Anatole Kaletsky Fri, 19 Dec 2014 11:41:51 +0000 en-US hourly 1 The reason oil could drop as low as $20 per barrel Fri, 19 Dec 2014 04:50:35 +0000 An oil pump jack pumps oil in a field near Calgary

How low can it go — and how long will it last? The 50 percent slump in oil prices raises both those questions and while nobody can confidently answer the first question (I will try to in a moment), the second is pretty easy.

Low oil prices will last long enough for one of two events to happen. The first possibility, the one most traders and analysts seem to expect, is that Saudi Arabia will re-establish OPEC’s monopoly power once it achieves the true geopolitical or economic objectives that spurred it to trigger the slump. The second possibility, one I wrote about two weeks ago, is that the global oil market will move toward normal competitive conditions in which prices are set by the marginal production costs, rather than Saudi or OPEC monopoly power. This may seem like a far-fetched scenario, but it is more or less how the oil market worked for two decades from 1986 to 2004.

Whichever outcome finally puts a floor under prices, we can be confident that the process will take a long time to unfold. It is inconceivable that just a few months of falling prices will be enough time for the Saudis to either break the Iranian-Russian axis or reverse the growth of shale oil production in the United States. It is equally inconceivable that the oil market could quickly transition from OPEC domination to a normal competitive one. The many bullish oil investors who still expect prices to rebound quickly to their pre-slump trading range are likely to be disappointed. The best that oil bulls can hope for is that a new, and substantially lower, trading range may be established as the multi-year battles over Middle East dominance and oil-market share play out.

The key question is whether the present price of around $55 will prove closer to the floor or the ceiling of this new range. The history of inflation-adjusted oil prices, deflated by the U.S. Consumer Price Index, offers some intriguing hints. The 40 years since OPEC first flexed its muscles in 1974 can be divided into three distinct periods. From 1974 to 1985, West Texas Intermediate, the U.S. benchmark, fluctuated between $48 and $120 in today’s money. From 1986 to 2004, the price ranged from $21 to $48 (apart from two brief aberrations during the 1998 Russian crisis and the 1991 war in Iraq). And from 2005 until this year, oil has again traded in its 1974 to 1985 range of roughly $50 to $120, apart from two very brief spikes in the 2008-09 financial crisis.

What makes these three periods significant is that the trading range of the past 10 years was very similar to the 1974-85 first decade of OPEC domination, but the 19 years from 1986 to 2004 represented a totally different regime. It seems plausible that the difference between these two regimes can be explained by the breakdown of OPEC power in 1985 and the shift from monopolistic to competitive pricing for the next 20 years, followed by the restoration of monopoly pricing in 2005 as OPEC took advantage of surging Chinese demand.

In view of this history, the demarcation line between the monopolistic and competitive regimes at a little below $50 a barrel seems a reasonable estimate of where one boundary of the new long-term trading range might end up. But will $50 be a floor or a ceiling for the oil price in the years ahead?

There are several reasons to expect a new trading range as low as $20 to $50, as in the period from 1986 to 2004. Technological and environmental pressures are reducing long-term oil demand and threatening to turn much of the high-cost oil outside the Middle East into a “stranded asset” similar to the earth’s vast unwanted coal reserves. Additional pressures for low oil prices in the long term include the possible lifting of sanctions on Iran and Russia and the ending of civil wars in Iraq and Libya, which between them would release additional oil reserves bigger than Saudi Arabia’s on to the world markets.

The U.S. shale revolution is perhaps the strongest argument for a return to competitive pricing instead of the OPEC-dominated monopoly regimes of 1974-85 and 2005-14. Although shale oil is relatively costly, production can be turned on and off much more easily – and cheaply – than from conventional oilfields. This means that shale prospectors should now be the “swing producers” in global oil markets instead of the Saudis. In a truly competitive market, the Saudis and other low-cost producers would always be pumping at maximum output, while shale shuts off when demand is weak and ramps up when demand is strong. This competitive logic suggests that marginal costs of U.S. shale oil, generally estimated at $40 to $50, should in the future be a ceiling for global oil prices, not a floor.

