The Outlook for the Global Economy in 2011

The present global financial crisis, a slow-motion multiple car crash, has many roots, some arguably going back to the 1990s. But the point at which the certainty of a huge crash seems in retrospect to have deserved to have become discernable to Western policy-makers was in my opinion in 2003.

Until the opening of archives we may not of course know how widely this certainty was actually recognised by such policy-makers. But many of them were by no means inactive which suggests that there was at least some degree of recognition of what was afoot. In particular, the Fed’s Alan Greenspan and Bush the Younger (and his advisers) acted as if they realised that a 1929 hour was at hand with Western stock markets falling dramatically.

But the broad US response was not the same as in 1929 when Herbert Hoover and his contemporaries in posts of financial importance decided to allow the bubble to burst and devleveraging to run its natural course. (“Liquidate! Liquidate! Liquidate!”). Hence by 1932 spectacular debts and imbalances in the United States (and in most other leading countries apart from Germany) had been eliminated – meaning that recovery under FDR, Neville Chamberlain et al could gradually occur.

In 2003, by contrast, the US led by example in an opposite direction: lowering interst rates, massively increasing fiscal deficits and running risks with currency stability. The bubble accordingly continued to inflate throughout the West. And stock markets began to rise again; house prices and mortgage lending soared (though the US, the UK, Spain, Iceland and Ireland were markedly more reckless in this direction than the norm); and borrowing from international markets by governments, banks, corporations and individuals continued unabated. None of this could have happened without a continuation of “globalisation” and the collusion of China, whose insatiable purchase of US T-bills was something that appeared to be motivated by strategic calculations rather than by any economic analysis that either Keynes or Freedman would have recognised.

It is at present impossible to be certain whether most Western policy-makers fully understood that the multiple car crash looming in 2003 had not in fact been avoided but merely postponed and greatly exacerbated. But this reality was brought home to them in quite unmistakable form in 2007-2008 in the months between the run on Northern Rock and the bankruptcy of Lehman Brothers.

Western policy since 2008 has in my opinion certainly been more defensible than before. And the the two leading powers, the US and Germany, are probably not far apart. Their assumptions seem to be:

1) The multiple car crash is upon us and that no rerun of 2003-2007 is possible because too many banks and even states are seen to be insolvent and lenders, including even China, have become risk-averse.

2) The aim is no longer to avoid deleveraging but to try to stretch it out over as long a period as possible. Hence Obama has not seriously sought to prevent rising US unemployment and Germany has tried to keep the Eurozone alive but at the same time to compel its members to reduce budget deficits and to give priority to avoiding early defaults on sovereign and bank debts at whatever cost this may entail for individual citizens’ living standards and for the prospects for growth.

3) There is a reluctance, particularly on the part of Obama, to confront China and/or to embrace full-blooded protectionism, let alone “socialism”.

The US in 2011: A Forecast

I expect more of the same from Obama. He will attempt to appease China and hence may favour modest interest-rate rises and Osborne-style half-hearted deficit reduction measures to appear to be trying to prevent China’s T-bills collapsing in value. Obama knows this will lead to rising US unemployment and more housing repossessions. But he may cling to the hope that he can nevertheless be reelected in 2012 if the Republicans cannot unite around an attractive alternative.

He will also do all he can to save US and even European banks rather than deliberately engineer a crisis that could usher in a radical new order. He will, I think, be largely but not perhaps wholly successful in this – just like Bush the Younger. The wild card is China which may elect to pull the plug on T-Bills. But my guess is that the Chinusa experiment will be allowed to limp on for another year.

The Eurozone in 2011: A Forecast

I expect the Eurozone still to exist at the end of 2012, though possibly with some changes in membership. The UK will of course not be offered overnight accession – not least because the admittedly slow learners in Europe Proper now surely grasp that the UK will opt for any amount of suffering rather than entertain such a humiliating possibility.

So changes of membership will be limited to departures. Ireland and Greece may be the first to go – for they desperately need to default on debt and to devalue and may not be allowed to do so without leaving the Eurozone. Domestic political manoeuvring, especially in the aftermath of the Irish General Election whenever it is held, could trump all other considerations. Less likely to leave in 2011 are Portugal, Spain, Belgium and Italy. For they may prove willing to try to work for at least a year with any “bailout” terms imposed by Germany and the IMF. My expectation is, however, that such terms will be severe.

