Watchman Newsletter

The coming global financial crisis

MSN Money (Link) - Jim Jubak (June 13, 2011)

Politics virtually guarantee that the global economy won�t go into crisis in 2011. Politics make it extremely unlikely that the global economy will slow down as much as the market seems to fear. Politics, in fact, put a safety net under the global economy this year.

And politics also virtually guarantee another, deeper crisis in 2012 or 2013. I�d bet 2013.

How come? You see, just about every politician in the world is trying to kick an economic problem down the road into 2012 or 2013. I think they�ll succeed in postponing the day of reckoning in 2011 using a combination of funny accounting, additional spending and subsidies. But the price for that postponement will be that problems will be bigger and harder to truly solve in 2012 or 2013 than they are now. And that will raise the odds that the global economy will face another serious crisis -- just five years or so after the last one.

This kick-it-down-the-road effort is most obvious in the eurozone, where the effort to put together a new rescue package for Greece really comes down to putting off a Greek default from 2012 to 2013 or 2014.

But the effect is also visible in the United States, where I think the most likely result of negotiations in the U.S. to raise the debt ceiling will be to kick the problem into the 2012 election campaign, with a �solution� postponed to 2013. You can also see it in China, where the leadership that takes over in 2012 and 2013 from President Hu Jintao will be extremely reluctant to rock the boat until it�s firmly in power.

Altogether, this politics of delay means that in 2011 the global economy will get enough stimulus to keep growth at the relatively high levels that politicians need to keep voters reasonably happy. Politicians won�t even think about making the tough choices that might inhibit growth until well into 2012.

Greece example is clear

You should be familiar with the politics of procrastination from my posts on the Greek debt crisis. The original rescue plan for Greece, cobbled together last year with funding from the European Union, the European Central Bank and the International Monetary Fund, turned out to be an all-too-hopeful effort to push the problem down the road into 2012. The thinking last year, when the rescue program was put together, was that if Greece could get enough cash from a European Union rescue program to get to 2012, the country would have enough time to get its house in order so it could start to finance its debt from private investors again.

That turns out to have been exceedingly optimistic (I�d call it just plain wrong). Greece has failed to quickly reform its dysfunctional system of tax collection; instead, the country has continued to collect less tax than it is owed (and less than it promised its rescuers it would collect). Meantime, budget cutting and asset sales -- while painful enough to elicit widespread protests in Greece -- haven�t lived up to projections, either. Add in the effects of the all-too-predictable slowdown in the economy as a result of these measures, and Greece clearly won�t be embraced by financial markets in 2012 and maybe not in 2013.

Efforts at a new package are held up now by fighting between the German government and the European Central Bank about whether bondholders should be required to extend the maturity of Greek bonds as part of any deal. But the real focus of the talks is on getting enough money from the European Union, the European Central Bank and the International Monetary Fund to support Greece until 2013 or 2014 when -- hope springs eternal -- Greece will be able to sell debt in the financial markets again.

The political imperatives driving this thinking are clear. The only alternative to this deal -- if it can be sold to voters in Germany and other northern European countries and assuming that it works -- is a painful re-examination and restructuring of the entire euro project. In the current political climate it�s unlikely that voters in the northern or southern eurozone would approve a restructuring that actually dealt with the problems of running a single currency for economies as different as those of Germany and Greece. Kick the problem down the road and hope seems like a pretty good alternative to European politicians.

US and the debt-ceiling debate

The situation is totally different in the United States, but the result is remarkably similar. In the U.S., the presidential election looms in 2012, and the anemic recovery is the issue where the Obama administration is most vulnerable to Republican attack. The Republican opposition certainly doesn�t want to strike any deal over the debt ceiling -- the U.S. will run out of room to borrow in August, according to the U.S. Treasury. That would remove the shocking state of U.S. finances from the minds of voters.

On the other hand, pragmatic Republicans don�t want to force the United States into even a technical default on its debt in August and risk creating a crisis a year too early or getting blamed for any crisis. Democrats, for their part, would like a deal this year that doesn�t preclude the chance that the economy will pick up speed and look better in June 2012 than it does now.