On the other hand, there are also good arguments for OPEC-monopoly pricing of $50 to $120 to be re-established once markets test the bottom of this range. OPEC members have a strong interest in preventing a return to competitive pricing and could learn to function again as an effective cartel. Although price-fixing becomes more difficult as U.S. producers increase market share, OPEC could try to impose pricing “discipline” if it can knock out many U.S. shale producers next year. The macro-economic impact of low oil prices on global growth could help this effort by boosting economic activity and energy demand.

So which of these arguments will prove right: The bearish case for a $20 to $50 trading-range based on competitive market pricing? Or the bullish one for $50 to $120 based on resumed OPEC dominance?

Ask me again once the price of oil has fallen to $50 – and stayed there for a year or so.


PHOTO: An oil pump jack pumps oil in a field near Calgary, Alberta, July 21, 2014. Pump jacks are used to pump crude oil out of the ground after an oil well has been drilled. REUTERS/Todd Korol

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Ukraine’s frozen war brings dramatic changes to world economy Fri, 12 Dec 2014 20:21:25 +0000 Pro-Russian separatists from the Chechen "Death" battalion take part in a training exercise in the territory controlled by the self-proclaimed Donetsk People's Republic

The “day of silence” observed this week by the Ukrainian army and its pro-Russian rebel opponents was an event of enormous economic importance for global economics as well as geopolitics.

The cease-fire’s success confirmed that the truce in Ukraine, agreed to on Sept. 5, is mostly holding, despite some local fighting and Western pundits’ virtually unanimous predictions that the war would quickly resume. The durability of September’s truce suggests that relations between Kiev and Moscow are gradually reverting toward an uneasy form of peaceful coexistence.

If so, then last summer’s civil war in Ukraine will probably evolve into a broadly stable “frozen conflict,” similar to the stalemates that have prevailed for years, even decades, in Georgia, Moldova, Armenia, Azerbaijan, Kosovo, Cyprus and Israel, to name just the frozen conflicts closest to Europe.

Though nobody can be fully satisfied with this outcome, Ukraine, Russia and Europe should all heave sighs of relief. So should anyone concerned about the outlook of the global economy.

Let us begin with Ukraine. The loss of Crimea is irrelevant because much of that peninsula was already leased to Russia and was not even part of Ukrainian territory until 1954. Losing Donbas is more serious because it is one of the country’s main industrial regions. But normal economic relationships could soon be reestablished because Russia needs to sell Donbas’ coal and steel as much as Ukraine needs to buy it.

Because the profits from these activities were largely misappropriated by corrupt officials and oligarchs, it will make no great difference to Ukraine if they are stolen by pro-Russian rebels instead.

Meanwhile, Ukrainian national identity has been strengthened by the conflict. Although Ukraine is unlikely ever to be admitted to either the European Union or the North Atlantic Treaty Organization — given the opposition in Germany and France, as well as in Russia — an EU association agreement, similar to Turkey’s, could help reduce corruption and encourage economic reform. A dual trading relationship with both Europe and Russia could ultimately offer Ukraine the only possible route to economic viability. This sort of relationship should become possible once this year’s conflict is definitively “frozen.”

Now consider Russia. Assuming that Kiev and the West reluctantly accept the status quo in Crimea and Donbas — and nobody seems to have any ideas about how to wrest this territory back from Moscow — President Vladimir Putin seems unlikely to attempt any further territorial expansion, at least without some new geopolitical pretext. In that case, the EU sanctions against Russia may well expire automatically in March and July. They have been set for a one-year term, and a consensus to extend them will be hard to muster if the fighting in Ukraine dies down.

Whether or not the sanctions are lifted, Russia is already undergoing an economic transformation.

With oil prices and the ruble collapsing, Russia’s political and business leaders are realizing that the post-Soviet economic model of full-scale financial liberalization and integration with the global economy has condemned them to overdependence on energy exports and industrial imports from Western Europe. Partly as a result, Russia has succumbed to the classic symptoms of the “natural resource curse”: an overvalued currency, deindustrialization, conspicuous consumption, excessive government spending, weak domestic tax collection and extreme vulnerability to international capital flows.

In response, Russia is starting to restructure its economy. It is moving away from the classical free-trade model that it adopted in the 1990s, which encouraged Moscow to export raw materials and import industrial goods because that was implied by the Ricardian law of comparative advantage. The alternative development model, which Russia will now favor, is the one followed by other big emerging economies, including China, India and Brazil, and before them, South Korea and Japan.

