London: Is Europe and America On The Brink Of Recession ?

18 Aug

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Video: ‘Dangerously Close To Recession’ Warns Bank 

Europe and America are on the brink of recession. Or at least they are according to Morgan Stanley.

In a rather ominously-titled research note – ‘Dangerously Close To Recession – the investment bank cut next year’s world growth forecast and forecasts for pretty much every major economy, including not just the euro area but also China and India.

In one sense, this analysis is quite right – the world economy is facing the prospect of a double-dip slowdown.

That, in the end, is what is spooking markets these days, along with the compounding issue that politicians seem incapable of addressing their deficits.

We have been well aware for some time that the crisis did not end in 2008; that banking debts were instead merely transferred across to sovereign balance sheets, setting us up for a far bigger crunch at some point in the future.

And there is no doubt that should the world’s big economies slow down – as indeed they have done in the second quarter of the year – we will all feel the impact.

But it is worth pointing out that worldwide growth prospects are far from identical.
To understand why, we need to look at money growth figures.

Money statistics measure the amount of cash flowing around an economy, in particular cash and current account balances.

Although it is rather out of fashion as an economic statistic, it nonetheless provides an indication of the direction in which certain economies are heading.

The Bank of England monitors these obscure statistics, and economic theory (the quantity theory of money, to be precise) says there is a direct relationship between money growth and the overall expansion of an economy (GDP).

The briefest look at the growth rate of so-called narrow money – specifically money changing hands on the street, and through debit card payments – shows that the real problem here is Europe, not the US.

Euro area money growth has slumped down to similar levels as were seen in the height of the recession in 2008.

And yet despite this obvious economic crunch, the European Central Bank saw fit to raise interest rates twice this year, piling further pressure on consumers.

According to Simon Ward, Henderson’s chief economist: “If the global economic upswing expires, the ECB’s finger-prints will be all over the murder weapon.

“The decision this year to increase interest rates despite a contracting real money supply ranks among the most egregious monetary policy blunders of recent decades, on a par with the Bundesbank undermining the Louvre accord to stabilise the dollar by hiking rates in 1987, thereby triggering the October stock market crash.”

Amid all the attention which has been paid to the separate issue of eurozone sovereign debt crises, this important point has been somewhat forgotten.

The ECB’s decision to raise rates in April looked rash at the time; in retrospect, it looks heinous.

Morgan Stanley’s warning is right: the developed world is on the brink of recession.

But the causality should be clearer: if the slump does indeed transpire, it will be European policymakers who are to blame.

Britain, meanwhile, will face further buffeting from this storm but, so far, remains the dog that has not barked.

UK borrowing costs remain low, the economy is still expanding – albeit very sluggishly – and Morgan Stanley believes Britain is one of the few countries not on the brink of recession.

I am less optimistic.

Though the Chancellor is to be commended for taking early and confident action to intervene and impose austerity, the sheer scale of Britain’s vulnerability (highest debt load in the world, biggest reliance on finance) means it will take a superhuman amount of luck and effort to avoid a further bout of bad news.

You only have to look at the performance of Britain’s bank shares (many of them down 50% in the past six months) to realise that the UK economy remains extremely sensitive to poor overseas sentiment.

That said, the retail sales figures released by the Office for National Statistics this morning were neither disastrous nor reassuring.

And if the worst to come from the next few years is tepid economic news, I do not think George Osborne would complain.

NEWS UPDATE:

Here we go again. The markets today have been hit by a trifecta of worries.

First, data on unemployment claims, manufacturing and existing home sales lent weight to the case that the U.S. economy is slowing. (Of course, other data released this week, such as the leading economic index and retail sales suggests the U.S. economy continues to plow along at a positive, but not satisfactory, rate.)

Second, Morgan Stanley and Goldman Sachs downgraded their forecasts for global growth in 2011 and 2012. Stocks are leveraged bets on growth. The big firms that populate the Dow Jones Industrial Average and the S&P 500 now get a very large chunk of their revenues, and much of their growth, from overseas. The prospect of a growth slowdown in China and India is far more daunting to investors than the possibility that U.S. and European growth could fall.

Third, there are continuing problems emanating from the euro zone. Growth seems to have stalled in both France and Germany, the engines of the continent’s economy. The big fear this week is that French and German banks might suffer a two-fold blow. They’re heavily exposed to government and private-sector debt in Greece, Spain and Italy — countries whose ability to repay debts is being questioned. And they’re also heavily exposed to consumers and businesses in their suddenly flat home markets.