That�s why, in my opinion, the most likely outcome isn�t a crisis this year but some patchwork compromise that gives both sides potential ammunition for 2012 and pushes off the hard work on reducing the U.S. deficit into 2012 or into the post-election period.

That would mean odds are relatively low that negotiations in Washington will produce budget cuts large enough to make a difference in the deficit or turn the current anemic slowdown into a double-dip recession. It�s more likely that U.S. fiscal policy will remain muddled, with the Federal Reserve able to hold growth at 2% -- or perhaps even better if the first-quarter slowdown was a result of temporary factors stemming from the Japanese earthquake and tsunami.

By 2013, no matter how the election goes, the Federal Reserve will be under almost unbearable pressure to reduce its balance sheet and raise interest rates. That�s when global bond markets will really pressure the United States to come up with a plan -- at the least -- for reducing its budget deficit over the long term.

As for China . . .

China won�t hold U.S.-style elections to pick its next leaders, but the politicking is no less intense just because it�s done behind closed doors and is limited to a handful of candidates at the top of the party hierarchy. All the evidence now points to intense jockeying as candidates for power try to move up the hierarchy as far as they can during the transition. The revival of Maoist slogans, songs and work campaigns in some regions in China are signs of that.

This transition is likely to be especially hard fought, because it marks the emergence of the so-called �princelings� onto the stage. The last generation was a transitional one between those who had led the revolution and the new generation, which is composed of the sons and daughters of revolutionary leaders. For example, Xi Jinping, the almost-certain successor to current President Hu Jintao, was born in 1963. His father, Xi Zhongxun, joined the party in 1928 and was deputy prime minister of China from 1959 to 1962. That background presents a generational contrast with Hu, the current president, who born in 1942, was a student during the Cultural Revolution and began his climb up the party hierarchy in the 1980s.

There are more princelings than leadership slots, and the princelings themselves represent a wide range of ideological positions, from economic reformers to cultural hard-liners who see the widespread corruption in China�s government as a sign that Chinese capitalism and democracy have gone too far.

You can imagine that no one set on moving toward the upper ranks of power wants to report a slowdown in growth in any region under his responsibility or to rile any of the economic powers that depend on government subsidies or credit. I think you can count on the politics of the 2012-2013 transition to favor a continuation of easy bank credit for the biggest Chinese companies, limited efforts to fight inflation and economic growth above 8% -- regardless of rhetoric.

After 2012-2013 all bets are off, however.

Economist Nouriel Roubini, famous for his early call on the global financial crisis, has recently pointed to the danger China faces of an economic �hard landing� after 2013. Beijing added massive stimulus to China�s economy in 2008 to head off damage to the Chinese economy from the global financial crisis. The government has been relatively unsuccessful in slowing the growth of the money supply, bank credit and fixed investment that helped boost growth -- even though the global crisis is clearly in the rearview mirror of a Chinese economy growing 10% a year.

That has led to a major distortion in the Chinese economy, Roubini says, because economic growth in China increasingly depends on investment in fixed assets that may not be economically productive in themselves but produce massive profits for well-connected Chinese officials and businesspeople. That has led to a serious bad-loan problem in China, he says, and has produced massive amounts of excess industrial capacity.

No one will challenge current policies during the leadership transition, but once leaders are in place, China will have to confront these problems. That will mean, I�d say, not only further attempts to dampen bank lending and raise reserve requirements but serious escalation of the battles on these fronts. It will mean new steps to fight inflation. And it might even mean willingness on the part of the new leadership to sacrifice some economic growth to achieve these ends.

One possible alternative to slower growth would be a shift from growth based on exports and investment in fixed assets to one based on domestic consumption. But that would require shifts in the economy -- and challenges to powerful interests in that economy -- that could be even more disruptive than a slowdown in growth.

If I�m right about the way that the political schedule works, it should provide support in 2011 that�s sufficient to avert the economic slowdown that the financial markets fear at the moment. The bad news, of course, is that the actions of the politicians that support growth now will have to be paid for in 2013. �

America ~ Economic Crisis ~ Europe ~ Kings of the East