This Asian model will mean more protection for domestic industries, more control over international capital flows and less reliance on imports — even if that means lower quality and higher prices for Russian consumers.

To the extent that Russia remains a major resource exporter, its trading and financial strategies, as well as its geopolitical alliances, will be redirected toward China and Asia. This strategic realignment will, over time, increase China’s economic dominance in Asia. It may also strengthen the influence of China’s authoritarian Confucian politics as a counterweight to the liberal democratic model promoted by the United States and the European Union, a philosophical shift that Putin would welcome.

What about the implications of a “frozen conflict” for Europe and the world? The good news is that a definitive end to the fighting in Ukraine would remove the biggest single obstacle to economic recovery in Europe. The threat of all-out war in Central Europe was probably the most important cause of last summer’s sudden slump in the eurozone, especially in Germany. If war were to break out again, the shock to business confidence would certainly overwhelm any stimulus efforts by the European Central Bank.

The bad news is that a frozen conflict in Ukraine will weaken the postwar assumption that European borders cannot be changed by force, as German Chancellor Angela Merkel lamented again this week. The fact is, however, that European borders have been violently redrawn throughout the past 25 years, after the breakup of the Soviet Union and Yugoslavia.

The principle of national sovereignty has been breached repeatedly — not least by the United States, Britain and France in Afghanistan, Iraq, Libya and Syria, as well as in Israel and Cyprus. Such breaches will doubtless continue from time to time, whether or not the sanctions against Russia continue.

More worrying to the West than the diplomatic precedents set by a frozen conflict in Ukraine should be the global implications of Russia moving into the Chinese geopolitical and economic orbit. But given the intensity of Western interactions with China, peaceful coexistence and economic cooperation should also be possible with a Russia that decides to follow the Chinese models of economic management, business transparency and nondemocratic government.

PHOTO: Pro-Russian separatists from the Chechen “Death” battalion take part in a training exercise in the territory controlled by the self-proclaimed Donetsk People’s Republic, eastern Ukraine, Dec. 8, 2014. REUTERS/Maxim Shemetov

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Here’s why oil companies should be a lot more profitable than they are Fri, 05 Dec 2014 01:36:17 +0000 Shaybah oilfield complex is seen at night in the Rub' al-Khali desert, Saudi Arabia

The 40 percent plunge in oil prices since July, when Brent crude peaked at $115 a barrel, is almost certainly good news for the world economy; but it is surely a crippling blow for oil producers. Oil prices below $70 certainly spell trouble for U.S. and Canadian shale and tar-sand producers and also for oil-exporting countries such as Venezuela, Nigeria, Mexico and Russia that depend on inflated oil revenues to finance government spending or pay foreign debts. On the other hand, the implications of lower oil prices for the biggest U.S. and European oil companies are more ambiguous and could even be positive.

In fact, the shareholders of oil majors such as Exxon, Chevron, Shell, BP and Total could be among the biggest beneficiaries of the price slump, if it forces their corporate managements to abandon some of the bad habits they acquired in the 40-year oil boom when OPEC first established itself as an effective cartel in January, 1974. If this period of cartelized monopoly pricing is now ending, as Saudi Arabia has strongly hinted in the past few weeks, then it is time to re-focus on some basic principles of resource economics that Big Oil managements have ignored for decades, to their shareholders’ enormous cost.

The most important of these principles is “diminishing returns”: The more oil that corporate geologists discover, the lower the returns their shareholders can hope to achieve, because new reserves will almost invariably be more expensive to develop than the ones discovered earlier that were, almost by definition, more accessible. This inherent flaw in the oil companies’ business model was disguised for the past 40 years by the fact that oil prices rose even faster than the costs of exploration and production. But this is where a second economic principle now starts to bite.

Unless a market is totally dominated by monopoly power, prices will be set by the most efficient supplier’s marginal costs of production – in layman’s terms, by the cost of producing an extra barrel from oil reserves that have already been discovered and developed. In a fully competitive market, the enormous sums of money invested in exploring for new oil fields could not be recovered until all lower-cost reserves ran dry and there would be no point in exploring for anywhere outside the Middle Eastern and central Asian oilfields where the oil is easiest to pump.

