Averting Another Global Recession

Uri Dadush, Philip Suttle
Originally published by the Carnegie Endowment for International Peace

With wild swings in global financial markets, Standard and Poor’s downgrade of America’s credit rating, and default threatening Italy and Spain, fears are high that the world is facing a new economic collapse.
In a Q&A, Philip Suttle, chief economist at the Institute of International Finance, and Carnegie’s Uri Dadush assess the risk of another global recession, market turmoil in the United States, Europe’s debt problems, and how emerging markets will fare amid renewed economic uncertainty.

• What is the current state of the global economy?
• Why has the global economic recovery faltered?
• Is the world facing a new economic collapse?
• What is the biggest economic concern at the moment? Is this another Lehman moment?
• What is the significance of Standard and Poor’s downgrade of America’s credit rating?
• Will the downgrade cause people to stop buying U.S. government debt?
• What triggered some of the worst days in financial markets since the economic crisis of 2008?
• Is there anything that U.S. policymakers can do to avoid a double-dip recession?
• Did the European Central Bank’s (ECB) decision to buy Spanish and Italian bonds prevent a euro meltdown?
• How can Europe calm markets, end its debt problems, and bolster economic growth?
• What are the chances that the euro will survive the crisis?
• How are emerging markets responding?

What is the current state of the global economy?

Suttle: There are three major concerns with the global economy today. The first is the global business cycle. We have seen a progressive slowing of the economy over the past year and there was a high degree of conviction in both markets and amongst analysts that the bottom would be hit in the middle of this year and the second half would be better. But what we are seeing is worry in financial markets—especially equity markets—that there is more slowing and weakness to come.

The second concern is the United States and the outlook for the consumer. This is driven in part by the debacle over the debt ceiling debate and what might happen—whether it’s more uncertainty in the near term or worries about more fiscal tightening that could hurt already feeble U.S. consumers.

The third issue is the big one behind the scenes and that is the tensions within the euro area and problems with debt in Europe. To put it bluntly, they are not going away, they are getting worse. This raises a great deal of fear about how things will play out in Europe and around the world.

Why has the global economic recovery faltered?

Dadush: Just a few months ago, it looked as though there were many good reasons for why the global expansion would continue. But three broad areas of shocks—extraneous, political, and economic policy—have changed the underlying dynamics.

The extraneous shocks include the earthquake and tsunami that hit Japan in March. This unanticipated shock had some impact on manufacturing and there are temporary repercussions for the global economy. On the political side, there is the Arab Spring, a mini-oil crisis, the inability of European leaders to find a path through the turmoil, and the protracted U.S. debt debacle that undermined confidence. And finally on the policy front, the emerging markets could not continue to carry the global expansion without overheating and this translated into some needed tightening. Fiscal tightening also happened in Europe.

This formidable combination of factors is hitting the economy all at once and leading to a global slowdown. But we are not at panic stations yet.

Is the World facing a new economic collapse?

Suttle: We are already in another slowdown and the question is how much longer the world will be constrained by subpar growth. This sluggish pace could easily continue for longer than anticipated, which is bad for two reasons. One, it makes it harder to deal with problems—unemployment and high debt levels could get worse. And second, it also raises concerns about deflation in mature economies.

An outright recession, however, remains unlikely. So many of the dynamics that would typically lead to a recession—excessive accumulation of inventories, excessive construction, excessive business spending, and excessive employment—were burned off in the deep recession that the world lived through just a couple of years ago. So, while the probability of a recession has certainly gone up compared to a few months ago, realistically the global economy is not likely to fall off the edge soon.

What is the biggest economic concern at the moment? Is this another Lehman moment?

Dadush: The big worry now is the interaction between a slowing global economy and the crisis in Europe. Huge economies—Italy and Spain in particular—are now in the eye of the storm and it is entirely possible that there will be a conflagration in Europe. It would resemble what happened in Greece and Portugal, but ten times bigger. And a slowing growing economy will simply escalate the crisis—the nexus between Europe’s problems and a weak global economy is the major risk.

