By John Greenwood, Chief Economist, Invesco Ltd.
The crisis in the eurozone is no nearer resolution. I believe without a fiscal union, the monetary union will collapse either as a result of accelerating bank runs in the periphery, or as a result of elections that bring radical leaders to power. Either set of events could cause moderate leaders in the core to lose control of events, resulting in an exit for one or more of the crisis economies.
Unfortunately for the monetary union, euro-area leaders are as reluctant as ever to embark on a far-reaching fiscal union because a federal Eurozone Treasury with powers to tax, control spending and issue bonds would be incompatible with the retention of national sovereignty.
The EU represents about one-fifth of global gross domestic product (GDP). Consequently, the crisis in the eurozone is not only generating a recession in the region, but is severely hampering global trade and undermining growth in the UK, eastern Europe and North America — as well as growth in export-dependent Asia. Further global economic weakness seems unavoidable until a credible, sustainable resolution to the euro-crisis is within sight.
In the US, which had been enjoying a better recovery than the UK or Europe, real GDP growth appears to be losing momentum again. The current policy impasse has shifted attention to the possibility of a "fiscal cliff" in early 2013 — i.e., the risk of a sharp cutback in government spending and a simultaneous rise in taxes together creating a hit to GDP of between -3% and -5%. In the meantime, monetary policy has limited ability to induce households or firms with debt-impaired balance sheets to spend more vigorously. Private investment is slowing — possibly in anticipation of the withdrawal of fiscal stimulus — and consumer confidence has been falling.
|Figure 1 - Inflation and Growth Forecasts|
|2011 Actual||2012 Forecast|
|Real GDP (%)||CPI Inflation (%)||Real GDP (%)||CPI Inflation (%)|
|US ||1.7 ||3.1 ||2.3 ||2.2 ||2.3 ||2.0|
|EU-17 ||1.5 ||2.7 ||-0.1 ||-0.3 ||2.4 ||2.8|
|UK ||0.7 ||4.5 ||0.4 ||0.3 ||2.9 ||2.8|
|Japan ||-0.7 ||-0.3 ||2.0 ||2.7 ||-0.1 ||0.6|
|Australia ||2.0 ||3.4 ||3.0 ||3.0 ||2.0 ||1.6|
|Canada ||2.5 ||2.9 ||2.1 ||2.2 ||2.1 ||1.9|
|China ||9.2 ||5.4 ||8.3 ||8.0 ||3.4 ||3.5|
|India1 ||6.7 ||8.4 ||7.2 ||5.6 ||7.2 ||7.6|
In China, the economy has avoided a hard landing, but it is clearly still slowing under the pressure of domestic and external factors. On the domestic side, the policymakers are still trying to bring shadow bank lending and property prices under control, while on the external side there are numerous signs of exports slowing further.
In view of the global economic weakness, central bank policy rates in the developed world are likely to remain close to the "zero bound" for an extended period, with policymakers periodically resorting to central bank balance-sheet expansion via asset purchases. In this situation, it is expected that investors will remain in a search-for-yield mode. This will in turn cause quality assets that generate safe and sustainable yields to be bid to a premium relative to assets generating lower income streams.
One consideration is that despite efforts at quantitative easing (QE) by different central banks, there is unlikely to be any upsurge in asset prices as there would have been in the past following traditional liquidity boosts. A second is that inflation is likely to fall more than expected in the second half of the year. A third is that commodity prices are likely to weaken further during the rest of the year.
Following a series of relatively favorable economic data releases in January and February, most of the economic data points released in the second quarter have again been disappointing and below expectations. This applies to housing, the labor market, investment, retail sales and consumer confidence. In addition, investors have become much more keenly aware of the possibility of an adverse fiscal shock that is likely to knock back real GDP growth by as much as 3% in the early months of 2013 if Congress does not act to mitigate the consequences of the impending fiscal contraction.