That is, of course, an over-simplification. In the real world of geopolitical conflicts and transport and infrastructure bottlenecks, consumers want energy security and will pay premium prices for supplies from their own oil-fields or from those that belong to trusted allies. Nevertheless, the broad principle applies: The vast sums spent on exploring and developing new reserves with production costs much higher than in Middle East oilfields will never be recovered if the oil market becomes even vaguely competitive.

Considering that Western companies spend about $450 billion annually on exploration and development according to the Ernst & Young oil reserves study, this could be one of the worst capital misallocations in history. The fact is that Western producers can never match the costs of oil pumped by Saudi Aramco, or even Rosneft or other state-owned companies with exclusive access to the world’s most accessible reserves. While Exxon or BP must spend billions drilling through Arctic ice-caps or exploring 5 miles under the Gulf of Mexico, the Saudis can pump oil from their deserts with machines not much more expensive than old-fashioned “nodding donkeys.”

In a competitive market the rational strategy for Western oil companies would be stop all exploration, while continuing to provide technology, geology and other profitable oilfield services to the nationalised owners of readily-accessible reserves. The vast amounts of cash generated by selling oil from existing low-cost reserves already developed could then be distributed to shareholders until these low-cost oilfields ran dry. This strategy of self-liquidation could be described euphemistically as “running the business for cash” in the same way as tobacco companies or closed insurance funds.

There are two reasons why this hasn’t happened thus far. Firstly, OPEC has sheltered Western oil companies from diminishing returns and marginal-cost pricing by keeping prices artificially high through output restraint and limited expansion of cheap Middle Eastern oilfields (strictures reinforced by wars and sanctions in Iraq and Iran). Secondly, oil company managements have believed with quasi-religious fervour in perpetually rising oil demand. Therefore finding new reserves seemed more important than maximising cash distributions to shareholders.

The second assumption could soon be overturned, as suggested by rumours of a takeover bid for BP. If private equity investors could raise the $160 billion needed to buy BP, they could liquidate for cash a company whose proven reserves of 10.05 billion barrels would be worth $350 billion even after another 50 percent price decline.

But what of the first condition? The Saudis would surely want to stabilize prices at some point by limiting production, but the target prices may now be considerably lower than previously assumed. The Saudis seem to have realised that by ceding market share to other producers they risk allowing much of their oil to become a worthless “stranded asset” that can never be sold or burnt. With the global atmosphere approaching its carbon limits and technological progress gradually reducing the price of non-fossil fuels, the Bank of England warned this week that some of the world’s oil reserves could become “stranded assets,” with no market value despite the huge sums sunk into the ground by oil companies, their shareholders and banks.

The Saudis are well aware of this risk. Back in the 1970s, Sheikh Zaki Yamani, the wily Saudi oil minister used to warn his compatriots not to rely forever on selling oil: “The stone age didn’t end because the cave-men ran out of stones.” Maybe the end of the “oil age” is now approaching, and the Saudis have understood this better than Western oil-men.

PHOTO: Shaybah oilfield complex is seen at night in the Rub’ al-Khali desert, Saudi Arabia, November 14, 2007. REUTERS/ Ali Jarekji

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Stock markets set to take off as Europe, Asia abandon austerity Fri, 28 Nov 2014 14:30:23 +0000 A pedestrian walks past an electronic board showing Japan's Nikkei average outside a brokerage in Tokyo

The Great Divergence is a term coined by economic historians to explain the sudden acceleration of growth and technology in Europe from the 16th century onward, while other civilizations such as China, India, Japan and Persia remained in their pre-modern state. This phrase has recently acquired a very different meaning, however,  more relevant to global economic and financial conditions today.

Early last year, the International Monetary Fund published in its World Economic Outlook an article analyzing “The Great Divergence of Policies” around the globe since the 2008 crisis. The article pointed out that “exceptionally accommodative” monetary policies designed to stimulate recovery were being counteracted by “unusually contractionary fiscal policies” in every advanced economy, first in in the eurozone and Britain, later in the United States and Japan.

More recently, financial markets have become obsessed with another “great divergence.” Allianz Global Investors, parent company of PIMCO, the world’s biggest bond fund, described it like this in “Navigating the Great Divergence”: “With the Fed[eral Reserve] pondering rate hikes and the ECB [European Central Bank] launching new stimulus … investors are faced with divergent influences from [monetary policy]. Investor concerns are diverging on both sides of the Atlantic.”

