Economics: A Major Macro Experiment
As economies in the United States and Europe continue to struggle with an already four-year long crisis (recession in 2008-09, subdued growth in 2010-11) and an uninspiring outlook for this year, financial markets are witnessing an unprecedented, at least for modern times, macro-economic policy divergence between the two regions, with potentially important implications for relative asset prices over the medium and long term.
In economics, as in other social sciences, there is hardly any opportunity to perform controlled experiments. The differentiated policy response in the US and Europe to the present environment of quasi-permanent deleveraging is as close as we can get to such an experiment, and the consequences of it will certainly be debated for years to come in academic circles. But, not only in those: The advantages and risks associated with each strategy, which are not easy to grasp fully, present enormous challenges also for financial markets.
How this Divergence came about
Policymakers’ reaction to the initial phase of the crisis (the 2008-09 economic collapse) was similar in both regions, in line with standard practice: Rapid monetary easing and fiscal stimulus. This treatment may have adopted slightly different forms and may have been conducted with varying conviction in various countries, but at least policies went in the same direction. There was a global policy consensus in tackling the most severe recession since the 1930s.
In 2010, however, the policy approach to deal with the present meagre economic recovery started to diverge, as some policymakers, mainly in Europe, perceived actual or potential limits to additional fiscal stimulus and to non-standard monetary measures. Those divergences intensified in 2011, and, despite some backtracking by the ECB in recent months, will not disappear this year.
In the US, the Fed embarked in 2010-11 in two rounds of quantitative easing (and there is talk of a third one this year) and, although Congress has refrained from massive additional fiscal stimulus, it keeps on putting fiscal consolidation further off. In the euro area, despite having reversed recently the early-2011 interest rate hikes, the ECB refuses to boost its balance sheet as much as the Fed and continues to resist pressures to embark in large purchases of government and private sector assets; meanwhile, governments, especially in the periphery, started in 2010 aggressive fiscal consolidation programs, which are being intensified this year. Somewhere in between, the United Kingdom has adopted simultaneously very bold monetary easing (via purchases of large amounts of public and private sector assets) and drastic fiscal tightening.
Those divergences result from both ideological differences and financial market pressures. Europeans typically accept that fiscal expansion may boost the economy in the short term but believe that it is a recipe for lower growth potential in the long term; some in Germany claim that fiscal stimulus may be counterproductive even in the short term. To complicate things further, some European governments started to suffer from reduced market access in 2010 – a trend that spread to more and larger countries in 2011 – and had no option but to consolidate public finances rapidly. The new UK government feared that the same might happen to them and decided to act in advance.
By contrast, US authorities tend to favour resuming growth and lowering unemployment quickly, and assume that there is plenty of time to address the long-term public finances problem. Of course, the US has much smaller risk of losing market access than other countries that either do not have an independent currency (like the euro area periphery) or lack a reserve currency status (the UK), and this privilege reduces pressure to act promptly. There is also an important constituency advocating additional fiscal stimulus as long as the economic recovery remains subpar.
Risk and Returns
Each strategy carries important implications for economies and for asset prices that investors, particularly those with a long-term horizon, cannot afford to overlook. Let us call them the American and the European strategies, and analyse them in turn.
The “American” combination of very loose monetary policy and fiscal profligacy (which is unlikely to change substantially this year) has the advantage of supporting growth in the near term. Although it has been disappointing by historical standards, the economic recovery has been so far more dynamic in the US than across the Atlantic, and this relative outperformance (in terms of GDP growth) is likely to persist this year. Contrary to Europe, the US has achieved a (modest) decline in the unemployment rate. Moreover, if the recovery should falter again this year, the Fed is willing to pursue further easing.
If this strategy is eventually successful in restoring the economy to its long-term growth path, the risk is that the Fed will be unable to reverse quickly enough its present monetary stance, and high inflation will follow. Of course, this event would not develop from one day to the other but rather gradually, with perhaps several years of slightly higher-than-expected inflation (the UK experience of 3% core inflation in 2010-11 comes to mind) followed suddenly by an outburst of accelerated price dynamics. Equities would provide a partial hedge but long-term bond prices would fall substantially.
There are also risks in case the strategy fails to restore the economy to its long-term growth path in coming years, that is, if deleveraging by the private sector dominates: Persistent fiscal deficits will boost public debt quickly, very much similar to the path undertaken by Japan in the past two decades of sluggish growth. Not only long-term growth potential would be reduced (with negative implications for earnings growth and equities) but the US could suffer a vast funding crisis, similar to that which Greece, Portugal, Ireland, Spain and Italy are mired in at present. A funding crisis would be negative for bonds and, given the US dependence on foreign capital, for the dollar.
The “European” strategy has an obvious near-term disadvantage: fiscal consolidation, combined with not less supportive monetary conditions, undermines economic growth. Not surprisingly, the recovery has lagged behind that in the US so far and a renewed, albeit mild, recession is possible this year (and almost certain in some large countries, like Italy and Spain). But, over the long term, it lowers the chances of a permanent funding crisis, and will help restore long-term growth potential eventually. If successful, current sovereign tensions will subside, creating opportunities for investors in peripheral countries. If this happened, the euro would probably come out stronger as a currency.
There is a major risk to this strategy, opposite to that in the US: that of plunging these economies into a vicious circle of fiscal tightening-recession-fiscal tightening, which would almost certainly leave several “corpses” in the way, in the form of sovereign and bank defaults, and perhaps even deflation. Greece is very close to that point, Portugal may be approaching it, and if Italy and Spain were to follow that path, the entire euro area would be at risk. In this case, apart from the losses in holdings of sovereign and other bonds, equity markets and the euro would suffer severely.
There is no alternative that looks better a priori. There are simply different conceptions of how the economy works, and diverse institutional arrangements and policymakers’ preferences. There is nothing investors can do to alter them. In the best of cases, all policymakers will prove right in dealing with their specific circumstances, and they will manage to steer their respective economies back to a sustainable growth path soon enough. But it would be optimistic to plan on that. It is imperative to be aware of the risks attached to those policy options.
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