July 2010
Return to: Our market viewGrowth conundrum
A two-speed global economic adjustment has emerged in recent months. While countries such as China and India continue to power ahead, the economies of Europe and the US are barely showing signs of life. In the western world, it is fair to say that we have left the recession behind us, at least for now, but this does mean that a sustainable economic recovery is underway.
The current dichotomy of the world economy is the result of global imbalances caused by a fundamental change in capital flows, which have, broadly speaking, favoured the developing world over the developed one. Because of this, the problems currently besetting the two areas are fundamentally different. China, for example, frets about the longer-term inflationary implications of its booming economy and is under pressure to allow interest rates to rise to offset this, whereas the generally low levels of economic growth in the western world, and the resultant lack of inflationary pressures, suggest that interest rates there are set to remain low for an extended period.
Compounding the problem for the US and Europe is the fact that their meagre growth rates are largely due to the enormous stimulus packages that formed the cornerstone of the policy response to the 2008-2009 financial crisis. These packages have created unsustainable national debt levels that must be addressed at some point. Western central banks therefore face a dilemma: if they remove the stimulus measures (Germany, Spain and the UK, for example, have already signalled substantial spending cuts), they risk economic stagnation; if they do not, sovereign default risk will increase.
The next course: Japanese or Greek?
Little comfort can be drawn from recent history as to which of these options is the most favourable, since the risks inherent in both choices are significant. The first scenario is reminiscent of Japan in the 1990s, when a combination of fiscal tightening and insufficiently loose monetary policy led the country into a deflationary environment from which it has yet to emerge; with inflation already very low in Germany, for example, and little room for manoeuvre on the interest-rate front, the risk of deflation there should not be taken lightly. Equally unappealingly, the second scenario could see contagion of the Greek debt problem spreading beyond other cash-strapped eurozone states to the major European economies.
While the world economy in the 1990s was easily able to absorb Japan’s distress, the same cannot be said today should the economies of the US and Europe contract again. Too much fiscal contraction too soon, or too little too late: the tightrope walk for western central banks and governments is far from over.