The pace of US recovery in this cycle has been notably weaker than in the average of past recoveries since 1970. Two theories have emerged to explain this sub-par performance. One theory argues that the US economy has been permanently damaged by the severity of the preceding recession of 2008 to 2009, and as a result the engine of growth will not be as strong going forward. This helps to explain why the unemployment rate has remained stubbornly high, why companies have been reluctant to invest despite having ample cash resources, and why excess capacity remains a feature of the post-recession economy.
An alternative explanation — which I prefer — is that the bubble and the recession caused serious damage to the balance sheets of the household and financial sectors, with both taking on excessive debt, and that it simply takes many years for individuals (who cannot raise capital and who are reluctant to sell their homes to raise the cash needed to repay debt) and financial institutions to repair their balance sheets. During this period of extended recuperation, real GDP growth is adversely affected because households are either cutting back consumption to increase savings and pay down debt, and/or investment is reduced because some of those savings are being used to repay debt rather than for new investments.
One reason I prefer the latter theory is that it helps to explain why monetary and fiscal policy have been unsuccessful in generating a normal recovery on this occasion. The US Federal Reserve (the Fed), for example, has engaged twice in large-scale QE operations, and since September 2011 it has bought $400 billion in long-dated US Treasuries and sold short-dated Treasuries in "Operation Twist." The Fed recently announced an extension of Operation Twist to December with an additional $267 billion of purchases and sales. But whether it has expanded its balance sheet or flattened the yield curve,1 the impact on asset markets has been short-lived, and the effect on real GDP growth has been limited. The problem is that both sets of operations are designed to boost spending — something indebted households and firms are reluctant to do — and neither operation significantly accelerates the process of balance sheet repair for households or financial institutions.
The risks to the US economy from the potential fiscal cliff after the presidential election in November arise from expiring tax legislation and the automatic application of certain "sequestrations," or spending reductions. Specifically, eliminating the Bush tax cuts that have already been extended for two years since 2010 would increase personal taxation by some $140 billion; the payroll tax cut, if reversed, would add roughly $95 billion to employment costs; scrapping the alternative minimum tax (AMT) would cost middle-income households another $90 billion; and the removal of other tax cuts would cost $100 billion, for a grand total of $425 billion in increased taxes.
On the spending side, unemployment insurance is set to be reduced by $26 billion, while sequestration applies to $52 billion of defense spending and $13 billion of health care annually, for a total of $91 billion per year. If implemented together, tax increases of $425 billion and spending cuts of $91 billion amount to a net contraction in the federal deficit of more than $515 billion, or nearly 3.5% of GDP — a drastic change by past standards.
Of course, nobody knows what will happen. It is possible that the lame duck Congress will be able to pass amending or extending legislation, but it is equally possible that gridlock will prevail. What I believe is that uncertainty will rise toward year end, which could lower planned business investment and consumer spending.
Looking forward, I expect real GDP growth to average 2.3% in 2012 — well below the normal 3% to 4% that is typical of the early stages of a recovery. Nevertheless, while I expect growth to remain moderate, in my view the current economic upswing will be sustained. However, I expect to see inflation fall significantly in the second half of 2012, with headline CPI inflation declining to 1.6% by year end or 2.2% for the year as a whole.
As this outlook was being written, the euro-area leaders of 27 nations were gathering in Brussels on June 28 and 29 for the 19th summit in a long series of meetings that have attempted to craft a solution to the continuing debt crisis in the eurozone.
On the agenda for consideration was a plan drawn up by European Union (EU) President Van Rompuy, EU Commission President Barosso, Euro Finance Group President Juncker and European Central Bank (ECB)
The plan proposed "developing a vision for the EMU" (Economic and Monetary Union) around four building blocks: an integrated financial sector, integrated budgetary and integrated economic policy frameworks, together with ensuring "democratic legitimacy and accountability." This plan is to be achieved over the next decade.
