This article was originally published August 12, 2011, on FT.com.
Any further mis-steps from American and European policymakers risk converting raging crises within the global economy to a more devastating crisis of the global system. That is how fragile the situation is; and it is why the world risks not just a recession but – even more worrisome – a prolonged one.
A morphing of the crisis would significantly change the odds for its successful and timely resolution. You see this already in Europe, where too much policy dithering has enabled dislocations to migrate from the periphery to the core. Just witness the mounting alarms about a possible French sovereign downgrade and, more importantly, the enormous pressures on European banks.
The initial crisis in Europe’s periphery required complex and unfortunately poorly-handled decisions about burden-sharing within the eurozone, as well as between taxpayers and private creditors. The contamination of the core now puts the very integrity of the single currency area at risk. In the process, the potential adverse implications for other regions in the world multiply in an alarming fashion.
Proper diagnosis is essential if policymakers are to finally get it right. Otherwise they will remain hostages of the type of ad hoc, partial and uncoordinated response that, ironically, fuels rather than arrests a crisis.
So, why is the global economy now risking a system-wide crisis? Undoubtedly, four recent developments have acted as catalysts: the extent to which America’s debt ceiling debacle eroded trust in the political elite; the country’s loss of its triple A rating; the failure of Europe to follow up promptly on summit declarations; and indicators of a synchronised weakening of activity across major regions of the global economy.
But if these were the main issues, unprecedented actions taken in the last week would have acted as a decisive circuit breaker. After all, the European Central Bank – a “Germanic” institution – became even more of a fiscal agency last Sunday by agreeing to buy Italian and Spanish government bonds, with European governments moving to ban short selling on Thursday. In America, the Federal Reserve overcame on Tuesday three public dissensions to signal that its policy rate will probably remain floored at 0 per cent for two more years.
Yet the ability of such dramatic actions (particularly those by central banks, which were deemed unthinkable just a few weeks ago) to act as durable circuit breakers is questionable. Indeed, recent developments confirm a worrisome trend that has been evident for two years now – policy outcomes have consistently fallen short not only of what is needed but also of policymakers’ own expectations.
If policymakers were to step back, they would quickly recognise that policy transmission mechanisms are severely undermined by structural weaknesses. Like clogged pipes, the output of actions is only weakly related to the input.
In America, this takes the form of persistently-malfunctioning housing and labour markets, uneven banking activity, poor infrastructure and medium-term fiscal rigidities. In Europe, the list also includes immediate debt solvency problems, fiscal governance issues and more severe competitiveness difficulties.
Such regional shortfalls have been accentuated by a stunning lack of effective multilateral coordination. As an example, Sunday’s Group of Seven communiqué met indifference among the few that actually read it; and neither the Group of 20 nor the International Monetary Fund appear engaged.
To get out of such an impasse, central bank crisis management remains critical; and it will probably involve further balance sheet operations and monetisation of debt. As critical as this is, it is unlikely to prove sufficient unless it is quickly accompanied by better policy framing at both the national and global level.
In this specific area, the world should learn from one aspect of China’s economic policy approach. If it does, it would do three things differently. First, it would get buy-in from broad segments of society for medium-term policy objectives (in this case, high growth, greater employment creation and financial soundness). Second, it would link the objectives to specific structural reforms that are implemented simultaneously and – equally importantly – owned, closely-followed and coordinated at the highest political level. Thirdly, it would build institutional flexibility that facilitates timely midcourse corrections if needed.
You would be surprised how effective such a reframing could be in overcoming the political squabbles that undermine the specification and implementation of individual measures. It also allows for much more effective global coordination.
The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilised financial markets. If policymakers do not act boldly, and do so in a globally-coordinated fashion, the world risks tipping into a prolonged recession with worrisome institutional, political and social consequences.