I cannot, for example, see the  Germans, under any conceivable administration, agreeing to join a full debtors’ union. Nor can I see them giving or lending serious sums to these countries for purposes of maintaining living standards. Still less can I see them joining a full fiscal union that could involve majority votes requiring Germans to pay taxes for transfer to other poorer European citizens. Germany might, on the other hand, agree, on a case by case basis, to give or lend money for purposes of servicing others’ sovereign or bank debts and/or rolling over maturing sovereign or banking bonds. The deal would likely entail Germany having the right to require default/haircuts at a time of its choosing but also requiring the borrower state to seek Germany’s consent to initiate default on pain of expulsion from the Eurozone if default were announced unilaterally.

Such an arrangement would amount to the restoration of the correct operation of the Stability Pact with the modification that deficits of up to 3 per cent would not be allowed for states who had sought bailouts.

Thus if, for example, Spain has to seek assistance during 2011, a rather likely eventuality in my opinion, it would have to operate in such a fashion that it could spend nothing on its own people other than revenue reaching it from taxation. (Susan Strange’s No New Money rule!) I think this would be too onerous for the Spanish people to bear for very long. But they might well get to the end of 2011 without decisive revolt against the Eurozone straightjacket blocking devaluation and reflation. For they might for a time entertain the hope that the Eurozone as a whole might collectively devalue and massively reflate. But my prediction is that Germany will not agree to do this on anything like the scale that Spain would think it needed. An impasse would thus arise (such as already exists so far as Ireland and Greece are concerned) and hence Spain would be heading for the exit. But this might not be played through to a conclusion during 2011.

In short, the multiple car crash is continuing in Europe but is not necessarily speeding up. There is, however, a wild card. It is that a Europe-wide banking crisis during 2011 gets completely out of control and leads a stricken Germany to abandon all its previous post-1949 policies relating to fiscal rectitude. I do not expect this to happen. After all, the US banking crisis in 2008 was extremely serious and involved some astonishing forced mergers but in the end only one bank went fully bankrupt and even that one was a casino bank rather than one with ATMs and main street branches. I am inclined to believe that the severity of the multiple car crash has not yet speeded up sufficiently to prevent Germany and the US finessing the European banking crisis in some similar fashion – though maybe with more than just one ultimate casualty. In short, for the present at least, I stand by Susan Strange’s other dictum: “The authorities will not let the big banks go under.”

The UK in 2011: A Forecast

I expect the Coalition, with its extremely comfortable majority, to remain in power throughout 2012 – though increasingly unpopular. There will be little growth and there will be scares about a double-dip recession. Worries will grow about the prospects for even modest deficit reduction. And banks may have to receive more bailouts – especially so if the banking problems in Europe Proper become acute enough to lead to big losses by London banks.

Any or all of these developments may lead rating agencies to threaten to strip the UK of triple A status. The logical response to this will be to behave as Ireland has repeatedly done: more fiscal downward adjustments. I expect at least one of these – with emphasis on taxation rather than another round of spending cuts. Interest rates will also begin to rise – especially if this is happening elsewhere. The housing market will then presumably slump and many new repossessions will be looming by the end of 2011. Unemployment will head upwards. Some public order problems are thus only to expected. But the Government will in my view have to endure them. For unlike in 1990, when the poll tax riots occurred, no partial retreat will make much sense; and it is hard to see where the initiative will come from to lead the country towards radically altered policies such as leaving the EU; or joining the Euozone; or adopting full-blooded protectionism; or capriciously allowing the pound to collapse given the need to import food and energy; or opting for a socialist siege economy.

In practice a coherent set of alternative policies seem likely to come only from the Labour Opposition and that seems quite unlikely to be ready to offer anything of this sort during 2011. In short, staying away from the danger zone of antagonising the international lending markets (which will still be around at the end of 2011 but afflicted with much risk aversion) will obsess the Coalition Government. But, as with Europe Proper, the wild card may be the banks and they may eventually prove fatal to the Coalition Government. But during 2011 Cameron will probably just about be able, like Brown in 2008, to keep the show on the road with the aid of more dramatic bailouts.

David Carlton is a Professorial Research Fellow at the Global Policy Institute.

About the GPI

The Global Policy Institute is a research institute on international affairs. It is based in the City of London, and draws on both a rich pool of international thinkers, academics as well as policy and business professionals. The Institute gives non-partisan guidance to policymakers and decision takers in business, government, and NGOs.