Of the three problems listed above, it’s the last that I find most troubling.

(In the accompanying video my Daily Ticker colleagues Aaron Task and Henry Blodget also express concern and discuss why the sharp selloff suggests the rally late last week and Monday was a reprieve rather than the end of the decline.)

Investors are now in a situation in which stability — and perhaps their ability to sleep — rests on effective European collective action.

Read the Financial Times, or read some histories of 20th century Europe, or spend some time in Budapest and Prague (as I did last month), and a theme emerges: European governments and institutions have been very poor at crisis management. Time and again through history, minor disputes over religion, borders or royal succession turned into wars that persisted for decades. The 1914 assassination of Archduke Franz Ferdinand by a Serbian separatist led to a devastating, continent-wide war that ultimately drew in the U.S. The 1920s and 1930s brought hyperinflation, banking system meltdowns, and the rise of Hitler. You can’t spend 15 minutes in Prague without learning how Europe collectively sold out independent Czechoslovakia to Nazi Germany in 1938.

In the post-war era, Europe finally seemed to get its hands around the problem of collective action. The creation of NATO bound Western Europe together in a security alliance. The creation of a (very weak) common government, a (stronger) common market, and a single European currency under a single monetary policy lead many to believe that the United States of Europe had finally arrived. (See, for example, T.R. Reid’s 2004 book: The United States of Europe: The Rise of a Superpower and the End of American Supremacy)

The collective arrangements worked well in the era of long expansions, from 1990 through 2008. But the European response to the rolling problems of sovereign credit debacles, banking system failures, sluggish economies and the need for reform, has been plagued by timidity, poor coordination and design flaws.

The difference between the United States of America and the (putatively) United States of Europe is instructive. In the fall of 2008 and winter of 2009, the U.S. central bank came in heavy, placing near-blanket guarantees on the nation’s financial markets, and bailing out banks and investors from all over the world. The political system followed with a decent-sized stimulus — spending increases and repeated rounds of tax cuts. Meanwhile, while plenty of pain was delayed, the private sector was encouraged to get its house in order.

Europe has followed almost the opposite approach to its crises. Since problems cropped up in Greece, Ireland, Portugal and Spain, the European response has been a piecemeal one: tentative guarantees, hemming and hawing over bailouts, and half-measures. The collective action broke down over national differences. Many European leaders regard the activities as button-down northern Europe bailing out free-spending Southern Europe. (There’s an element of truth to that. But by bailing out the countries of Ireland, Greece and Spain, the Europeans are really bailing out the banking systems of Germany and France.)

Rather than respond with collective fiscal stimulus, Europe has responded with collective fiscal contraction. In every instance, the price of the bailouts has been huge budget cuts and tax increases. The U.K. austeritized itself in the absence of any severe market or institutional pressure. The European policy-making elite believes that raising taxes and cutting budgets sharply in a time of slack demand would somehow lead to lower interest rates, greater confidence, and greater demand. That hasn’t worked.

Meanwhile, the crisis has laid bare the conflict that lies at the center of Europe. European institutions, and especially the European Central Bank, are dominated by France and Germany. While the ECB is tasked with making monetary policy for countries from Greece to Belgium, it really makes it for Germany, which remains the world’s most skittish inflation-phobe. Which helps explain why the ECB in April raised interest rates.

And if you think the U.S. left the banks off easy, consider what has happened in Europe. The stress tents European banks have endured were more like massages. Collective action has dictated that bondholders of failed private banks in Ireland, and of functionally insolvent governments like Greece not face significant losses on their holdings. (In the U.S., by contrast, the creditors of Lehman Brothers and plenty of other banks and bailed-out companies, took collective buzz cuts. )

Add it all up, and Europe is dishing up a toxic brew: a rigid currency, fiscal contraction, begrudging aid from the central bank, and a long history of enmity between its constituents. That’s a recipe for collective paralysis, not for the sort of bold collective action that is required to halt banking crises. Pundits have floated the idea that Europe could solve its problems by issuing eurobonds. And it’s true that selling bonds that are guaranteed collectively by European countries would allow countries to escape the tender mercies of the bond markets. But that plan, which would require true collective action, has been rejected.

