It is very difficult to find a rational explanation for the current confused behaviour of financial markets. This is hardly surprising when there is a total lack of consensus among highly respected commentators, be they economists, journalists, investment managers, regulators or politicians whose opinions/policies are often dictated by the location from which they build their argumentation.
In the United States, the debate centres principally on the question of employment and is heavily influenced by the upcoming mid-term elections. Job creation is considered the key to restoring confidence and ranks clearly ahead of dealing with the budget or external deficits. However, the uncertainties facing employers in terms of future tax hikes, the cost of employee health insurance, the impact of financial reform on the cost of capital (including the upcoming Basel regulations) and the expiry/reinstatement of stimulus measures strongly inhibit their willingness to hire, despite having often achieved enviable profits in the early stages of the recovery. These uncertainties translate directly into renewed weakness in the housing market in which existing house sales reach new lows and foreclosures new highs, initiating a vicious circle of “wealth destruction”.
In this environment, fear of a “double dip” recession is resurfacing, giving rise to demands for a new bout of quantitative easing by the FED and a reinstatement of stimulus measures by the Government. If these calls are heeded, one can expect a further deterioration in the budget deficit and further weakness in the dollar, the latter being considered a low priority problem.
In Europe, faced with the same challenge of fostering economic growth, the absolute priority is clearly to reinforce budgetary discipline as a precondition for re-establishing confidence in the financial system. It is indeed incumbent on the weaker European States to restore the trust of investors in their respective sovereign debt issues, after the erosion of their ratings in the wake of salvaging of the banking system and financing stimulus programs (to the point where their “solvency” has been put into question). After the Greek case, which has been temporarily defused by the €110 billion EU/IMF funding facility, the capacity of the Irish Government to finance the further necessary recapitalisation of its banks (and/or the purchase of their toxic assets) is being seriously tested by market operators: borrowing spreads over Bunds have reached higher levels than at the height of the financial crisis.
The fact that the single currency removes the option of addressing the problem – even partially – through currency devaluation puts an even greater strain on corrective fiscal and budgetary measures. The ensuing austerity measures announced or in preparation by EU governments cannot fail to dampen or even stall an already anaemic recovery.
In the (unlikely) event that measures taken reach their prime objectives on either side of the Atlantic, it is hard to believe that a corresponding “unwelcome” strengthening of the € is avoidable. The EU will therefore be facing an acute dilemma between imitating the Chinese policy of accumulating dollar reserves (assets) to forestall further € appreciation (and thereby contribute to the worsening of the global structural imbalances that it strongly stigmatises) or impeding the desired European export lead recovery, as the prospect of a consumer lead recovery is unrealistic in the face a propensity of households to increase savings as a hedge against poor employment prospects and inescapable future tax increases.
Turning now to the emerging markets on which the developed world counts to reignite world economic prosperity, several remarks are in order:
Despite the high rates of growth, these economies account only for a relatively limited share of world GDP and cannot, on their own, provide the solution to the developed world’s economic problems.
In the event that growth trends in emerging markets prove sustainable, the continued strong demand for commodities and raw materials from these areas is likely to put a strong upward pressure on prices, which will adversely affect consumer prices the world over. Only a marked slowdown in economic activity could reverse the trend but this would of course worsen recovery prospects in mature markets: a catch 22 situation liable to reawaken calls for destructive protectionist measures.
China and other emerging countries are bound to continue to “manage” firmly the external value of their currencies with primary focus on their domestic priorities, justified by their “moral right” to catch up. If, for instance, in order to facilitate its exports, China decides to limit the revaluation of the Yuan versus the dollar, through continuing purchases of US Treasury securities (or other dollar denominated assets), then the EU will face even greater problems if the € strengthens against the dollar (see above).
A further “trap” is the belief that prevailing record low interest rates provide a harmless opportunity to issue additional government debt because current “servicing costs” are being reduced, easing commensurately the scope of unpopular austerity measures. Indeed, when interest rates increase - as they must if a strong recovery gets underway - servicing costs will explode, severely testing continued budgetary discipline. This will make the Central Banks task to manage successfully “inflationary expectations” particularly difficult, all the more that their actions are supposed anticipate rather than to follow developments. Authorities will then be confronted with the dilemma of killing the recovery or tolerating inflation.
