Imagine the world economy as a video game, one observer said. You have to complete a number of stages before you win, and the idea is to dodge all the bad stuff that can come at you at any moment. If you really get it wrong, you are zapped and you have to start all over again.
The game played by the policymakers who assembled in Davos, Switzerland, late last month should be called Global Apocalypse. It now even has its own Super Mario figure in the president of the European Central Bank (ECB), Mario Draghi.
Sad to say, it is taking those in charge of the global economy a long time to master the controls. After four-and-a-half years they have made it to the first level, but are now stuck there. Missiles rained down on them last year, and by the year’s end there was a very real fear of a wipeout as the euro crisis deepened.
A bit of clever footwork from Super Mario has averted the immediate danger. The ECB has flooded Europe’s financial system with cheap money and that has prevented banks from going to the wall. Bank of Canada Governor Mark Carney, who is also chairman of the G20’s Financial Stability Board, said on Jan. 28 that the long-term refinancing arrangements meant there was no longer the risk of a repeat of the chaos that followed the collapse of Lehman Brothers in September 2008.
However, as former British prime minister Winston Churchill said after Dunkirk, wars are not won by retreats, however brilliantly executed, and getting beyond level one is still proving challenging, at least for the developed countries in the West, where it has taken unprecedented intervention from central banks to prevent it from being game over. Martin Wolf, of the Financial Times, aptly describes it as a contained depression.
It should come as no surprise that victory has so far proved elusive. British Chancellor of the Exchequer George Osborne is right when he says that recoveries from recessions are always more difficult when the downturns are caused by excessive debt, but this slump has been accompanied by two other shocks: a big technological shift from an analog to a digital world and a big geographical shift that has seen the center of gravity move from Europe and North America to Asia. Companies such as Nokia that were world-beaters only a few years ago are finding out exactly what the economist Joseph Schumpeter meant by creative destruction, but that process also seems to be at work between countries and regions.
Even so, there is a way through the labyrinth, provided policymakers avoid obvious pitfalls and work methodically. One problem has been that they have tried to find short cuts over the past few years rather than work their way through the levels in the right sequence.
So, if getting to the first level called for urgent and aggressive action to ease monetary policy and shore up the financial system, the next phase should be to deal with the global imbalances that caused the problem in the first place.
The fundamental issue in the years up to the 2007 crisis was not the number of US subprime mortgages or even the explosion in derivatives; it was the instability caused by one half of the world running massive current account surpluses and the other half running massive current account deficits.
What needs to happen now is that the surplus countries accept the need to increase domestic demand, thereby soaking up exports from the debtor countries, resulting in more balanced growth all round.
Once the global economy has enough demand to allow the resumption of solid growth, there will be the right environment to repair the damage to the banking system. Regulation needs to be improved; banks have to provide themselves with bigger capital and liquidity buffers, and a solution has to be found to the “too big to fail” issue.
Stronger banks will reduce the risk of a second credit crunch, making it easier for private-sector firms to finance expansion or secure working capital. Higher investment by the private sector will mean that governments will no longer have to shoulder so much of the burden of growth. Once a vigorous private-sector recovery is under way, finance ministries can adopt tougher fiscal policies without the risk of pushing economies back into recession.
By this stage, an end to the game is in sight. Governments can use the fruits of stronger growth to finance supply-side improvements to their economy, including extra spending on education, skills and infrastructure. Growth can be made sustainable by championing vibrant green technology sectors. Regulatory regimes can be tinkered with to prevent “irrational exuberance.”
There was little sign at the Davos meeting of this sort of strategy.
In part, that’s because some measures taken by central banks to prevent catastrophe have had unintended consequences: the impact of quantitative easing on commodity prices and hence inflation, for example.
In part, it has been the result of “black swan” events, such as Japan’s tsunami, but mostly, it has been due to inertia, complacency and error.
Policymakers have put the question of global rebalancing into a box labeled “too hard to deal with” and have been dilatory in sorting out their financial sectors. Instead, whether through a misguided belief in financial orthodoxy or a fear of bond markets, they have concentrated on heavy-handed, blanket austerity, something that should have come at the very end of the game.
The result has been sluggish growth in the west because every element of growth — public expenditure, consumer spending and investment — has been choked off simultaneously. If government is to retrench without causing recession, private demand has to rise, but the squeeze on real incomes and a reluctance to invest means this is not happening. The result is an unbalanced global economy, drifting toward a double-dip recession (in the west at least), a dysfunctional financial system and — a new ingredient in the toxic mix — a deeply disaffected public.
IMF Managing Director Christine Lagarde spent the time rattling the tin for a US$2 trillion war chest. European policymakers were trying to finish a Greek debt deal. Draghi made it clear that providing liquidity to Europe’s banks would not be enough on its own.
What does it mean? It means blanket austerity is not working, and a global response to a global crisis has become national responses to national crises. Europe is treating a three-dimensional problem (growth, banks, public finances) with a one-dimensional fix of deficit reduction. It means the global economy is struggling to get beyond level one of Global Apocalypse. And if policymakers don’t start showing a bit more skill, it will soon be Game Over and time to play Global Apocalypse 2.
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