Thursday 21 November 2019

US is facing a double dip but Europe is bracing for another plunge


FINANCIAL markets are frustrated with the pace of recovery in both the United States and Europe but this common distress should not be allowed to obscure crucial differences between the two economies.

Recuperation from a recession that incorporates a financial crisis is generally expected to be slow -- because large debts need to be resolved over time -- but the prospect of a return to negative growth is now apparent.

In the US, this is because the path to debt resolution has been obscured; in Europe, it is because debt still needs to be allocated in a credible manner -- and it may take another crisis to do this.

President Barack Obama will today deliver a major speech on job creation. Unemployment is stuck at 9pc so Democrats are urging a bold approach that could include new stimulus spending.

Republicans are already worried about the high level of spending and warn that larger debts imply more taxes in the future and discourage investment and growth. This is an honest debate.

Obama opted for a large stimulus when the crisis first hit -- including the nationalisation of bank debts.

The strategy gambled on a vibrant recovery to deliver the taxes needed to service the new federal debt but growth disappointed and the debt overhang has become a drag on demand.

The policy dilemma on whether to double down on the stimulus or opt for caution is in a political limbo and the Federal Reserve is also low on options. A gloomy economy could take a second dip into recession.

ECB meeting

Meanwhile, the European Central Bank will be cautious at today's meeting. Jean-Claude Trichet will again insist that fiscal consolidation in member countries is the key to recovery and will point out -- with less conviction than before -- that some member countries are growing.

Of course, when a large chunk of the European debt burden was initially diverted on to a few smaller economies, the larger -- and thereby relieved -- economies did indeed begin to recover.

But the smaller economies are sagging and banks in the core are increasingly likely to have to share the load through losses on their holdings of peripheral sovereign debt.

This prospect is undermining recovery and fuelling speculation against banks in the core that may require government support.

Still, the eurozone refuses to share the burden more widely. Leaders continue to portray the crisis as a fiscal phenomenon -- with national origins -- and deny that a common monetary and banking splurge played a significant role.

This admission could give them the necessary political space to distribute the pain but, instead, they indulge in damaging debates on how to finance "the delinquents".

Whatever the principles of the issue, it is simply not possible to divert large losses into a few economic backwaters and expect them to stay there.

In simple mechanics, a load that bears on a small portion of the available structure is more likely to tumble on to the next level and, eventually, bring collapse to the whole. Better by far to spread the load across a broader base from the outset.

IMF call

At a recent conference, the managing director of the IMF, Christine Lagarde, called for more financial support for the periphery in Europe and for further recapitalisation of the banks in the core so that they will be prepared to accept more of the strain. European leaders reacted with indignation.

At the same conference, Mr Trichet delivered yet another ode to the eurozone, noting that growth since 1999 had equalled growth in the US.

One can almost feel the discomfort with which people must have shifted in their seats as they listened to the head of a leading central bank quote data from a boom and bust in support of his confidence in the long-term stability of an economic regime.

The departing Mr Trichet is defending his legacy, of course. He knows that the structure is crumbling because the ECB's exposure to the sovereign debt of afflicted countries is growing.

The ECB is committed to acquiring even more suspect debt as Italy and Spain come under pressure and it has an escalating role to play in providing funding to banks that are suspected of harbouring losses.

In short, the ECB is losing control over the structure of its own balance sheet -- it is reacting to events rather than shaping them. And so, as often happens in these situations, the crisis has come home to its main source.

With no near-term political solution in sight, the ECB has become the next line of defence and may have to accept significant losses on its balance sheet.

Lorenzo Bini Smaghi, a board member, points to €315bn in accumulated gold profits across euro central banks that can be used to absorb these losses, in addition to €80bn in capital.

Central banks

But these billions actually belong to member central banks, and it is not clear that they will continue to allow them to be put at risk. Germany opposes the bond purchase programme and fears inflation if money is printed to defray losses.

So the next stage in the crisis will be enacted on the board of the ECB.

Gary O'Callaghan is Professor of Economics at Dubrovnik International University. He was a member of the staff of the IMF and has advised numerous governments on macroeconomic policies.

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