Denying Imbalances, G20 Risks Chaos – Part II

MEDFORD: As feared, the G20 summit in Cannes ended with a whimper, eclipsed by the Greek drama of on-again–off-again referendum on debt. The headline-grabbing drama over Greece’s debt has obscured more fundamental challenges to the global economy. Italy, the fourth largest bond market in the world, is paying over 6 percent on its debt – a rate that, without wrenching changes to its way of life and fiscal position, will lead to default. European banks are holding huge amounts of sovereign debt and holding little capital against any “haircut” – a reduction in value paid out – due to the insolvency of the governments. If fact, the banks’ capital is €100 billion to €200 billion short of what’s needed even if Italy does not default. Italy and some European banks are “too big to save” if they get into real trouble. The eurozone would probably collapse if Italy had to impose a 20 percent haircut on its $2.5 trillion in debt.  

Slow growth, high government debt levels in the eurozone and difficulties agreeing on an adequate response to these problems are the biggest immediate threats to the global economy. As it is, growth is slowing in the north, and the economies of the southern tier have begun to shrink. Austerity is destroying the possibility of growing out of the problem, and zero or negative growth in the eurozone is likely next year.

The US has a medium-term problem of immense proportions. Its political process cannot agree on a fiscal policy to deal with short-term weakness in demand and long-term chronic deficits so large that they would undermine its economy. The Super Committee, or US Congress Joint Committee on Deficit Reduction, is charged with cutting about 1 percent a year in spending and/or raising revenues, and it appears to be deadlocked. Longer- term cuts in social security and Medicare entitlements and increases in revenue are needed to head off an unmanageable fiscal situation. US growth next year is targeted by the ever-optimistic Federal Reserve at 2.5 to 3 percent, but below 2 percent by most independent forecasters.

Japan has over 200 percent debt to GDP, the highest in the world of any major actor. Combine this with an aging and shrinking population and an expensive rebuilding program to recover from the earthquake-tsunami-nuclear disaster and Japan’s prospects are uncertain, though next year should see a rebound from this year’s shrinkage in GDP due to the disasters.

China has provided a large part of increased demand over the past year, but a number of warning flags are flying. The Li and Fung manufacturing index that provides a leading indicator of trends has fallen to just above neutral over the past few months. Iron ore and copper prices are down sharply from recent peaks, suggesting softening demand.  Housing has been a major pillar supporting demand, yet prices have begun to decline and not only in the top-tier cities. Some analysts anticipate that a reversal of tight credit could turn this around, but the shaky condition of banks laden with nonperforming loans and the even shakier condition of the non-bank financial system makes this a tricky option – especially when inflation is officially 5 to 6 percent, but really double that, well above levels considered acceptable. If China’s demand slows, a number of commodity prices and the economies of commodity-exporting developing nations such as Brazil or Russia will feel the pinch.

As bad as the outlook is for global growth next year, there are deeper issues. A few nations – China, Japan and Germany – have set up their economies to be in perpetual surplus. This is done by setting currencies hyper-competitively or directing capital to exports or depressing consumption and subsidizing exports. They have run export surpluses in every kind of economic weather and accumulated large reserves. But surpluses in one country are deficits in another, and the unacceptably high debt levels in many of the import-surplus countries such as the United States, Spain and Italy suggest that this mercantilist approach is unsustainable. The world needs to move to a realignment of currencies or internal demand. The surplus countries must buy more and export less, while the import surplus countries need to export more and import less. And “less” can mean a slower rate of growth rather than an actual drop in the volume or value of imports. China is being pressed to revalue its currency by more than the modest amount it has allowed so far, but its main adjustment has been in rapidly rising wages – they rose 22 percent last year. If this continues, it will eventually reduce the huge disparity.

With $3000 billion of foreign-exchange reserves, China is as much captured by its debtors as it is master of them. The Chinese must be uncomfortable as the Europeans turn to them to buy euro bonds, even if they do extract concessions on trade or other issues. These purchases are not popular at home and could end up being a bad investment.

Japan has allowed its yen to appreciate so much that it recently intervened to reverse the ascent. Since the country still is running a surplus, this move was met with dismay. Such appreciation runs the risk of getting into competitive devaluations and currency wars, similar to what happened during the 1930s when the world trading system collapsed. However, Japan’s export-dependent economy was hurting because of the yen’s higher price of the yen. Action was needed, even if that passed the demand problem onto other nations.

The US does not target its currency, but its super-low interest-rate policy and quantitative easing – creating money by buying government debt directly – have pushed the dollar down. China, rather richly, has complained about this. But the spectacle of Congress unable to agree on a budget has probably done as much to create uncertainty, hurting foreign confidence in the dollar while denting domestic willingness to spend and invest – a response that is getting the inflationary results of devaluation without the benefit of improving demand! The unwillingness of Congress to pass an infrastructure bill to create jobs suggests that any government impact on the economy next year will be negative to neutral.

It’s unclear where policymakers go next. There are limits to what central bankers can do when politicians are paralyzed, as seen in Europe and the US. Interest rates are already close to zero – the European Central Bank just lowered its key rate to 1.25 percent – well below the rate of inflation. It’s unclear that more quantitative easing would do much good and might do harm by inflating speculative bubbles in commodity markets. Banks are reluctant to lend even to one another. Companies are flush with money but cautious.

It’s possible to imagine a series of steps that reduce debt to realistic levels but give creditors share of any upside with mortgages or public assets in indebted nations. It’s possible to imagine fiscal policy that balances short-term investments with significant longer-term restraint in spending and higher taxes. It’s possible to suggest ways surplus countries could do their part to help reduce global imbalances and promote growth in deficit nations. But it seems unlikely that such steps might happen in sufficient measure in the next year or two to avoid a continuation of slow growth or worse.

And so, if chaos does not yet rule, it threatens many more places than Greece, where the word originated.