Why should businesses and investors care about this lexicography? Because by the time an economic trend has become an analytical cliché, it is usually over — and sometimes a counter-trend has already begun.

European Central Bank Governor Mario Draghi speaks at a news conference during the World Bank/IMF annual meetings in WashingtonThe Great Divergence — both between fiscal and monetary policy and between the United States and other countries — is a case in point. The important trends today, especially after October policy changes in Japan and Europe, are not divergence but convergence.

This Great Convergence of macroeconomic policies between the United States and the rest of the world will drive financial markets and dominate business conditions in the year ahead. It is not yet reflected, however, in asset prices or market trends. Investors continue to obsess about the tiny gap that may or may not open up between U.S. and European policies sometime next year, when the Fed starts gently raising interest rates.

Far more important than a likely difference next year of a quarter or half a percentage point between short-term interest rates on both sides of the Atlantic, though, is the convergence of economic philosophies and objectives for the first time since the 2008 economic crisis. In the past two months, Japan, Europe and China all moved toward further aggressive monetary stimulus and reversed previous commitments to fiscal austerity.

Though it is true that these global policy shifts coincided with the end of the Fed’s quantitative-easing program, this accident of timing does not imply that the United States is diverging from Europe and Asia. What is really happening is that Europe and Asia are finally — and reluctantly — following Washington’s road map out of the Great Recession.

In the eurozone, Britain and China, hawkish central bankers have been silenced and monetary policy has been reset for full-scale stimulus — most recently by the European Central Bank, which has belatedly accepted the principle of U.S.-style quantitative easing. In Japan, where money-printing presses were already running at full throttle, they have speeded up even more.

Japan's Prime Minister Abe attends a news conference at his official residence in Tokyo

The budgetary consolidation planned in Japan and the eurozone has been abandoned — discretely in Italy, France and Britain, where the government will confirm a massive budget slippage next Wednesday, or spectacularly in Japan, where Prime Minister Shinzo Abe has called a snap general election to confirm his political victory over the austerity-minded ministry of finance bureaucrats who were insisting on another tax hike next year. Even though they created a recession this year with the same policy mistake.

The upshot is that every advanced economy is now following broadly the same macroeconomic policies as the United States: maximal monetary stimulus combined with fiscal neutrality and the suspension of counterproductive budget rules. Assuming that Europe and Japan continue to pursue with conviction these Washington-style expansionary policies, they should eventually achieve similar results — gradual improvements in employment and financial conditions, powered by faster economic growth. This trend was confirmed in the United States again this week by the upward revision of 3rd-quarter gross domestic product growth to 3.9 percent.

In addition to the likely improvement in European and Asian economies, convergence of global economic policies toward the U.S. monetary and fiscal model could have several unexpected financial implications.

The euro and the yen, instead of continuing to fall against the dollar as most experts now expect, could stabilize if the European and Japanese economies start improving. By next year, these currencies may even strengthen because the Bank of Japan and the ECB will need to print less money than now expected if their governments reverse self-destructive fiscal austerity.

Similarly, stock markets around the world would start to perform better than Wall Street if investors became convinced that Europe, Japan and China were as committed as Washington is to expansionary policies. The first signs of this sentiment shift could be detected in Japan, after Abe’s reflationary measures in late October, and in China, after the surprise monetary easing last week. If ECB President Mario Draghi can convince investors that he has political support for aggressive monetary stimulus, European equities could also start to outperform.

In bond markets, by contrast, U.S. investors should be the main beneficiaries of global policy convergence. More aggressive quantitative easing in Japan and Europe will likely increase the demand for bonds in the United States, as well as in those economies. As a result, U.S. bond prices will remain higher than normal — instead of falling in response to stronger economic growth.

Better still, the Fed will face less pressure to tighten monetary policy than usual in an economic expansion because quantitative easing in Japan and Europe will keep U.S. bond yields reassuringly low.

In short, the global abandonment of austerity and shift towards the U.S. macroeconomic model is good news all round. Let’s hope the Great Convergence continues.

