (it's not new...).

    11. Commentedhari naidu

      Soros has always been critical of Merkel and her management of the financial crisis - Greece in particular - and one forgets she is surrounded by policy advisers who are lawyers (Weidmann moved to Bundesbank).

      Finally it's clear that Euro(ECB) is not the policy constraint - in spite of EMU - but EU governance both at Brussels and in member states. North/South divide reflects it infinitely.

      Merkel is already fighting EU Commission on Banking Union and wants to manage it in Council - 28 sovereign states. One has no idea how ECB will end up managing the effort while EU politics continues to create one policy constraint after another. Perhaps May election result to EP will scare Merkel and gang.

      In case of mainland China, I suspect consolidation of state power will be Li's foremost goal. However central governance of such a vast modernizing country is going to challenge the CCP. Especially now when the principle object of policy is to urbanize the countryside. +40M Chinese are still in rural economy and it's their plight which will test Li and CCP.

    12. CommentedZsolt Hermann

      It is an interesting article containing many sparks, aspects, some contradicting, some visionary, but overall despite the title talking about a "shift" the article still falls short of suggesting a real shift, staying within the boundaries and human-made rules of the present framework.
      Maybe two points to pick:
      1. Mr. Soros says: "..As a result, the crisis has transformed the EU from the “fantastic object” that inspired enthusiasm into something radically different. What was meant to be a voluntary association of equal states that sacrificed part of their sovereignty for the common good – the embodiment of the principles of an open society – has now been transformed by the euro crisis into a relationship between creditor and debtor countries that is neither voluntary nor equal. Indeed, the euro could destroy the EU altogether...."
      There is no such thing as partial, "part of" in a natural system. There cannot be partial unity. If nations decide to unite such union has to be complete. In a natural, integral system everything is absolute, almost black and white, something is either united or is separate. The European Union is not falling apart because of the Euro, it is falling apart because they did not have the courage to integrate fully, going the whole distance, instead they tried to build a roof for a house that had no foundations either walls. No they are retreating and trying to build walls, but still without foundations. We try to reinvent laws that are absolute, we think we can appeal against nature, or that there are short cuts, tricks, but there aren't any.
      Tricks, shortcuts, appeals are only in this imaginary human bubble we created and which is now falling apart.
      2. Mr Soros says "...The other great unresolved problem is the absence of proper global governance..."
      This is true and this is the foundation we all need. But again only if we understand that it means a comprehensive, no-compromise, supra-national governance for the sake of the whole system, above any individual or national self-calculations.
      In today's global, integral world our usual ruthless, exploitative competitive behavior, attitude has become destructive.
      We entered the age of mutual responsibility, mutually complementing cooperation.
      The shift we are facing has to reflect that.