The massive volatility and sharp equity-price correction now hitting global financial markets signal that most advanced economies are on the brink of a double-dip recession. A financial and economic crisis caused by too much private-sector debt and leverage led to a massive releveraging of the public sector in order to prevent Great Depression 2.0. However, the subsequent recovery has been anemic and sub-par in most advanced economies given painful deleveraging.
Now a combination of high oil and commodity prices, turmoil in the Middle East, Japan’s earthquake and tsunami, eurozone debt crises and the US’ fiscal problems (and now its rating downgrade) have led to a massive increase in risk aversion. Economically, the US, the eurozone, the UK and Japan are all idling. Even fast-growing emerging markets (China, emerging Asia and Latin America), and export-oriented economies that rely on these markets (Germany and resource-rich Australia), are experiencing sharp slowdowns.
Until last year, policymakers could always produce a new rabbit from their hat to reflate asset prices and trigger economic recovery. Fiscal stimulus, near-zero interest rates, two rounds of “quantitative easing,” ring-fencing of bad debt and trillions of dollars in bailouts and liquidity provision for banks and financial institutions: Officials tried them all. Now they have run out of rabbits.
Fiscal policy currently is a drag on economic growth in both the eurozone and the UK. Even in the US, state and local governments, and now the federal government, are cutting expenditure and reducing transfer payments. Soon enough, they will be raising taxes.
Another round of bank bailouts is politically unacceptable and economically unfeasible: Most governments, especially in Europe, are so distressed that bailouts are unaffordable; indeed, their sovereign risk is actually fueling concern about the health of Europe’s banks, which hold most of the increasingly shaky government paper.
Nor could monetary policy help very much. Quantitative easing is constrained by above-target inflation in the eurozone and UK. The US Federal Reserve will likely start a third round of quantitative easing (QE3), but it will be too little, too late. Last year’s US$600 billion QE2 and US$1 trillion in tax cuts and transfers delivered growth of barely 3 percent for one quarter. Then growth slumped to below 1 percent in the first half of this year. QE3 will be much smaller, and will do much less to reflate asset prices and restore growth.
Currency depreciation is not a feasible option for all advanced economies: They all need a weaker currency and better trade balance to restore growth, but they all cannot have it at the same time. So relying on exchange rates to influence trade balances is a zero-sum game. Currency wars are thus on the horizon, with Japan and Switzerland engaging in early battles to weaken their exchange rates. Others will soon follow.
Meanwhile, in the eurozone, Italy and Spain are now at risk of losing market access, with financial pressures now mounting on France, too. However, Italy and Spain are both too big to fail and too big to be bailed out. For now, the European Central Bank will purchase some of their bonds as a bridge to the eurozone’s new European Financial Stabilization Facility (EFSF). However, if Italy and/or Spain lose market access, the EFSF’s 440 billion euro (US$627 billion) war chest could be depleted by the end of this year or early next year.