The clash between politicians and the financial markets is becoming more ugly, most notably in Europe.
The decision by Angela Merkel to go on the attack spooked the markets, which in effect froze. They may unfreeze in the next few days, but the weaker eurozone countries will find it very difficult to raise new money – or even roll over existing debt – unless there are guarantees from the more solid members, most notably Germany.
This sort of tension does occur from time to time as politicians' agendas are different from that of the global investment community. Politics is national; the pool of global savings is international. Politicians want to get re-elected; savers want the best possible return for their money at the lowest risk. And, of course, both sides make mistakes.
If you stand back from what is inherently right or wrong – and people have very different views on that – the practical economic issue is to what extent the commotion on the markets will undermine the recovery. (The practical political issue as far as Europe is concerned is whether the euro will survive, on which my own view has been unchanged for many years. It is that the political will to support it is so great that it will get through this cyclical downturn, but not the next one.)
So how much damage is being done to the recovery? We have had a severe stock market "correction" – I always love that expression, suggesting, as it does, that there is a fundamental direction that share prices ought to be taking, but every now and again they get a bit skittish and need to be brought back to the correct and proper path. The truth, of course, is that the so-called wisdom of crowds can produce pretty odd results for a while, and only with hindsight can we see what was correct and what was nuts.
The fall in the market is more a symptom of a wider concern than a driver of it. It reflects a fall-off in business confidence worldwide and, in some parts of the world, a decline in consumer confidence, too. But it also feeds back into business confidence. Companies find it difficult, maybe impossible, to raise new capital by rights issues. So they either postpone investment or seek funds from elsewhere, private equity perhaps. You should not take these dips too seriously, but at the margin they do damage confidence.
In any case, just as the turning point in share prices in March last year anticipated the turning point in developed-world economies by three or four months, so the present dip may signal trouble ahead in the real economy. Actually, a double-dip recession would be perfectly normal. As you can see from the graph, this is what has frequently happened in the past.
The figures are for the UK rather than for the world, but we are an exceptionally open economy and they give a good feeling for what is happening more widely. The National Institute of Economic and Social Research does a monthly estimate of GDP and used this to plot the progress of the current recession against those of the 1930s, 1970s, 1980s and 1990s. This time, we have had a more serious recession than most other developed countries (about the same as Germany, but worse than the US or France). Yet, as you can see, what has happened is not really any worse than that of the 1980s.
Nevertheless, there were frequently double-dips in the past. Certainly, in the 1930s and 1970s; and there was a bumpy pull-out of the 1980s recession. People talk about this recession being unprecedented, but it is not. People who think that have no knowledge of economic history.
So what will happen? Well, let's stay with the UK because things here are going to become very interesting. We have the emergency Budget next month and that will, just slightly, tighten fiscal policy. There is the promise of £6bn of spending cuts, or "efficiencies" if you prefer. When you have a deficit of £163bn, you might think £6bn is neither here nor there. Mathematically, that is true. What we don't know is what it will do to confidence. Taken in isolation it should increase it. At last we have a government that is getting on with it, rather than making speeches about the need to do something in the future.
But the cuts will not be in isolation, for they will be part of a longer-term programme of spending cuts and tax increases. It will also coincide with new forecasts for economic growth and government revenues. These will be independently verified by the new Office for Budget Responsibility, and you don't need a degree in economics to understand that the new forecasts are likely to be less optimistic than those previously published.
So we will be getting a lot of new information. We will be told that things were worse than the previous government had admitted and we will get a plan of how the new Government will cope. Then there will, from an economic perspective, be two opposing forces at work.
On the one hand, figures that are credible will increase confidence. The economy is inherently self-healing while markets are able to carry out their normal functions of signalling how companies should meet demand. When people are uncertain about the future, it becomes harder for this self-healing process to work. Coupled with the relatively cheap pound, which increases export demand and tends to curb imports, a steady recovery on the lines of previous cycles should get going. Ill-judged comments by politicians can undermine that, as we have seen in Germany in the past week, but I cannot quite see the new Government falling into that trap.
On the other hand, there will be countervailing forces. In the next few years, the fiscal tightening will be sharper than anything since the Second World War. I think people will be quite shocked when they realise what is going to happen. It is not just a one- or two-year squeeze. It will go on and on through the life of this parliament. So the key question is whether the mathematical loss to demand from fiscal tightening will be more than offset by the rise in confidence in the private sector, despite the higher taxes being loaded on to it.
We can't know the answer. But we can take a little comfort from the reverse situation of the past year. We have the biggest deficit of the G20. But we have not had a particularly strong recovery. So perhaps the deficit has not helped as much help in sustaining demand as you might have expected. So maybe when the deficit is cut, it will not reduce demand by as much as you would expect. That would be my instinct, but I wish I had some evidence to back that view up.
One thing is for sure. This clash in Europe between politicians and the markets will damage the recovery. Let's hope the clash does not also erupt on this side of the Channel.
President Obama acts tough with tighter regulation for US banks
One of the things absent from the radar of most people in Europe has been the unfolding drama in the US over bank regulation. Until a few weeks ago, it seemed the bank lobbyists were winning the battle in Congress and the industry would receive a relatively benign revision of existing legislation – benign, that is, from the perspective of the banks.
This seems to have changed. Maybe it was through a general revulsion at the arrogance of the industry representatives, maybe a wider hostility towards the business community, evident in the response to BP's environmental disaster. Maybe it has been simply that President Obama felt himself mocked by the financial services industry – not a good idea – and reckons it's pay-back time.
Thus the industry is now aware that billions spent in lobbying may have been wasted, and while the final form of legislation is unclear, it does not like what it is hearing. Or, rather, part of it does not, because there is a sizeable body of opinion wanting to see the industry nudged back towards its old customer-service values. You don't sell financial products that are not in your customers' self-interest, since you have fiduciary responsibility to them as well as commercial responsibility to your own institution.
One key issue will be the level of separation between client sales and trading. It is hard to see a full return to separation, for that distinction has long broken down. You have to start with the structure you have got. And of course banks have to be able to trade on the markets on their own account – ie, not for clients. But banks may find they to separate their client business much more explicitly from their own trading. The idea that you sell a product to a client and then bet against it has proved repugnant to all.
There is a further issue. The market in state and municipal debt is facing up to the probability that a city may declare itself bankrupt in the next few months. This would give a further shock to the financial system, some parts of which could be caught in the crossfire. Conclusion? The US financial system remains fragile and that fragility will reinforce the calls for tighter regulation.Reuse content