The 2012 Recovery: Handle With Care
What does 2012 hold in store for the world economy? Let us start by looking at the battered high-income countries. Is there a good reason to expect healthy recoveries? Not really. The outcome in the euro zone might be a disaster that spreads around the world. Even the US recovery is likely to be fragile. The shadow cast by events before 2007 passes slowly.
The December consensus of forecasts is gloomy. The most recent views on likely growth this year are far below those expected a year ago. This is particularly true for the euro zone, which is expected to fall into recession. The economies of Italy and Spain are expected to contract, while France and Germany are expected to produce negligible growth. The UK is forecast to be in the same state as the euro zone's two largest members. Only Japan and the US are forecast to show anything close to reasonable economic growth this year. In the case of the US, growth was forecast at 2.1 percent in December, up from 1.9 percent in November.
Let us put this performance in context. In the third quarter of 2011, Canada was the only member of the Group of Seven leading high-income countries whose gross domestic product was much above its pre-crisis peak. The US and German economies were marginally above their pre-crisis peaks, while France was marginally below it. The UK, Japan and Italy were still far below their pre-crisis peaks. Recovery? What recovery?
Yet the highest interest rate now applied by the four most important central banks is the European Central Bank’s only 1 percent. The balance sheets of these central banks have also expanded dramatically. Moreover, between 2006 and 2013, the ratio of gross public debt to GDP will jump by 56 percentage points in the UK, 55 points in Japan, 48 points in the US and 33 points in France. Why have such drastic policy actions brought forth such modest results?
On this ideologically charged debates rage. The dominant theoretical paradigm holds that a financial crisis cannot happen and cannot matter if it does happen, at least provided broad money is not allowed to collapse. In this view, the only things now holding economies back are structural rigidities and policy-induced uncertainties. This is, in my view, a fairy story, based on theories that reduce capitalism to a barter economy under a thin monetary veil.
Far more persuasive, to me, are views that accept that people make important mistakes. The big divide is between those – the Austrians – who hold that the mistakes are made by governments while the solution is to let the distorted financial edifice collapse and those – the post-Keynesians – who hold that a modern economy is inherently unstable, while letting it collapse would take us back to the 1930s. I am decidedly in the latter camp.
In his prescient 1986 masterpiece, Stabilizing an Unstable Economy, the late Hyman Minsky laid out his financial instability hypothesis. Janet Yellen, vice-chair of the US Federal Reserve, remarked in 2009 that “with the financial world in turmoil, Minsky’s work has become required reading”.
What makes his work compelling is that it ties investment decisions oriented to an inherently uncertain future to the balance sheets that finance them and so to the financial system. In Minsky’s view, leverage – and so fragility – are determined by the economic cycle. A lengthy period of tranquillity will raise fragility: people will underestimate dangers and overestimate opportunities. Minsky would have warned that the “great moderation” contained seeds of its own destruction.
The years before 2007 saw an extraordinary private credit cycle, notably in the US, UK and Spain, backed by rising prices of housing. The bursting of these bubbles led to an explosion of fiscal deficits, largely automatically, as Minsky foretold. This was one of the three policy mechanisms that prevented collapse into a great depression, the others being the financial and monetary interventions. Economies are still struggling with the post-collapse adjustment. With interest rates close to zero, fiscal deficits of creditworthy sovereigns offer three forms of help – to demand, to deleveraging and to raising the quality of private assets.
How far then has the deleveraging proceeded? In the US, quite a long way. By the third quarter of 2011 the ratio of financial sector gross debt to GDP was where it was in 2001 and the ratio of household debt to GDP was where it was in 2003. Furthermore, notes Goldman Sachs: “We believe that housing starts have probably bottomed already, while nominal house prices are likely to bottom in the course of 2012.” The US is now set for recovery, albeit one limited by the premature fiscal tightening, ongoing deleveraging, risks in the euro zone and, perhaps, higher oil prices. Recovery will also be built on what is still an unbalanced economy.
Yet the fragility of the euro zone is far greater. The Organisation for Economic Co-operation and Development forecasts a reduction in the underlying fiscal deficit of the euro zone by 1.4 percent of GDP between 2011 and 2012, against just 0.2 percent of GDP in the US. Yet the big danger for the euro zone’s weaker economies is that public and private sectors will seek to retrench simultaneously. This is a recipe for deep and prolonged slumps. The uncreditworthy sovereigns are trapped in a probably doomed effort to tighten their fiscal positions in the absence of adequate private sector and external offsets. For these countries, a euro zone-wide recession is a calamity: it must greatly hinder the external adjustment they need. Against this background, the ECB’s offer of cheap three-year financing of banks that might relend to battered sovereigns is little more than a palliative – clever, but inadequate.
The high-income countries have been running a series of fascinating experiments. One was with financial sector deregulation and housing-led growth. It failed. Another was with a strongly interventionist response to the financial crisis of 2008. It worked, more or less. Yet another is with post-crisis deleveraging and a return to more normal fiscal and monetary settings. The jury is out on this effort. In the euro zone, however, this shift to fiscal austerity is running alongside a still bigger experiment: the construction of a currency union around a structurally mercantilist core among countries with negligible fiscal solidarity, fragile banking systems, inflexible economies and divergent competitiveness. Good luck for 2012. Everybody will need it.