Concretely, the proposed financial framework only calls for "single European banking supervision and a common deposit insurance and resolution framework," while in the budgetary arena the plan only calls for "a qualitative move toward a fiscal union." In the medium term it says that "the issuance of common debt could be explored," and "steps toward the introduction of joint and several sovereign liabilities could be considered as long as a robust framework for budgetary discipline and competitiveness is in place to avoid moral hazard and foster responsibility and compliance." A more detailed interim plan is proposed for October, with a final report in December.
These ideas still fall a long way short of what is required to ensure that the European monetary union is genuinely robust and sustainable. The proposal to create a "single European banking supervisor and a common deposit insurance and resolution framework" may be fine for containing or addressing the next crisis, but as far as the current crisis is concerned, the horse has already bolted. In essence, I believe these elements are a sideshow and will not stop the current banking and debt crisis from escalating.
On June 29, it was announced that the eurozone leaders had agreed to permit the European Financial Stability Facility/European Stability Mechanism rescue funds to be used to recapitalize banks directly without first being lent to governments, but only after an overall euro-banking supervisor has been set up. This should help to weaken the toxic link between sovereigns and banks, but it does not put the solvency of euro-area banks beyond doubt, and it does not resolve the problem of the sovereign debt markets, given that the total rescue funds (€500 billion) are only 20% of total Spanish and Italian government debt (€2,400 billion). It was also agreed that loans by the rescue funds for bank recapitalization would not rank senior to private creditors, an important condition for ensuring continued private sector buying support for peripheral sovereign debt. These are small steps in the right direction, but a long way from a comprehensive solution.
To see what is needed to solve the euro-debt crisis once and for all, it is helpful to ask not "What else can be integrated?" or "How many banking or other unions can be created?" but "What protection can a depositor expect when placing funds with euro-area banks?" Banks are leveraged institutions and therefore potentially very vulnerable to losses or deposit withdrawals. Normally, in a sound monetary system, there typically would be several layers of protection available to worried depositors. The problem is that the eurozone fails in the vital, final or ultimate layer of protection — namely, government protection.
This is the fundamental reason why I maintain fiscal unions must precede monetary unions, and why fiscal unions must be contiguous with monetary unions. In modern economies with fiat money systems, the ultimate guarantor of people’s money is the state. But if the state is already overindebted — as in Europe’s peripheral member states — and cannot act to rescue the banks, then the crisis could easily be exacerbated by deposit withdrawals or bank losses. Already in the eurozone today there are silent bank runs occurring in Greece, Spain, Portugal and Ireland. There is now a serious risk that these runs could intensify, tightening the financial squeeze and deepening the recessions.
Yet almost all of the member states are resolutely opposed to giving up their national sovereignty in favor of a federal eurozone Treasury with full powers to tax, spend and borrow on behalf of all members. The refusal to correct this fundamental flaw in the architecture of the eurozone risks is tearing the edifice apart.
But consumers are instinctively aware of the problem and are seeking to protect their funds by deposit withdrawals. In the face of this crisis, it is to be hoped that the eurozone authorities can act with speed and firmness. However, it is sadly probable that the euro-area institutions are too complex, too bureaucratic and too legalistic to be able to respond promptly.
The best hope for the eurozone as a whole is that the ECB provides additional three-year long-term refinancing operations (LTROs), fuelling a strong recovery in Germany and other core economies. This could have favorable spill-over effects on the struggling peripheral economies, encouraging southern eurozone exporters and raising relative prices in the core. In practice, however, the recessions in seven eurozone economies — mainly in the periphery — are starting to drag down the economies of the core. In Germany, for example, retail sales fell in April and May, while Germany’s IFO business conditions survey also weakened in May. For the year 2012 across the eurozone as a whole I expect -0.3% real GDP growth and 2.8% CPI inflation.
Real GDP growth in the first quarter of 2012 was negative for the second quarter in a row, putting the UK economy back in recession according to the common yardstick. The other significant development in the quarter was the surprise decline in the CPI inflation measure to 2.8% year-on-year in May. In my view, both of these developments are consistent with the abnormally low rates of monetary growth since the second half of 2009. The combination of low money growth and rising import prices had been squeezing households’ purchasing power, and the economy is showing the symptoms in the form of weaker nominal and real spending growth.
