Sunday, October 24, 2010

EMU: The recovery goes on

EMU: The recovery goes on

  • EMU. The pace of growth in the euro zone has more than halved after the very strong spring quarter. That was, however, inevitable. Nevertheless, GDP still succeeded in posting fairly robust growth over the summer months with +0.4%. And the recovery is continuing, even though it will be moderate. A double-dip recession is improbable.
  • Risks. Not even the recent euro appreciation can do much to change this. It will, however, be a drag, primarily at the beginning of next year. But this compares with upside risks after the latest equity market rally and better-than-expected survey readings. There is, therefore, no reason to change our GDP forecast for 2011 (+1.3%; 2010: +1.6%, pages 4-6).
  • Germany continues to top the growth league. Even though the global economic slowdown is taking its toll on net exports, the domestic economy is pointing clearly north. And this morning's release of the Ifo index underlines once again that the German recovery will remain robust (p. 7-10).
  • ECB. The economy and the euro should not, therefore, cause the ECB any major headaches. It can, therefore, forge ahead undeterred with its exit from the excessive supply of liquidity. If, however, EUR-USD rises rapidly above the "pain threshold" of 1.50 and remains there, the first rate hike will probably be postponed (pages 11-12).
  • US. The Fed, in contrast, will pump even more money into the economy. Unlike in the euro zone, growth in the US remained not only below potential in the summer but also below (Fed) expectations. The domestic economy cannot provide the hoped-for impulses in light of the persisting labor market problems (pages 13-14).
  • Further topics:
  1. Weekly Comment: Denial syndrome (page 2).
  2. Data outlook: German labor market remains on the road to recovery; US housing market still vulnerable (page 15).
  3. Market outlook: EUR-USD hovers around 1.40 (page 23).
Denial Syndrome
The brief golden age of international cooperation is over, as underscored by the G-20 meeting underway in Korea and the discussions on reforms of the EU’s economic governance. European leaders seem yet again unable to agree on sufficiently ambitious reforms to match the scale of the challenges facing them; and G-20 finance ministers and central bank heads will at best agree on the rules of engagement for the brewing currency wars. The generally accepted explanation for this breakdown in international cooperation is that countries are fighting over a shrinking pie, treating global growth as a zero-sum game to be won via conquering a greater share of world markets. But behind this there is something more dangerous and distressing: advanced economies are in denial, unwilling to face the historical magnitude of the structural challenges they face. Globalization brings to bear a relentless and intensifying pressure on countries already burdened by aging populations and which have allowed their education systems to deteriorate. The focus should be on improving education and infrastructure, on reforms to bolster flexibility and productivity, and on fiscal reforms to reduce the cost of aging populations and making it sustainable – not on currencies.

Globalization need not be a zero-sum game, but advanced economies should abandon their sense of entitlement and engage emerging market on a cooperative approach to the fundamental long-term challenge of smoothing the transition to a more balanced distribution of global incomes. Otherwise, the counterproductive tensions we are witnessing today will not disappear once global growth picks up more decisively – they will only get worse.

It would be tempting to conclude that the much-trumpeted international policy coordination has always been little more than an optical illusion, the clever marketing of policymakers’ “herd behavior” as they simultaneously rushed to loosen monetary and fiscal policy responding to a shared fear of economic collapse. This would be unfair. At the height of the crisis, we had seen a genuine important strengthening of coordination, from the simultaneous interest rate cuts to the joint announcement by EU leaders of measures to support the financial sector, to the ongoing efforts for reform of the global financial architecture. That is all gone now, and the current state of affairs is extremely disappointing.

Within Europe, the picture is dispiritingly familiar. We start with ambitious plans for stronger frameworks and coordinated efforts that should not only ensure the seamless and stable working of the EU, but also propel it to its rightful place as an economic powerhouse on the world economic scene.

