Although the pundits had all kinds of explanations, there was in reality little new information to justify a 500-point fall in the Dow Jones index on Thursday. That the summit in late July designed to solve the crisis in the euro zone had solved nothing was already apparent in, well, late July. The new data for US GDP that reinforced the picture of weak growth were similarly well beyond their sell-by date — they had been released on 29 July. The terms of the deal raising the debt ceiling were already known on 1 August. None of this was news. The truth is that market psychology is volatile. Investor sentiment is erratic. We saw a dramatic demonstration of that last week.
The best analysis of the week’s market moves is probably that a combination of factors, each of which was known individually, coalesced to create fears of a double dip recession in the US and Europe. In the US, the supposed anomaly baffling analysts was the apparent disconnect between GDP growth and employment. The most popular explanation was that the US was enjoying a productivity miracle, so businesses needed fewer workers. We now know that there was no anomaly and no productivity miracle: the entire story was that the earlier GDP figures were overstated.
Then there was the debt-ceiling deal which took all possibility of further short-term fiscal support for the economy off the table. No one disputes the need for fiscal consolidation in the US in the medium term. But medium term is, in practice, when recovery is secure and the economy is firing on all cylinders. The fiscal impulse had already turned contractionary because the 2009–10 stimulus was being progressively withdrawn. The debt deal guaranteed that there would be a further, albeit small, contractionary impulse starting this October. More importantly, it boxed in the Obama administration, preventing it from doing anything substantive to get the economy going again.
How likely is a double dip? Larry Summers says that the odds are now one in three. Martin Feldstein says one in two. Odds like these are telling us that no one knows. But what we can say with confidence is that the probabilities are now far from negligible.
The European situation is if anything more dismal. Fiscal policy is even more contractionary in Europe than the US. The European Central Bank (ECB) is even less supportive than the Federal Reserve. Exactly nothing has been done to resolve the debt problems of the crisis countries. Greece is still insolvent, even after the cosmetic agreement reached a couple of weeks ago to nominally restructure its debt.
Italy is ‘too big to fail but also too big to bail’. Its problems can be solved only by a combination of three policies. First, a primary surplus of 5 per cent of GDP, which holds out real hope of reducing the country’s public debt. Second, structural reform sufficient to get growth going again. Third, support for the Italian bond market from the ECB for as long as it takes to put those other elements in place. The first two components will require a new Italian government, the third a new ECB president. Both are coming. Whether they arrive in time to avert disaster remains to be seen.
How worried should Asia be? The situation is far less manageable than it was in 2008–9. Then it was possible for China to pull out all the stops and unleash a massive fiscal stimulus. To support investment spending, it could instruct the banks to lend like there was no tomorrow. Today Chinese policy makers have less room for maneuver. With inflation already running at 5 per cent, they are anxious to rein in bank lending. Credit policies that inflated further an already expanding property bubble would not be helpful. Then there are worries about the balance sheets of financial institutions, like the credit cooperatives that financed local government’s infrastructure projects. Standard & Poor’s has already warned that a third of their loans may have to be written off. More generally, analysts are concerned that the public-sector debt burden, considering all levels of government, is higher than suggested by the headline figures and higher than is healthy for an emerging economy.
Add it up and it is clear that the Chinese authorities will not be able to respond as vigorously as in 2008–9. Were China’s exports to the West to drop off as sharply as they did then, there would be no way that the government could substitute a commensurate amount of domestic spending. Chinese growth would fall. The implications of other economies that sell parts, components and, above all, raw materials to China would not be pretty.
Barry Eichengreen is George C Pardee and Helen N Pardee Professor of Economics and Political Science at the University of California, Berkeley. His new book is Exorbitant Privilege: The Rise and Fall of the Dollar (Oxford 2011).
An outstanding analysis. Politicians and policy makers in Australia should take strong note.
Barry is, as always, lucid and succinct. The room for policy maneuver for any of the G-3 or China is reduced as a new global financial storm darkens the horizon. The silver lining, though, is the suddenness and volatility that equity markets have shown in the last few trading days. Moves like these are signs of panic that can reverse when met with central banks willing to act, as the ECB now is, as buyers/lenders of last resort.
As Barry points out, markets have to deal with a weaker outlook, but it is not clear that they will have to adjust to the vicious circle of declining asset prices worsening financial conditions, worsening real growth prospects, worsening asset prices . . .
If panic, rather than the material impairment of the global financial/trading system we saw in late 2008, is a large component of the events of the last few days, then concerns about the scope for China or the rest of Asia to adjust are better.
So, too, are number of defenses of Asia. Relative to the inflation Asia faced in 2008, today’s situation is improved. In China, inflation was running over 7-8% as crisis unfolded in the summer of 2008.
International reserves relative to short-term debt or foreign asset holding across Asia are generally lower, while better relative fiscal positions are also helping lessen the likelihood, severity or impact of capital flight.
Analysts are worried about contingent liabilities in China’s banking system. Barry cites the S&P’s concerns. But S&P’s professionalism in tracking the debt of local governments is no better than the sums they did on the US debt (what’s $2 trillion among friends). In China’s case, news agencies widely reported CNY3 trillion in local government debt that S&P claimed was unaccounted for by China’s National Audit Office. But that “missing” debt was crudely arrived at by assuming that every province had the debt level as a share of GDP held by the most heavily indebted!
The local government debt problem isn’t likely to be a real brake on a stimulus package. In the face of panic, China still has the huge advantage of owning significant swathes of both the financial system and the real economy. It will use that advantage.
There is a new wrinkle already, though, to China’s response to this market turmoil. Rather than fixing the yuan against the US dollar as it did in mid 2008, China has accelerated the pace of yuan appreciation. China’s move is likely driven by a desire to slow its accumulation of foreign assets, especially US dollars. Whatever, the reason, a stronger yuan will imply a larger market in China for the rest of the world–a welcome port in this financial squall.