Suppose that in June 2007 you had been told that the U.K. 10-year bond would be yielding 1.54 per cent, the U.S. Treasury 10-year 1.47 per cent and the German 10-year 1.17 per cent on June 1, 2012. Suppose, too, you had been told that official short rates varied from zero in the United States and Japan to 1 per cent in the euro zone. What would you think?
You would think the world economy was in a depression. You would have been wrong if you had meant something like the 1930s. But you would have been right about the forces at work: the west is in a contained depression; worse, forces for another downswing are building, above all in the euro zone. Meanwhile, policy makers are making huge errors.
The most powerful indicator – and proximate cause – of economic weakness is the shift in the private sector financial balance (the difference between income and spending by households and businesses) towards surplus. Retrenchment by indebted and frightened people has caused the weakness of western economies. Even countries that are not directly affected, such as Germany, are indirectly affected by the massive retrenchment in their partners.
According to the International Monetary Fund, between 2007 and 2012 the financial balance of the U.S. private sector will shift towards surplus by 7.1 per cent of gross domestic product. The shift will be 6.0 per cent in the U.K., 5.2 per cent in Japan and just 2.9 per cent in the euro zone. But the latter contains countries with persistent private surpluses, notably Germany, ones with private sectors in rough balance (such as France and Italy) and ones that had huge swings towards surplus: in Spain, the forecast shift is 15.8 per cent of GDP. Meanwhile, emerging countries will also have a surplus of $450-billion this year, according to the IMF.
One would expect feeble demand in such a world. The willingness to implement expansionary monetary policies and tolerate huge fiscal deficits has contained depression and even induced weak recoveries. Yet the fact that unprecedented monetary policies and huge fiscal deficits have not induced strong recoveries shows how powerful the forces depressing economies have been. This is the legacy of a huge financial crisis preceded by large asset price bubbles and huge expansions in debt.
Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the euro zone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the euro zone, towards countries that retain monetary sovereignty, such as the U.S. and even the U.K. (see chart).
It is often forgotten that the failure of Austria’s Creditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the euro zone, the closest thing the world now has to the old gold standard. The failure of the euro zone would, in turn, generate further massive disruption in the European and even global financial systems, possibly even knocking over the walls now containing the depression.
How realistic is this fear? Quite realistic. One reason for this is that so many fear it. In a panic, fear has its own power. To assuage it one needs a lender of last resort willing and able to act on an unlimited scale. It is unclear whether the euro zone has such a lender. The agreed funds that might support countries in difficulty are limited in a number of ways. The European Central Bank, though able to act on an unlimited scale in theory, might be unable to do so in practice, if the runs it had to deal with were large enough. What, people must wonder, is the limit on the credit that the Bundesbank would be willing (or allowed) to offer other central banks in a massive run? In a severe crisis, could even the ECB, let alone the governments, act effectively?
Furthermore, people know that both banks and sovereigns are under severe stress in important countries that seem to lack any prospect of an early return to growth and so suffer the costs of high and rising unemployment. No better indication of this can be imagined than Spain’s final cry for help with its banks. Political systems are under stress: in Greece, a fragile democracy has imploded. Meanwhile, the German government seems to have reiterated opposition to more support.
How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the euro zone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile.
Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events. Perhaps the panic will vanish. But investors who are buying bonds at current rates are indicating a deep aversion to the downside risks. Policy makers must eliminate this panic, not stoke it.
In the euro zone, they are failing to do so. If those with good credit refuse to support those under pressure, when the latter cannot save themselves, the system will surely perish. Nobody knows what damage this would do to the world economy. But who wants to find out?
Copyright The Financial Times Ltd. All rights reserved.
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