14 July 2012
Naive politics will create uncertainty and undermine public confidence.
I DELIVERED the 19th Tun Dr Ismail Oration at the 46th Malaysia-Singapore Congress of Medicine in Kuala Lumpur on Thursday. Here are excerpts.
In search of safe haven
The surest sign that all is not well about the global economy is when investors rush to buy gilt-edged or sovereign bonds of the US, Germany, UK and Japan. Indeed, they are even prepared to “pay” (after adjusting for inflation) the German and Japanese governments for the privilege of holding their two-year bonds which earn them practically nothing. They will even lend to US, Germany and UK for 10 years in exchange for bonds yielding a nominal 1.5% a year. What they receive is a return below the target inflation rate set by central banks!
In the eurozone, only Germany enjoys this privilege. People are just scared of the dangers out there. They expect either years of stagnation or imminent disaster. Either way, they feel uncomfortable with the global outlook, so they opt to pay for safety. For them, what matters today is return OF capital, not return ON capital.
Michel Barnier (left), the European Union Commissioner for Internal Market and Services, and European Union Commissioner for Monetary Affairs Olli Rehn at a news conference in Brussels recently. Europe is showing no signs of an early economic recover. — EPA
I have been in this business for 50 years. I have seen crises come and go. Not even the Great Depression pushed bond yields down this far. History suggests that investing in low yielding Treasuries is not a good deal. In 1945, I recall investors took in 2% a year on 10-year Treasuries. Over the next 35 years, they earn effectively a negative return of 2.3% a year after inflation. That's a bad deal. Still, investors continue to do it. To set the current perspective: since 2009, US$1 trillion have moved into bond funds. Foreigners today hold 43% of US Treasuries. Official institutions (mainly in Asia and the Middle East) own US$3.5 trillion worth of them. That's a big deal. What's frightening is that these low rates will persist. Last week, central banks in Europe, UK, Denmark and China moved in sync to ease monetary conditions, keeping interest rates still lower, reflecting grave disquiet about the future.
What went wrong?
Why is this so? What's going on? As I see it, what's happening is a combination of: (i) slackening economic growth, (ii) rising risk of financial disaster, (iii) collapse of trust in politics, and (iv) an unwillingness to reform to raise competitiveness. All these in combination work to add on uncertainty. They raise risks associated with a loss of confidence in politicians, many of whom are still in denial, and in their lack of will to take tough decisions.
The first challenge involves the slackening of global growth. This time the situation has become more serious growth in rich and emerging nations is slackening in sync; i.e. in tandem. The world's factories are running out of steam.
In June, services and industrial production fell across most of Asia and in US and Europe. Job data worsened pointing to a continuing weak global outlook which the IMF now considers to have become “more worrisome.” Recovery in the US remains “tepid,” vulnerable to contagion from the evolving euro crisis. In June, US manufacturing & services activity contracted for the first time in three years, further denting confidence in a global economy that is already feeling the recessionary effects of European & Chinese slowdown. Also, new orders posted their biggest monthly drop in more than a decade, indicating faltering demand. Some of the fragility is coming from outside the US, signalling that it is catching the slowdown that is well underway in Europe and China, India, Russia and Brazil.
The latest IMF assessment of the US remains “regrettably” tentative. It cites strong headwinds persisting in private consumption as households continue to deleverage, i.e. unwind its debt. Job creation has slowed, while business investment seems to have lost some momentum. Further compounding concerns is the present danger of going over by year-end, the “fiscal cliff” so-called because of two “cliff-like” budgetary cuts involving the equivalent of 4% of US GDP viz expiring temporary tax cuts and automatic spending cuts. There is also the need to raise the US$16.4 trillion debt ceiling.
If no political accommodation is reached, the bi-partisan US Congressional Budget Office predicts it would provoke a US recession in 2013. Such political brinkmanship could prove disastrous.
Europe is showing no signs of an early recovery. Already at least seven eurozone economies are in recession. Germany and France are slipping with the slowdown getting more entrenched and businesses getting less optimistic. Eurozone GDP fell in the past quarter, with output held flat in the first quarter after shrinking in the fourth quarter 2011. Of concern are signs that Germany is succumbing to spreading recessionary forces as activity in manufacturing and services turned for the worst in June. More worrisome is unemployment in the eurozone, which hit a record 11.1% in May, with close to 18 million out of work; and likely to rise further to 12%. Youth employment matters most. The young are being left behind as never before. Once this gap emerges, history suggests it tends to persist and is difficult to close. The situation is getting more dangerous with rates for under-25 jobless at record highs: one in two young Greeks and Spaniards are out of work; youth unemployment in Italy, at 35%, is four times the older jobless rate. It is 22% in both UK and France. The outlook for jobs in Europe looks lousy.
Across the world, Europe remains the epicentre of global concern. Much of its problems reflect the counter-productive nature of the cult-of-austerity, involving draconian cuts in public services and living standards. This compact has since proved economically ineffective, socially disruptive, and I think, politically naive. Simply put, you just can't cut and grow. Austerity depresses growth, reduces jobs and makes it more difficult to reduce deficits, thereby risk pushing the economy into a self-defeating vicious cycle. Furthermore, activity in the biggest emerging market China appears to have cooled. In June, China's factory activity shrank at the fastest pace in seven months. New export orders fell to depths last seen three years ago. Growth in the services sector also slackened in June, expanding the slowest in 10 months. This sector, which is fast approaching one-half of China's GDP, has so far weathered global contraction well. It is likely to benefit from the rebalancing of activity in favour of services and consumption.