Then these plans get watered down in successive rounds of political compromise, until we are left with something which, however embellished in the official statements, falls short not only of the initial targets but also of what is really desperately needed. The current discussions on a reform of the eurozone’s economic governance are a case in point. After a lot of high quality work by the European Commission on how to improve the macro surveillance framework, EU leaders have been unable to agree on what matters most, namely ensuring that sanctions can really be enforced. Even the Commission’s proposal of quasi-automatic sanctions has quickly been rejected by a French-German compromise.

ECB President Trichet deserves praise for the courage to openly disagree with the current compromise. And the ECB’s disappointment with current plans is telling: the bank is, after all, the one left holding the bag; it is the ECB that has to buy the government bonds of high-debt countries and keep ailing banks on life support. If the bank opposes the current reform plans so openly, it is because it knows that they are not strong enough to remove the serious constraints to its operational independence.

On the global scene, countries are shamelessly treating global growth as a zero-sum game where the objective is to grab as large a share of the pie as possible. The facts are well-known: China keeps its currency cheap to support exports; the US’s move towards QE2 is widely seen as a way of weakening the USD, and Germany proudly pursues its export-led growth strategy even in the face of a rising euro. I still believe QE2 would bring more risks on the global liquidity front than benefits on the US growth front, but the US has a point: we all criticized the US’s consumption binge and bulging C/A deficit before the crisis, and the adjustment so many of us predicted now involves lower US private consumption, so that someone else in the global economy must pick up the slack. For me, this also implies that US potential growth is lower and structural unemployment is higher, but that does not distract from the fact that other countries should do more to pick up some of the slack.

China’s exchange rate is the most politically visible part of the equation, but probably not the most important: accelerating structural measures to bolster private domestic demand would be much more effective, even if it does not fit the timetable of domestic political debates. The concern is that focusing on the exchange rate, while politically expedient, might be extremely counterproductive. With a growingly impatient Congress, the US Administration has an extremely difficult balancing act to perform to achieve some progress.

My greatest concern, however, is that the disintegration of international coordination is a symptom of a much more serious underlying problem: the unwillingness to face structural and historical challenges that can no longer be delayed, at both the national and international level. In Europe, we see the first signs of self-congratulation for having weathered the crisis reasonably well, combined with a measure of Schadenfreude for the US which now faces European-style high unemployment. In the meanwhile, we act as if fiscal consolidation were an option (hence, the lack of agreement on enforceable SGP sanctions); as if unfunded aging-related liabilities will magically disappear (just look at France’s population up in arms against a modest 2-year increase in the retirement age to a still unsustainable 62 years); and as if structural reforms to boost productivity and growth were a luxury. Similarly, the US finds it hard to face the truth that pre-crisis growth rates were drugged and unsustainable, and that to boost living standards once more will require an acceleration of structural reforms, including a serious overhaul of aging-related programs and a renewed act of confidence in the flexibility of the private sector.

Underlying all this is the relentless pressure of globalization. Before the crisis, attention was focused largely on the positive impact of globalization, as a larger global workforce boosted world growth while giving more people access to cheaper products. Blue-collar workers in advanced countries felt the competition via fewer and smaller increases in their paychecks, but reaped the benefits via better and cheaper goods. Now the competition continues to be felt even with world growth running at a slower pace, and it is gradually running up the value-added chain. To maintain their leading position for longer, advanced economies need to up their game and bolster their human capital – yet nearly all have allowed their education systems to deteriorate and are not yet taking remedial action.

Globalization need not be a zero-sum game. Intensified competition can make us all stronger. And more importantly, hundreds of millions of people around the world have a right to work their way out of poverty, especially when they are committed to work hard enough for it. But advanced economies must accept that the game has gotten tougher and that they must fight harder, abandoning any sense of entitlement. Managing globalization does require better global policy coordination, and this should be initiated now. Otherwise, the counterproductive tensions we are witnessing today will not disappear once global growth picks up more decisively – they will only get worse.

Full report: EMU: The recovery goes on

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