The current “flight to safety” into quasi cash government securities should, on the contrary, serve as a strong warning that markets consider seriously the possibility of a double dip recession which in turn, because of the limited capacity of governments to intervene, could readily transform itself into a fully fledged depression with all its attendant political social and economic consequences. The recent speech of Ben Bernanke at Jackson Hole shows how vigilant he remains on this matter.
In his address on August 25th to the annual meeting of French Ambassadors, President Sarkosy fingered some of the burning issues facing the international community. He proposed a very ambitious agenda for the forthcoming French presidencies of the G20 and G8, putting a strong emphasis on policy coordination in several areas, some of which were touched upon here above: foreign exchange policy (developing a framework to replace Breton Woods), volatility of commodity prices (with their attendant derivative markets), stabilisation of energy markets as well as developing new governance standards etc.
However well intended and necessary such an agenda may be, including the pragmatic recognition that these subjects must be addressed without preconceived ideas, the reality is that discussions will face the inbuilt ideological rigidities that riddle the positions defended by each of the interested parties (see below). This means that any tangible results will emerge too late and that solutions, which might have been adequate to deal with current difficulties, may no longer be suited following a new crisis.
The United States are unlikely to surrender graciously the advantages of controlling the world’s major currency. Rather than devoting efforts to creating a new “artificial” multilateral world reserve asset, other major economic powers should pursue their quest for “multilateralism” by ensuring that their own currencies present an attractive alternative to the US dollar. Such an approach has the merit of replacing a negative attitude: “If I can’t have it, I don’t want you to have it” by a healthier more positive stance: “May the best win”, which is certainly closer to the dynamic American view than the defensive inward looking European mood.
France (and the United Kingdom) is similarly unlikely to surrender its seat on the Security Council in favour of a united European Union representation underscoring the implied non-negotiable limits that the President imposes on his strong plea for strengthening the EU as a major force on the world scene, thus contributing to the stalemate of UN reform that he so rightly stigmatises.
China and other emerging market and developing countries will also find ample reasons for defending tooth and nail their perceived vital interests which western powers will find difficult to reconcile with their own. The former will demand what amounts to a very considerable transfer of resources to the detriment of the latter. It is clear that this transfer has already been initiated “passively” since the first oil shock; it is, however, unlikely to be endorsed “proactively” by the industrialised world which remains immersed in an ideology dominated by the sanctity of private property, a concept that has undoubtedly served it extremely well but which is considered largely irrelevant in large areas of the globalised world.
If history is any guide, the probabilities indicate that these imbedded contradictions will finally be resolved through the unfolding of catastrophic events. This outcome is all the more regrettable that we have both the experience, the knowledge and the resources to deal constructively with these immense challenges but chances are that national and individual egoisms as well as the greed factor are most likely to gain the upper hand.
It is therefore hardly surprising that in the face of so many implicit and explicit contradictions, financial markets behave in such a highly unpredictable manner.
I would like, in conclusion, to summarise my assessment of addressing the financial in the form of a parable.
Dealing with the financial crisis can be compared to 3 men seeking treatment for gangrene.
The first goes to his doctor who recommends the immediate amputation of a leg; after a painful convalescence and having made significant adjustments to his way of life, the patient resumes a productive and gratifying activity.
The second is told that he should be patient because a conference of specialists on the subject is to be held next year at the WHO and that, in the mean time he should take some pills that should see him through the intervening period; for the next two years he has sleepless nights, anxiety paralysing any new initiative and he becomes increasingly aggressive and intolerant with his neighbours. After a two year delay both legs must be amputated.
The third patient is told not to worry, that he does not need treatment and should carry on as before; a year later his friends attend his funeral.
Deciding on submitting to amputation needs a lot of courage, but is, in the end, the only viable solution. “That those who have ears…..”.
Brussels, 27th August 2010
Paul N. Goldschmidt
Director, European Commission (ret); Member of the Thomas More Institute.
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Tel: +32 (02) 6475310 +33 (04) 94732015 Mob: +32 (0497) 549259
© Paul Goldschmidt
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