Stagnant policy, sluggish recovery
The recent dramatic declines in equity markets worldwide are a response to the interaction of two factors: economic fundamentals and policy responses – or, rather, the lack of policy responses.
First, the fundamentals. Economic growth rates in the United States and Europe are low, well below even recent expectations. This has hit equity valuations hard and both economies are at risk of a major downturn.
A slowdown in one is bound to produce a slowdown in the other – and in the major emerging economies, which could previously sustain high growth despite sluggish performance in the advanced economies. Their resilience will not extend to double-dip recessions; they cannot offset sharp falls in advanced-country demand by themselves.
America's domestic demand shortfall reflects rising savings, balance-sheet damage in the household sector, unemployment and fiscal distress. As a result, the large non-tradable sector and the domestic-demand portion of the tradable sector cannot serve as engines of growth and employment. That leaves exports – goods and services sold to global growth regions, mostly the emerging economies – to carry the load. And strengthening the U.S. export sector requires overcoming significant structural and competitive barriers.
This is a correlated growth slowdown across most advanced countries, and across all of the systemically important parts of the global economy, possibly including the emerging economies. Declining equity values will further weaken aggregate demand and growth. Hence the rising risk of a major downturn. Combined, these factors should produce a correction in asset prices that brings them into line with revised expectations of the global economy's medium-term prospects.
But the situation is more foreboding than a major correction. Even as expectations adjust, there is a growing loss of investor confidence in the official policy responses of Europe and the United States, and to a lesser extent the emerging economies. It is unclear whether officials have the capacity to identify the critical issues and the political will to address them.
In Europe, risks spreads are rising on Italian and Spanish sovereign debt. Combined with their low and declining GDP growth prospects, their debt burdens are becoming sufficiently onerous to raise questions about whether they can stabilize the situation and restore growth on their own.
Italy and Spain expose the full extent of Europe's vulnerability. Like fellow euro members Greece, Ireland and Portugal, they are denied devaluation and inflation as policy tools. But the declining value of their sovereign debt – and the size of that debt relative to that of Europe's smaller distressed countries – implies much greater erosion of banks' capital base, raising the additional risk of liquidity problems and further economic damage.
Europe's domestic policy focus has been to cut deficits, with scant attention to reforms or investments aimed at medium-term growth. There is not yet a complementary EU policy response designed to halt the vicious cycle of rising yields and growth impairment now faced by Italy and Spain.
Credible domestic and EU-wide policies are needed to stabilize the situation. Neither is forthcoming. Recent market volatility has been partly in response.
In the U.S. side, the integrity of sovereign debt was kept in question for too long. During those months of political dithering, U.S. treasuries became a riskier asset. Then, with the immediate default risk removed, money stormed out of risky assets into treasuries to wait out the economic bad news – feeble growth, employment stagnation, falling equity prices.
There is little in U.S. domestic policy debates to hint at a viable growth and employment strategy. In fairness, some believe cutting the budget is sufficient. But that is neither the majority view nor the view reflected by the markets.
The details may elude voters and some investors, but the policy focus isn't on restoring medium- and long-term growth and employment. Indeed, there is profound uncertainty about whether and when these imperatives will move to the centre of the agenda.
In emerging economies, by contrast, inflation is a challenge, but the main risk to growth stems from advanced countries' problems. Reforms and major structural changes are needed to sustain growth, and these could be postponed in a decelerating global economy.
The resetting of asset values in line with realistic growth prospects is probably not a bad outcome, although it will add to the demand shortfall in the short run. But uncertainty, lack of confidence and policy paralysis could easily cause value destruction to overshoot, inflicting extensive damage on all parts of the global economy.
Stability can return, but not until domestic policy in the advanced countries, together with international policy co-ordination, credibly shifts to restoring a pattern of inclusive growth, with fiscal stabilization carried out in a way that supports growth and employment.
In short, we confront two interacting problems: a global economy losing the struggle to restore growth and the absence of credible policy responses. Too many countries seem focused on political outcomes rather than economic performance. Markets are simply holding up a mirror to these flaws and risks.
Michael Spence, a Nobel laureate in economics, is professor of economics at New York University's Stern School of Business.