Even though there are legitimate worries about what’s going on in the United States and Japan, these problems are more manageable. Both countries could slow and face more unemployment, but they have control over their monetary policies and their exchange rates can adjust which is not the case in the eurozone. The United States is the biggest economy in the world; it has a very flexible and competitive private sector, even with the terrible politics. The European outlook is much more dangerous, and that could turn into a Lehman class crisis.

What is the significance of standard and poor’s downgrade of America’s credit rating?

Suttle: Standard and Poor’s downgrade turned out to be hugely significant. For all of the bluster and talk about the Tea Party and an intractable political standoff, the problem is really that the United States has now had two major fiscal confrontations this year—the partisan quarrelling and intense negotiations at the end of 2010 and the latest showdown over the debt ceiling—that have done nothing to produce medium-term budget improvements. S&P responded to the idea that both deals essentially pushed off the real decisions.

If you had to design U.S. fiscal policy to be as suboptimal as possible, you would come up with something close to what we are witnessing today. It’s not clear who is to blame on this, as it is more the outcome of a process rather than the fault of an individual alone. But the Obama administration showed a tremendous amount of immaturity in the way it responded to the downgrade. They responded in the way that emerging markets used to react when faced with their own economic crises.

What S&P does is an art, rather than a science, but they are largely sensible and objective in what they do. The downgrade was justified, but it is somewhat surprising how much of an impact it ended up having on the markets.

Will the downgrade cause people to stop buying U.S. government debt?

Dadush: The downgrade sends an important message to the United States, but it’s unclear if that message will be received. Still, in the end, people need to put their money somewhere and they want to put it somewhere that is safe. Standing back from the post-downgrade situation, it is not obvious that the relative risk of buying U.S. debt is any larger than it was six months ago.

It is in fact paradoxically easy to argue the opposite. If you are looking for a safe place to put your assets today, you are less likely to put them in euros. And the euro remains the main alternative to the dollar. The yen has its own problems with Japan’s abysmal public debt ratios and the Swiss franc is feared to be overvalued. Those alternatives are exhausted because of the appreciation of the currencies and worries about the sustainability of their value. There really aren’t alternatives to the dollar at the moment.

What triggered some of the worst days in financial markets since the economic crisis of 2008?

Suttle: The conflagration of the euro crisis and the S&P downgrade are clearly important developments. There are two other important elements that help explain financial developments. The first is the downgrading of profit expectations. It looked like the earnings in the corporate sector would be robust, but growth figures have been revised down. That’s a small part of what has gone on in the last week.

The bigger factor is what people in financial markets call positioning. In other words, there was a situation where investors were effectively forcibly encouraged to hold equities. Instead of having a bank account with very low interest rates, people were pushed into an equity product. A big part of our problem is that we’re lurching from one period of financial instability to another. And all we’re doing is pouring gasoline on the fire through policies that either set zero percent interest rates or cajole investors to take on more risk. It’s the natural way for central banks to think about how to solve this problem, but it’s a very unhealthy way to do so.

Is there anything that U.S. policymakers cqn do to avoid a double-dip recession?

Suttle: The problem is 99.9 percent political. Getting people to agree on sensible measures is the toughest thing. Many of the recommendations of President Obama’s National Commission on Fiscal Responsibility and Reform— the bipartisan group formed in February 2010 to find ways to reduce the mounting American debt— are the right solutions, but trying to get anyone to take action on them is the real hard part. There are other things that should be changed, including the banking regulatory environment that has also become unnecessarily aggressive.

Dadush: Countries can be overactive in monetary and fiscal policies. Until a few weeks ago, the most important thing that the United States could do was to let the recovery continue and provide a social safety net for the most vulnerable in order to avoid the extreme, long-term repercussions of the recession. A social safety net and help for the unemployed are remarkably inexpensive—what becomes expensive is when tax cuts or payroll holidays are made across the entire labor force.

Today, the United States faces a serious threat, but it is largely coming from overseas. So Washington needs to have some contingency plans in place if there is a major deterioration of the crisis in Europe. I would not argue, however, for a major policy change right now.

