The US will shortly have a new President. Congratulations to all concerned, particularly those who kept their cool during the intense moments of crisis during the fall and who surmised – early and correctly – that the current situation requires decisive and comprehensive action. We already have a large fiscal stimulus in the works, a significant housing refinance program was surely being signalled last week, and we are waiting to hear through exactly what kind of new structure the bulk of TARP II funding will be deployed.
If banking stabilizes of its own accord over the next week or so, the new Administration will lean towards a New Bank focused primarily on restarting consumer lending (or they can expand the mandate of a relatively clean existing structure such as Fannie or Freddie). If banking continues to deteriorate, then more of an RTC-type structure is likely to prevail, i.e., at least partially cleaning up banks’ balance sheets – presumably in return for lending requirements.
There is definite potential for inflation in this strategy, but this would not be the worst thing – the gap between the consensus and our view is narrowing on this. And in any case President Obama can, quite reasonably, blame his predesssor for almost everything that goes wrong. And Obama can also argue, plausibly, that things would be even worse without his bold actions.
Unfortunately, in most of the rest of the world the economics and politics are not so favorable. Let me remind you of the main points, illustrated with some of the latest developments.
First, the European Union’s “don’t worry, be happy” strategy for East-Central Europe is coming apart at the seams. Social tension is mounting in Latvia and elsewhere. The Latvian government is struggling to reduce nominal wages; this is an almost impossible task anywhere. Fresh waves of financial market pressure are likely to move throughout the region, probably triggered by the timing of external debt rollover needs.
Second, Spain’s sovereign debt was downgraded today - a further demonstration that the weaker eurozone countries continue to be reappraised. The spreads on their debts, relative to German government debt, continue to widen. The UK’s banking moves today may or may not bring local stability; they definitely seem likely to destabilize regionally – fears of bank nationalization are spreading.
Third, the recently released OECD leading indicators suggest that while almost everyone is decelerating sharply (aside: and this is at a time when all official forecasts err on the side of overoptimism!), there are some interesting bedfellows in sharp slowdown: Germany, Russia, and China. In fact, almost all of Europe, Asia, and Latin America is caught up with the rapid decline in international trade in one form or another. We have surely only begun to see the social impact.
What are the macroeconomic implications in the immediate future?
- Very few countries now find room for a fiscal stimulus; debt levels are too high and fiscal capacity is hard pressed by contingent liabilities in the banking system – particularly with an increasing probability of quasi-nationalization.
- The idea of a 2% of GDP global fiscal stimulus seems quite far-fetched at this point.
- Further monetary easing is therefore in the cards, both for developed countries and emerging markets, and there may now be some catching up by central banks - in that regard, see the latest Turkish move as a foreshadowing.
- Fear of deflation will take hold almost everywhere, further pushing central banks towards interest rate cuts.
- Commodity prices will likely decline further.
- The worldwide reduction in credit continues, largely driven by lower demand for credit as households and firms try to strengthen their balance sheets by saving rather than spending.
The crisis and associated slowdown started in the US, but the recession is now global. The US economy is no more than 1/4 of the world economy, so even the largest US fiscal stimulus (say 3% of US GDP per annum) cannot be not large enough to move the world at this stage. If we stabilize our financial system fully and restore consumer credit, this will help. But remember that we are subject to shocks from outside and, right now, a major problem appears to be developing in Europe. President Obama’s leadership is just as much needed internationally as in the United States. But outside the US the tasks look much harder.