The reality is that Europe today resembles the U.S. states during the Article of Confederation period — an agglomeration of allies and frenemies, unwilling fully to cast their lot with one another. European policymakers aren’t inclined to take advice from American political thinkers. But they’d be well-advised to heed the warning Benjamin Franklin issued at a time when collective action was being considered: “We must all hang together, or assuredly we shall all hang separately.”

Daniel Gross is economics editor at Yahoo! Finance.

Email him at grossdaniel11@yahoo.com; follow him on Twitter @grossdm.

NEWS UPDATE:

(Repeat of item initially published on Sunday, Aug 14)

WASHINGTON, Aug 15 (Reuters) – The rich world appears stuck in a vicious cycle: subpar growth begets market volatility that then dampens confidence and damages prospects for further economic expansion.

U.S. consumer sentiment plunged to its lowest level since 1980 in early August, a drop due in part to shaken nerves following a swoon in stock markets around the world.

The same applies to Europe (Chicago Options: ^REURTRUSDnews) , where efforts to reduce government debt have had the perverse effect of stifling economic growth, thereby making deficits costlier to sustain.

Eurozone industrial output posted a surprise decline in June, boding poorly for second-quarter gross domestic product, which is due on Tuesday and forecast to have expanded just 0.3 percent compared with the first quarter.

At the same time, concerns that until recently had been relegated to the so-called European periphery — countries like Greece, Ireland (Berlin: IIK.BEnews) and Portugal — are now knocking at the door of major economies like France and Italy.

This has prompted a spike in bank borrowing costs that is raising fears of a reprisal of the late 2008 credit crunch.

“It is hard not to get a sense of deja vu,” said Maneesh Deshpande, head of U.S. equity derivatives strategy at Barclays (LSE: BARC.Lnews) Capital, in a conference call addressing market volatility.

“Once unthinkable things have happened, such as the U.S. losing its AAA rating. Investors are literally feeling the earth shifting under their feet, you just don’t know what else you thought of as rock solid, might turn out to be untrue.”

A Reuters poll this week suggested economists are no longer certain the euro zone’s recovery can be maintained, with a few expecting near stagnation until at least 2013.

For IFR’s forecasts for the week ahead in U.S. economic data, please click on http://link.reuters.com/xuv23s

FULL CIRCLE

In a way, erratic financial markets are a reflection of what many analysts see as a central contradiction of global economic policy — a predilection for spending cuts at a time when stimulus is what is most needed.

Europe is the perfect example. Many of its nations are faced with high unemployment but also elevated debt burdens. With short-term investor fears driving a focus on the latter, joblessness has been ignored.

That omission is now coming back to haunt markets as analysts sense the possibility of a renewed period of economic contraction in either the United States, Europe or both.

“Fiscal tightening in an environment where unemployment decreases only slowly could erode consumption growth,” said Laurence Boone, European economist at Bank of America (NYSE: IKJnews) -Merrill Lynch (AMEX: LGLnews) .

The same worries apply to the United States. Growth in the world’s largest economy slowed to a trickle in the first half, and recent data suggest a long-heralded second-half rebound will be meeker than first thought. Unemployment has also remained stuck near 9 percent, raising speculation the Federal (SES: E1:F20.SInews) Reserve might have to be even more aggressive in its monetary policy in order to revive the labor market.

Inflation data from the Labor Department due on Thursday will give policymakers a sense of how much wiggle room they have. U.S. consumer prices are forecast to have risen 0.2 percent in July. Prices outside food and energy, the U.S. central bank’s preferred way of looking at inflation, are forecast to rise 1.7 percent on an annualized basis — just around the Fed’s comfort range, but too high for many policymakers to allow for additional easing.

Which takes us back to the markets. A key reason equities have rebounded from a nearly 20 percent slump was that the Fed, apart from making an unprecedented promise to keep rates near zero for another two years, said it was exploring other options for monetary support.

If the central bank fails to deliver a new dose of cash to a hungry market, it could lead to another market slide that could again imperil the recovery.

“In an environment in which market participants are concerned about the debt crisis in Europe, fiscal problems in the U.S. and signs of a broader global economic slump, every additional risk factor might be the straw that breaks the camel’s back,” said Harm Bandholz, chief U.S. economist at UniCredit Research.

 

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