Did the European Central Bank’s (ECB) decision to buy Spanish and Italian bonds prevent a Euro meltdown?

Suttle: This is the one piece of good news this week. For once, the ECB’s decision seemed to work. It is too early to celebrate, but yields on the bonds have come down to around 5 percent. While this is still unsustainably high, it is a marked improvement.

Most economists would agree that the issue facing the euro area is the incoherence between monetary and fiscal policies. Europe needs to match the two policies. In a backdoor way, Europe is getting there. European countries are not unifying their budgets, but in many ways they are gradually beginning to unify their debt. The ECB is a key ingredient in this. In due course, however, the ECB’s holdings of government debts should be taken on by a centralized European authority, probably the European Stability Mechanism. I expect this will happen.

How can Europe calm markets, end its debt problems, and bolster economic growth?

Dadush: The ECB intervention was important and essential, but it’s not a long-term solution. Unfortunately, the ECB also intervened in the cases of Greece, Portugal, and Ireland at different stages that enjoyed pretty favorable effects, but they were only short-term improvements.

It’s not a long-term solution for four reasons. One, similar ECB action in the past did not stem the panic for long, even for much smaller economies. There is even more of a worry with Spain and Italy. Two, this is essentially an abrogation of sovereignty. A technical agency is effectively deciding for French and German taxpayers to pay for Italian and Spanish bonds. Three, this is basically printing money. Right now, this is not a big concern as inflation is under control, but that is not necessarily true over the long term. Fourth, it is extremely awkward for the ECB to “set conditions” on the Italian and Spanish governments, and so there is a major moral hazard issue here: aren’t these governments incentives to reform diluted by sustained ECB intervention?

All of this is not to say that this shouldn’t have been done, but Europe is playing with fire. The only durable solution is an explicit and agreed construct for European countries to essentially pool their fiscal management. There are many ways to do this. And the countries in Europe’s periphery need to regain competitiveness through a combination of structural reforms and austerity.

What are the chances that the Euro will survive the crisis?

Suttle: There is a phenomenal commitment to hold on to the euro. It is still more likely to survive than not, but the chances that the euro doesn’t endure in its existing format are not trivial. When looking back to major currency changes historically, most people never see them coming. The consensus before a major transformation takes place is often that it can’t be done, but these things do happen. It is hard to see who will break with the euro, but the possibility should not be ignored.

Dadush: Greece, in particular, will find it hard to stay with the euro. Even if half of Greece’s debts were forgiven to allow the country to move back to a sustainable position, its competitiveness would probably deteriorate as the “windfall” of debt forgiveness reduces the incentives to save and to reform. It is not hard to imagine a Greece that can’t grow, and with its wages taking decades to adjust; this means that it would face tremendous pressures to exit the euro at some point.

With this in mind, it’s difficult to see how the eurozone remains in its current configuration. The chances are sadly quite low. This doesn’t mean that the entire euro will blow up, but changes seem almost inevitable.

How are emerging markets responding?

Suttle: It is interesting to note that six months ago China was much higher on the global list of concerns. But through all of this China has been a steady hand. And in a funny sense, the chances of China enjoying a soft landing have gone up with the effects of everything playing out and with falling commodity prices.

As far as emerging markets overall go, they are moving from tightening policy to a more neutral policy. In a sense, it is a good sign that they are moving toward a steadier pace of long-term growth, but a downturn in Europe and the United States could complicate this.

Policymakers in these countries would have said a few months ago that they wanted less upward pressure on their currencies, less upward pressure on their asset markets, and generally a little more control over their booms. Emerging markets in some ways got what they wanted and more.

The concern now is that there is too much cooling. But in general terms it is still going in the right direction for emerging markets. There are still one or two hot spots to worry about. The Mediterranean seems to be the epicenter of the world’s economic problems—it’s not just Greece, Italy, etc., but also Turkey. This is the major emerging economy that could most give the world headaches in the next year, as Turkey seems to be going from boom to bust quite quickly.