Stephen King: No bust, but still far from boom

Economies are on life support, and it's not clear what happens when that is removed

On arriving in Davos on Tuesday, I detected a mood of cautious optimism. Perhaps it was the snow, the sunny weather and, for some of the delegates at the annual World Economic Forum, the prospect of a bit of skiing a little later in the week. More likely, however, many of those attending were simply relieved. After all, a year earlier, the world's great and good were dreading the onset of a Great Depression Mark II, doubtless fuelled by assorted apocalyptic warnings from Nouriel Roubini, Davos's self-styled Doctor Doom. In the event, however, a Great Depression Mark II didn't materialise. For those who think we live in a binary world in which economies either boom or bust, the avoidance of the worst possible outcome was obviously very good news indeed: if the bust was out of the way, it was surely time to pop open a few bottles of chilled Laurent Perrier.

Yet, as the week progressed, the mood of this gathering of supposedly strategic long-term thinkers darkened. Why did optimism shift so quickly to gritty realism and then to renewed pessimism?

Partly, I suspect, it dawned on delegates that this was no ordinary economic recovery (if, indeed, there is ever such a thing). There were, it seemed, too many bumps in the road ahead. Over the last three decades – a working lifetime for most people at Davos – recoveries have been mostly market-led. This recovery, however, is rather unusual. The market has not played much of a role. Interest rates are remarkably low but, rather than stimulating a big increase in credit growth, banks remain cautious and, within the private sector, there's a shortage of willing borrowers. Money supply growth has collapsed. Admittedly, the inventory cycle is still working – as demon- strated by the big rebound in US economic activity at the tail end of last year – but the overall impression is that economies are still on life support, demonstrated by huge increases in budget deficits. It's not obvious what happens when that life support is removed. Stock-market jitters since the beginning of the year have only served to reinforce this fear.

Put another way, the economic outlook depends, critically, not so much on tried-and-tested market mechanisms but, instead, on the sometimes-fickle choices made by policymakers. And, as the week progressed, there seemed to be little clarity regarding those choices.

Following last year's promises that any reforms to the financial system would be made under the auspices of the G20, it suddenly appears that the appetite for a multilateral solution is fading. Whatever anyone thinks about the details of President Obama's proposals to reform the banks, the message is abundantly clear: the US has adopted a unilateral approach which may endanger the functioning of what, over the years, has evolved into a genuinely global capital market. It may well be that that huge cross-border capital flows have created additional instability, but it is surely important to recognise also that heightened capital flows have been instrumental in lifting people in many hitherto un- successful economies out of poverty.

Then there's the issue of exit strategies from the life support policies which now dominate economies in the Western world. Some think that it's too early to do anything. Others believe that interest rates should rise immediately to reduce the risk of yet more financial bubbles. And there are still others – and I include myself in this category – who believe that it's better to start by tightening fiscal policy, leaving interest rates lower for longer.

This level of confusion is not good for economic recovery. What should businesses be worrying about? Higher interest rates, higher taxes or cutbacks in public services? Should they be concerned about exchange-rate instability or, instead, should they be worrying about sovereign default and a possible rise in long-term borrowing costs?

The problem stems, in part, from the rather comfortable distinction made in recent years between the aims of monetary policy – designed to control inflation – and fiscal policy – aimed primarily at good budgetary housekeeping at the national level.

This compartmentalised approach no longer works. The scale of budgetary adjustment now required in the US, the UK and elsewhere is so large that it will inevitably have an impact on inflation. That makes life tough for central bankers. Having had sole responsibility for the control of inflation, they will now find themselves in an unwanted power-sharing agreement with governments comprised of ministers who, inevitably, will respond not only to economic necessity but also to electoral expediency. Indeed, in a speech in Davos on Friday, David Cameron, the leader of the Conservative Party, appeared to be softening his line on the need for early and aggressive spending cuts in the event of a Tory victory at the next general election. If a changing political calculus determines the amount of austerity likely to be delivered in any one year, how should the Bank of England react?

Uncertainty over the fiscal outlook is not, of course, restricted to the US or the UK. Another big theme last week was the growing fiscal crisis in Greece. Would the Greek government deliver the necessary austerity? Would the Germans and French be happy with any Athens fiscal plan? What if the Greeks were forced to default? Was there a risk of contagion spreading to other fiscally incontinent nations within the eurozone?

Unlike the US, the eurozone has no centralised fiscal authority to smooth over local fiscal difficulties. That's one key reason why financial markets are much more worried about Greece than they are about California, which, frankly, is also in a deep fiscal crisis. Greece, however, reveals a deeper truth about the state of the world economy. We are no longer living in a world in which economic outcomes will be determined by the invisible hand of the market; economic outcomes are increasingly dependent on the politically possible. As the Greek example demonstrates, there is no guarantee that the result will be either economically or financially attractive.

But perhaps the biggest concern at Davos, at least from a Western perspective, was the sense that economic power was shifting eastwards. Plenty of platitudes were expressed about the importance of open trade and the opportunities provided by economic strength in China and other emerging nations. The truth, however, is that Davos will look very different in 25 years' time. The Americans will still have a voice, but China and India will increasingly dominate. Individual European countries will have little of importance to say and will, increasingly, be ignored. And, despite the image of happy families and photo shoots in the snow, the world will be dominated by superpower rivalry. Indeed, as this year's Davos drew to a close, the Americans were already rattling their sabres through the announcement of a new arms deal with Taiwan. International relations are undoubtedly moving in a less harmonious direction as the Western world, economically, struggles to recover.

stephen.king@hsbcib.com

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