The main reason for the UK economy’s weak performance last year was the erosion of personal incomes in real terms by high inflation. The outlook for inflation will therefore be crucial to the restoration of economic growth over the next two years. In this respect, the surprise decline of CPI inflation in May to 2.8% was a positive development, and I expect it to fall to 2% by year end (2.8% for the year as a whole). However, real GDP growth for the year will remain in my view very weak at 0.4%, adversely affected both by the eurozone crisis and by the effects of high inflation in the first half of the year.
China is facing two types of economic slowdown: a self-imposed domestic slowdown following the panic measures of credit expansion in 2008 and 2009, and an involuntary downturn in exports to its major markets — Europe and the US. Neither slowdown looks likely to be turned around quickly.
The domestic slowdown is necessary on account of the overheating generated by the excessive surge in money and credit associated with the stimulus policies of 2008 and 2009.
The external slowdown is more problematic for China. Employment in the export-related sectors is huge, and much of the economy’s enormous investment program is tied to exports. Another clear sign of ongoing concern by policymakers about the outlook is that the authorities have frozen the appreciation of the Chinese currency against the US dollar, exactly as they did between July 2008 and June 2010. In fact, they have even allowed some depreciation.
For 2012 as a whole I expect 8.0% real GDP growth and 3.5% CPI inflation.
Following the disastrous tsunami of March 2011 and the subsequent electricity supply problems, the economic recovery has shown two quarters of strength, but is not expected to maintain this pace.
For example, the Bank of Japan’s Tankan (short-term outlook) survey has been negative over the past two quarters, and industrial production fell sharply in May, although some of this was due to the timing of holiday dates. Overall, Japanese economic output remains in a gradual uptrend that is expected to continue during June and July, according to Ministry of Economy, Trade and Industry’s (METI’s) survey.
For the year as a whole I expect 2.7% real GDP growth (largely due to favorable base effects) and 0.6% headline CPI inflation.
Most East Asian economies have experienced some further weakening in growth in the opening months of 2012, especially as their exports have slowed. Exports of Taiwan and Korea, for example, both fell in year-on-year terms in May, the third successive month of decline. The data from these two economies is significant because both economies are heavily industrialized and, therefore, their export performance is closely related to the strength of consumer demand in the developed economies of Europe and North America. In addition, because both economies succeed in producing their trade data reports within a few days of the month end, they act as lead indicators for other economies in the region.
The June consensus forecasts for real GDP and inflation put Asia ex-Japan’s real GDP and CPI inflation in 2012 at 6.4% and 3.9%, respectively.
Having rallied between early October 2011 and late February of this year as economic growth in the US and elsewhere took a temporary upswing, commodity prices have subsequently sold off.
The decline in oil prices since March has been steep and striking, and metal prices have generally followed crude oil prices downward with a short lag since peaking in February or March, but have not yet fallen as far.
Agricultural and food prices have been more mixed, with wheat and coffee prices falling but soybean prices rising. In broad terms, commodity prices have been weakening in the cold light of disillusion about a global recovery or rising inflation. My view is that, except in the event of a shock such as conflict with Iran, commodity prices are likely to weaken further in 2012, reducing headline inflation rates in most economies.
The seemingly unending eurozone debt crisis is the single most worrying problem for the global economy, but unfortunately the June 28 and 29 summit meeting of eurozone leaders did not put an end to the fundamental flaws in the architecture of the single currency.
The US, meanwhile, is expected to continue to grow at a moderate rate, well below its potential, as balance sheets in the household and financial sectors are repaired.
The UK is following in the track of the US in terms of balance sheet repair, but starts from a worse position due to the greater leverage of its banks and households going into the downturn, and the larger size of its government sector, but also due to its proximity to and export-dependence on the eurozone.
Elsewhere, major exporting economies of the emerging world such as China, the other East Asian tigers, and Brazil are also expected to continue to be caught in the eurozone downdraft.