As of now, Asian policymakers are under pressure to shield their economies from the protracted global slowdown. In China, the policy to revive growth will likely front-load public spending on social welfare, social housing and social infrastructure. All told, we are in for a rough ride.
The second challenge involves the rising risk of financial disaster. The longer the eurozone crisis drags on, the higher the risk of financial catastrophe. After two years (and 19 summits), the leaders of the eurozone finally agreed on some important steps to save the euro. But they are not enough, as reflected in its impact which has gotten more brief with each round of talks. The recent June 28 summit rally lasted about a day: the euro gained nearly 2% against the US dollar; major European stock markets rose more than 4%; and Spanish and Italian bond yields fell sharply.
But this reflected more about how low market expectations were, than about the measures announced. It took only the weekend for investors to reverse sentiment, realising the measures lack commitment. Indeed, Finland and the Netherlands are already withholding support. German opposition is challenging the measures' constitutionality. It marked yet another in a string of rallies that quickly faded. Be that as it may, the summit seems to be in my view on the right track. It severed the disastrous link (or the economists' “deadly embrace”) between banks and governments, by allowing the bailout funds to be used (i) to buy up sovereign bonds directly and (ii) to recapitalise banks directly; and (iii) to appoint a euro-wide banking regulator by year-end. No doubt, lack of details adds uncertainty on their implementation. Already two major problems had since surfaced which can complicate matters: first, the bailout “firewall” fund, European Stabilisation Mechanism will require to triple its present size to be effective; and second, ceding sovereignty by national bank regulators to the euro-wide regulator will be tough to sell. Sure, the summit has taken a big step, but markets need to be convinced that the European Central Bank will come on board. Continuing political dysfunction will fuel turmoil amplifying the eurozone's design flaws. Europe remains vulnerable to rising risks from the next fallout on the euro.
The third challenge dwells into the space of politics. More than at any time in recent history, the global economy's fate is tied to the capriciousness of politicians. As I see it, the final outcome rests more on politics, not economics. Compounding concerns over the health of the US economy, the IMF had cautioned correctly, I think on the danger of going over the “fiscal cliff,” calling on politicians to act early. My understanding is that this is not going to happen anytime soon.
In Europe, time and again, eurozone leaders only make critical decisions on situations of dire stress they just don't take difficult steps in normal times. Bear in mind also that Europe can't act without Germany. But few realise how vulnerable Germany is. True, Germany is large and its economy is doing better than most. However, the economies of France, Italy and Spain combined are twice its size. Its debt to GDP ratio is already 81%. Germany has committed 6.5% of GDP to the various rescue measures. In addition, if all pledges to the bailout funds were added up, and potential central bank “losses” in the event of a euro break-up counted-in, Germany's total “casualty” bill could reach 30%-40% of GDP.
So, Germany does have high risks at stake in the euro. Sure, its resources are not limitless. To be fair, it is the biggest beneficiary of the euro, running consistently huge payment surpluses within the region. But Germany does have domestic problems. Politically, despite the continuing crisis and bail-out fatigue, a recent Forsa poll showed 54% of Germans support the euro. However, 75% is against a “United States of Europe” which requires ceding more sovereignty to the EU; 59% is opposed to budgetary control by Brussels; and 66% is against any joint eurozone debt liability, or euro bonds. In the end, the reality remains that the EU is a collective of nation states with notable economic, financial, social and cultural divergences. Left on their own devices, they are vulnerable to recurrent bickering, disruptive posturing, and differing visions of the future.
Even in the best of times, progress towards economic integration is slow and hesitant, and steps to political integration, painful. As always, this can quickly change in a crisis. Hence, the inherent dangerous risks of European politics. The fourth challenge involves serious reform to raise competitiveness after falling behind in productivity gains. As I see it, there is a bigger picture to preserve the euro. It involves shifting from austerity to a far greater focus on economic growth and instituting supply-side reforms to raise competitiveness. This needs to be complemented by a banking union (i.e. a single banking regulator with joint means to recapitalise and resolve weak banks, including deposit insurance); and then, some form of limited debt union. Realistically, this is still far off. Europeans, I think, are not yet ready for full political union. So, reform to overhaul their governance, economies and finances is not going to happen anytime soon. So, expect more crises to erupt.
Naive politics
By creating policy paralysis, political brinkmanship is stalling global growth. The cost of failed, deeply divisive policies extends well beyond economics to engulf social justice. Naive politics of confrontation can bring about a double-dip recession in the US in 2013. Naive politics in pushing for more austerity and in doing more kicking-the-can-down-the-road will endure the recession to persist in Europe. Naive politics definitely ferments uncertainty and undermines public confidence. Together, they will sap business and consumer resolve to spend, spread unemployment, stall economic expansion in the advanced rich, and bring about sub-par growth among the vast BRICS economies of Brazil, Russia, India, China and South Africa. So, I am afraid naive politics will make the world a far, far more dangerous place than it already is.
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