Tuesday, October 21, 2014
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Stagnant and Paralyzed

MILAN – The recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and policy responses – or, rather, the lack of policy responses.

First, the fundamentals. Economic growth rates in the United States and Europe are low – and well below even recent expectations. Slow growth has hit equity valuations hard, and both economies are at risk of a major downturn.

A slowdown in one is bound to produce a slowdown in the other – and in the major emerging economies, which, until now, could sustain high growth in the face of sluggish performance in the advanced economies. Emerging countries’ resilience will not extend to double-dip recessions in America and Europe: they cannot offset sharp falls in advanced-country demand by themselves, notwithstanding their healthy public-sector balance sheets.

America’s domestic-demand shortfall reflects rising savings, balance-sheet damage in the household sector, unemployment, and fiscal distress. As a result, the large non-tradable sector and the domestic-demand portion of the tradable sector cannot serve as engines of growth and employment. That leaves exports – goods and services sold to the global economy’s growth regions (mostly the emerging economies) – to carry the load. And strengthening the US export sector requires overcoming some significant structural and competitive barriers.

What the world is witnessing is a correlated growth slowdown across the advanced countries (with a few exceptions), and across all of the systemically important parts of the global economy, possibly including the emerging economies. And equity values’ decline toward a more realistic reflection of economic fundamentals will further weaken aggregate demand and growth. Hence the rising risk of a major downturn – and additional fiscal distress. Combined, these factors should produce a correction in asset prices that brings them into line with revised expectations of the global economy’s medium-term prospects.

But the situation is more foreboding than a major correction. Even as expectations adjust, there is a growing loss of confidence among investors in the adequacy of official policy responses in Europe and the US (and to a lesser extent in emerging economies). It now seems clear that the structural and balance-sheet impediments to growth have been persistently underestimated, but it is far less clear whether officials have the capacity to identify the critical issues and the political will to address them.

In Europe, risks spreads are rising on Italian and Spanish sovereign debt. Yields are in the 6-7% range (generally viewed as a danger zone) for both countries. Combined with their low and declining GDP growth prospects, their debt burdens are becoming sufficiently onerous to raise questions about whether they can stabilize the situation and restore growth on their own.

Italy and Spain expose the full extent of Europe’s vulnerability. Like Greece, Ireland, and Portugal, membership in the euro denies Italy and Spain devaluation and inflation as policy tools. But the declining value of their sovereign debt – and the size of that debt relative to that of Europe’s smaller distressed countries – implies much greater erosion of banks’ capital base, raising the additional risk of liquidity problems and further economic damage.

The domestic policy focus in Europe has been to cut deficits, with scant attention to reforms or investments aimed at boosting medium-term growth. At the EU level, there is not yet a complementary policy response designed to halt the vicious cycle of rising yields and growth impairment now faced by Italy and Spain.

Credible domestic and EU-wide policies are needed to stabilize the situation. Neither is forthcoming. Recent market volatility has been partly a response to the apparent rise in the downside risk of policy paralysis or denial.

In the US side, the integrity of sovereign debt was kept in question for too long. During those months of political dithering, US treasuries became a riskier asset. Then, with the immediate default risk removed, money stormed out of risky assets into Treasuries to wait out the economic bad news – mainly feeble and declining growth, employment stagnation, and falling equity prices.

Little in America’s domestic policy debates hints at a viable growth and employment-oriented strategy. In fairness, some believe that cutting the budget is a sufficient growth strategy. But that is neither the majority view, nor the view reflected by the markets.

Structural and competitive impediments to growth have been largely ignored. There is little recognition that domestic aggregate demand cannot be restored to its pre-crisis levels except through growth. In fact, the household savings rate continues to rise.

The details may elude voters and some investors, but the focus of policy is not on restoring medium- and long-term growth and employment. Indeed, there is profound uncertainty about whether and when these imperatives will move to the center of the agenda.

In the emerging economies, by contrast, inflation is a challenge, but the main risk to growth stems from the advanced countries’ problems. In addition, reforms and major structural changes are needed to sustain growth, and these could be postponed, or run into delays, in a decelerating global economy.

The resetting of asset values in line with realistic growth prospects is probably not a bad outcome, though it will add to the demand shortfall in the short run. But uncertainty, lack of confidence, and policy paralysis or gridlock could easily cause value destruction to overshoot, inflicting extensive damage on all parts of the global economy.

This somewhat bleak picture could change, though probably not in the short run. Stability can return, but not until domestic policy in the advanced countries, together with international policy coordination, credibly shifts to restoring a pattern of inclusive growth, with fiscal stabilization carried out in a way that supports growth and employment.

In short, we confront two interacting problems: a global economy losing the struggle to restore growth and the absence of any credible policy response. Too many countries seem to be focused more on political outcomes than on economic performance. Markets are simply holding up a mirror to these flaws and risks.

Read more from our "Michael Spence on Reinventing Growth" Focal Point.

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