The Triumph of Politics
Investors have long seen politicians as free riders on the business cycle, riding its ups and downs but seldom able to change its speed or direction.
Not any more. In Europe, China and America, the major determinants of economic and market performance in the year ahead are political, not economic. And I’m not talking garden variety politics such as whether capital gains taxes go up. I mean existential questions about what kind of society emerges a few years from now.
Start with Europe. Monetary union was the product of a methodical, decade long, start-stop path of technical, economic and political work and consensus building. Europe is now trying to rush from that to a fiscal, banking and perhaps even political union with financial calamity threatening to swallow the entire region at every turn. Ultimately, the euro’s survival will require creditor countries led by Germany to provide a backstop to the region’s debts, through a bailout fund, the European Central Bank, or both. In return, debtor countries will have to submit to collective oversight of their budgets and banks. Elites in both groups of countries understand this, but are at odds with their voters who in turn are holding the European project in ever greater contempt. Spain is dragging its feet on signing an agreement with Europe and the IMF on its budget that would activate the ECB’s backstop because it would deeply unpopular, and wants to make sure Germany will say yes. Meanwhile, Germans are fed up with repeated bailouts being charged to their credit card. I think the euro will survive, but I assign only 60% odds to that outcome.
China’s spectacular growth of the last decade was fueled in great part by the reforms that led up to and immediately followed its accession to the World Trade Organization in 2001. That growth, however, was highly unbalanced, first towards exports and then towards investment, in particular state-directed investment. China’s leaders want to transition towards growth led by consumers and services. That means not just throwing more money at big public sector works and property, but liberalizing more of the economy so that smaller, private enterprises can compete for credit and market share against state-owned enterprises.
This transition may already be happening; this year’s slowdown was a deliberate attempt by authorities to clamp down on excessive speculation. There are two risks to this scenario. One is that the slowdown turns into a hard landing (growth in low-single digits or negative) as investment collapses. In fact, Michael Pettis, one of the savviest China watchers, says this is precisely what China needs. The other is that the authorities panic and return to the stimulative policies of old –more state-directed lending, more public works, no further appreciation of the yuan. Complicating matters, China is going through its own political transition. We won’t know for another year whether its new leaders have the support and inclination to return to the path of reform and liberalization, especially when the country’s intertwined public and private elites have profited so much from the current system. Still, it’s dangerous to bet against China so the probability that this transition proceeds in the next year without a hard landing is around 80%.
Finally, there’s America. The year-end fiscal cliff will unleash a 5% hit to GDP. Both Democrats and Republicans want to avoid it. The conventional wisdom is that there will be a quick deal during the lame duck session to avert the cliff, coupled with the outline of grand bargain next year that reforms taxes and entitlements while cutting the deficit. There are two flaws in this sanguine outlook. First, it assumes the election will be some cathartic moment that settles the question of how big government in America should be in favor one party’s vision. But the cliff exists precisely because the two parties are so polarized in their visions, and those differences will not magically recede the day after the election. America’s politicians could easily carry the country over the cliff. Alternatively, they may punt everything down the road, guaranteeing more gridlock and uncertainty and even another fight over the debt ceiling come February. The odds of an orderly resolution are 70%.
The odds any one of these challenges is resolved happily are each over 50%, but note the odds of all of them end happily are only about one in three (80% X 60% X 70% = 34%). As Felix Salmon notes, the odds of “apocalypse” – of the euro breaking up, China having a hard landing, and America going over the fiscal cliff, are a not-immaterial 2.4%.
These, as I said, are big, even existential questions and even someone with a lifetime of experience in the markets and economics should be humble about their ability to forecast the outcome. Small wonder the enormous uncertainty about how they all shake out is such a huge headwind to economic growth right now.
Greg Ip is US Economics Editor for The Economist and author of The Little Book of Economics.