Their is no way to candy-coat the global economy. Since the spring, conditions have clearly soured. Chinese GDP has weakened, U.S. leading indicators have dipped and Europe remains deeply recessionary and embroiled in yet another round of crisis.
Fortunately, policy makers are now striking back.
The market’s most pressing fears at the beginning of the summer were the Greek election and Spain’s troubled banks. Both have been tidily resolved, via a pro-Europe Greek election outcome and a credible commitment to recapitalize Spanish banks.
Next came a European summit in late June – the twentieth since Europe’s woes began. Conditioned by nineteen earlier disappointments, market expectations were understandably limited. But for once, policy makers delivered.
Of far greater importance than the usual garnishes thrown atop are two seemingly obscure tweaks to bailout procedures. First, future European bailouts should no longer enjoy senior status relative to other creditors. In the past, bailouts had the perverse effect of punishing existing bondholders by rendering them junior partners and thus first in line to suffer losses in the event of default. This prompted capital flight and higher bond yields, worsening conditions. Not any more.
Second, Europe is now looking at directly recapitalize banks, instead of first funneling money through the host country. That means the money no longer shows up as additional debt on the sovereign’s balance sheet. This goes a long way toward short-circuiting the vicious circle between struggling banks and imperiled countries that had come to dominate the crisis.
But perhaps the most promising thing of all about the European Summit is how it signalled a long-awaited shift in focus towards the true flaw at the heart of the euro zone: a monetary union without a fiscal union.
This mistake is starting to be fixed. As a preliminary step, European leaders have announced plans for a banking union. A common regulatory platform will not only ensure better managed banks, but also enable the pursuit of a much more exciting goal: European-wide deposit insurance that might halt the crippling deposit flight out of Greek and Spanish banks.
Equally, a banking union is a way station along the path to a deeper fiscal union, one in which countries are credibly bound by fiscal limits and beholden to a European fiscal authority. With a fiscal union in place, debt mutualization becomes possible: the sharing of government debt (and with it, Germany’s low interest rates). This would rescue a number of euro zone countries from the edge of insolvency.
Germany’s apparent opposition to this requires careful parsing. It is less about the final destination, and more about the route. Germany actually stands ready to embrace the “United States of Europe,” if done right. It is just that a deposit-insurance program makes no sense until banks are first centrally regulated. And euro bonds are foolish until governments are bound to fiscal prudence.
Europe’s end game remains well beyond the horizon and plenty of implementation risks remain. But greater clarity is nonetheless becoming possible. It is becoming easier to predict with confidence that the euro zone will not break apart, that no systemically important bank will fail and that no large country will default. The favorable Greek election and tentative steps towards a banking and fiscal union demonstrate that the public and political will for an integrated Europe is remarkably unbowed. The Spanish bank recapitalization plan proves once again that big banks will not fail. And efforts to decouple banks from sovereigns greatly reduces the risk of a large country stumbling.
On other playing fields, central banks have been busy battling the economic slowdown. Among emerging markets, China, Brazil and South Korea are cutting rates. The Bank of England has opened a new liquidity spigot and delivered another round of quantitative easing. The European Central Bank has just cut its policy rate to a record low and broadened collateral rules. The U.S. Federal Reserve recently extended Operation Twist, depressing bond yields globally. They are likely to do more, and every little bit helps.
None of this is enough to spark steady economic growth or take markets entirely off tenterhooks, but it at least provides a counterweight to the bleak trends afoot and keeps global recession risks muzzled. Sluggish economic growth is still likely the best that we can expect, but policy makers are demonstrating once again that downside risks – with particular relevance to Europe – may not be quite as large as they initially seemed.
Eric Lascelles is chief economist of RBC Global Asset Management
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