Views from the World
A sombre 2010 as taxpayers face up to cost of war on recession
Vanessa Rossi, Senior Research Fellow, Chatham House
(Keizai Koho, February 2010 issue)

Recovery is hard work and the heavy lifting in 2010 must come from self-sustaining growth in the private sector. At the peak of the crisis in early 2009, governments took on the gargantuan task of steering the massive global downturn to a halt but their resources are now severely constrained and policy tightening looms. The European Central Bank (ECB) sees near zero interest rates and easy money as a potential risk that needs to be reined in to avoid speculative bubbles in markets and currencies ? although the Euro will come under pressure if the ECB acts without the US Fed, which will be reluctant to raise rates as long as turbulence continues in the property and banking sectors. The US fiscal package also continues into 2010 but European governments are under pressure to reassert control over deficits and debt, in line with EU policy targets. The bill for the war on recession will start to arrive in 2010.

Policy efforts succeeded in taming the recession and generating at least a modest pick-up in growth in the second half of 2009. There is nothing like a massive slump in demand in the world?fs leading economies for driving synchronization in the global economic cycle but also creating a show of G20 policy cooperation and more funding for bailouts. But the next phase of the recovery will have quite different characteristics. It will be far slower and more uneven than the plunge into recession, and policymakers will give more priority to picking their own exit strategies, adding to the risks ahead. Indeed, the ECB and US Fed are starting to rein in liquidity and, in the UK, competing exit strategies are already centre stage in the political campaign preparing for the election expected in late spring.

Yet it is clear that the world economy is still a long way from full recovery. Compared with a year ago, the mood has changed from panic-stricken to simply sombre, but recovery euphoria is distinctly lacking. Economic performance remains fragile and risk prone in most countries - in fact, even the developing world looks less buoyant if high fliers China and India are stripped out. Europe faces a particularly tough situation ? emerging Europe has seen the worst slump of any region in the world, while the Euro area recession has been far deeper than expected in spite of costly support programmes. The outbreak of financial crises in some Euro states, for example Greece at the end of 2009 and Ireland earlier in the year, may not lead to a break-up of the Euro area (as some suggest) but it will tarnish its reputation. The emergence of these problems reveals previously poor assessments of country risk.

The next stages of recovery must rely on self-sustaining growth in the private sector, yet EU consumers face a tougher year in 2010 as inflation returns and unemployment is set to rise. Many companies are struggling to reverse the slump in revenues and avoid job cuts, leaving little scope for investment spending. And there are threats from further shock waves in the financial system as well as post-crisis policy tightening - tax payers are waiting for the inevitable bill for the war on recession. 2010 is likely to be a bumpy ride ? there is only a slim chance of a smooth return to growth after such a troubled recession.

Risk of turbulence as markets react to policy tightening?

Near zero policy rates are beginning to look unhealthy to hawkish central bankers, especially as deflation has come to an end in Europe and the US, and there is rising concern about the impact of cheap money on asset prices and exchange rates. Speculative investments such as carry trade (that is, borrowing in a cheap currency such as the dollar to invest in high-yielding currencies) may boost profits in parts of the banking sector but this will backfire if it fuels bankers?f profits and pay rather than supporting the wider economy, for example through credit to small to medium-sized enterprises. Inflows of speculative money have already caused Brazil to put a tax on foreign capital because of fears that the exchange rate will appreciate faster and further than the economy can withstand. Easy money has been criticized for fuelling a bubble in equity and commodity markets as well as currencies. These concerns all point to central banks reining in liquidity in 2010. And either the ECB alone or the ECB along with the US Fed will take the first step in raising interest rates earlier rather than later in 2010. This could cause tremors in the financial system and currency markets.

Adding to the threat of turbulence are the three original drivers of the financial crisis: property, debt and banks. They are all interlinked. Property market failures continue to play havoc, as highlighted by recent news from Dubai and also tremors in some parts of emerging Europe, still reeling from the aftermath of the abrupt halt to credit-fuelled growth.

Even without any new problems, many leading European banks are seen as starting the year in a relatively weak position, having substantial bad debts to write off, high levels of leverage and low capital adequacy: some fear that these factors could exacerbate the credit crunch in Europe in 2010.

Reining in public debt

While central bankers ponder the timing of the first rise in policy rates, governments must face up to the task of regaining control over public finances as both deficits and debt have risen sharply. Fiscal policy is likely to take longer than monetary policy to adjust as policymakers vacillate between concern about fiscal prudence and the threat of voter distress over the economy and jobs. But the direction is clear. Governments have little scope to take on more debt ? in Europe they will start to cut expenditure and raise taxes sooner rather than later. Indeed, some EU member states, such as Greece and the Baltic States, are battling to cope with tough adjustments to the post-crisis reality. The problems are not only in the small states.

Taxpayers will ultimately be responsible for repaying the cost of efforts made to combat recession and limit the short-term damage to their economies: a less deep recession has been won at the cost of a long period of below-trend growth. Excessive rigour might lead to voter rebellions ? even to defaults ? and therefore easy repayment terms are more likely, spreading the burden over as much as a decade rather than just a few years. This main flaw in this strategy is the risk of another downturn during the payback period, adding renewed stress to public finances. Governments will not have the capacity to spend their way out of two recessions in a decade. This is why regaining fiscal authority may be a race against time over the next cycle.

Hard work ahead to achieve recovery

In summary, there are too many problems still to be addressed for 2010 to be anything other than a very difficult year. Growth will almost certainly be mildly positive for 2010 as a whole, as it will be measured against the depths of the 2009 recession, but there is an uncomfortably high probability of instability ? that is, a W-shaped recovery. After picking up in late 2009, economies will relapse unless momentum can be built up and turned into sustainable growth.

The key sectors that will have to do the heavy lifting in 2010 will be services and industries such as ICT ? this is demonstrated by the trends seen in 2009. Provided these sectors can continue to boost growth and create jobs, then the prospects for more troubled cyclical sectors such as investment goods and construction will gradually improve. This will be essential to pave the way towards a new round of innovation and higher productivity growth in the advanced countries and world economy over the longer run.

Will the US or the EU be the first to achieve a true recovery to self-sustaining growth? The answer to this question matters as it will probably dictate the course of the dollar by late 2010 and the sustainability of recovery into 2011 and beyond.

The EU is clearly struggling with disparate problems across member states, hoping that individual responses will meet each challenge while Brussels and the ECB impose a tough policy framework to meet public sector debt and monetary stability targets. In contrast, the US is likely to keep central policies as easy as possible to support the worst-affected regions and sectors ? and in so doing to spread the effect of low-cost borrowing around the country and the world. The ultimate aim should be to restore sustainable growth, whatever adjustment method is preferred, soft-touch US or EU sanctions-led.

Historically, it has been the US economy that has rebounded most strongly from recessions, pulling Europe along. The soft touch, while controversial, won the recovery race (e.g. in the early 1980s and 1990s), typically initiating a dollar rebound as well. Confidence is too low for a positive US scenario to be taken for granted but consumption is improving and efforts are underway to engineer a positive response from the corporate sector. Another important deciding factor is that, for all the talk about imbalances and alternatives to the dollar, the US is able to boost growth under a stronger dollar whereas the Euro area simply buckles under a stronger currency, highlighting its excessive dependence on exports as the engine of growth and inability to mobilise its own consumers. The US has to be the winner of the recovery race. Effectively, Europe can never be the driver of global growth ? it will always be the follower unless it changes its internal dynamics.

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