PHOTO (TOP): A pedestrian walks past an electronic board showing Japan’s Nikkei average outside a brokerage in Tokyo November 11, 2014. REUTERS/Yuya Shino

European Central Bank Governor Mario Draghi speaks at a news conference during the World Bank/IMF annual meetings in Washington October 11, 2014. REUTERS/Joshua Roberts

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Why Britain’s days as a haven of political, economic stability are numbered Fri, 21 Nov 2014 20:06:37 +0000 Flares are let off as police stand guard while pro-union protestors clash with pro-independence protestors during a demonstration at George Square in Glasgow

For the past five years, Britain has been a haven of political and economic stability amid the turbulence in Europe. No longer.

In the years ahead, Britain will likely be Europe’s most politically unpredictable country. This risk, first brought to the world’s attention by the Scottish independence referendum in September, has been confirmed by the defeat suffered by Prime Minister David Cameron’s Conservative Party in a special election on Thursday.

Yet the loss of Britain’s safe-haven status is not yet factored into asset prices — especially sterling. The pound is still near its strongest since 2008 despite the country’s current-account and budget deficits, the biggest in Europe relative to gross domestic product.

Although Britain faces an unpredictable general election on May 7, most investors and businesses are still behaving as if political uncertainty would have limited impact on economic conditions. This complacency seems misplaced, for three reasons:

Britain's Prime Minister David Cameron delivers a speech at the Aberdeen Exhibition and Conference Centre in Aberdeen, Scotland

First, Britain could become literally ungovernable after the election, with no single party or coalition of parties able to form a majority government. Current public opinion polls predict that neither the Conservatives nor the Labour Party will win enough seats to form a majority government — even in a coalition with Liberal Democrats.

Conservative-Liberal and Labour-Liberal majorities may both prove arithmetically impossible because of the rise of previously insignificant fringe parties. The Scottish Nationalists look able to boost their six seats in Parliament to anything between 20 and 50, largely at Labour’s expense. The United Kingdom Independence Party is threatening dozens of Conservative incumbents. Meanwhile, the Liberals are almost certain to lose about half their 56-seat representation. As a result, a ruling coalition may have to include not just two parties but three or four, including fringe nationalist groups.

The Scottish National Party is sure to demand another Scottish independence referendum as its price for supporting a coalition, while the UK Independent Party will likely insist on Britain’s withdrawal from the European Union. It is hard to imagine either Labour or Conservatives agreeing to such terms.

This means that a government may have to be formed without a majority in Parliament. While minority governments are quite common in continental Europe, the British Parliament has only once failed to produce a government majority — during a brief interlude in 1974 under Harold Wilson. It created seismic upheavals in Britain’s adversarial politics.

The second reason for concern is that a multiparty coalition or minority government, even if it can be patched together in post-election haggling, will probably collapse within a year or two. Whether the next prime minister turns out to be Cameron or Labour’s Ed Miliband, he will be seen as a short-term caretaker, passing only non-controversial measures.

United Kingdom Independence Party (UKIP) supporters canvas for votes in Rochester

At some point in 2016 or 2017 at the latest, the opposition parties are almost certain to unite in a vote of no confidence on some major issue — bringing down the government. This would force a new election in spite of the theoretical requirement that Parliament should serve a fixed five-year term.

The near-certainty that whatever government emerges in May will fall within a year or so, raises the third and most troubling business issue. A snap election in 2016 or 2017 is most likely to produce an overtly euro-sceptic government, committed to taking Britain out of the European Union.

Since a continuation of the current coalition is almost impossible because of Tory commitment to an EU referendum, which the Liberals oppose, Cameron may only be able to lead the next government if his party wins an outright majority or forms an alliance with the Scottish Nationalists, UK Independent Party and other fringe parties. An outright Tory majority is out of the question, according to current opinion polls, and time is running out for the surge in support the Tories were expecting as a result of economic recovery.

A Tory government supported by Scottish Nationalists and UKIP is a more plausible option. But the glue holding together such a coalition would be an EU referendum on membership terms that the rest of Europe would be extremely unlikely to accept.

UKIP would certainly press for such an impossible negotiating mandate and even the Scottish Nationalists would do so for tactical reasons. The Scots would insist that a British vote to exit the European Union should be followed immediately by one on Scotland leaving Britain. And in this second referendum, the generally pro-European Scots would almost certainly vote to leave. The chaotic breakup of the constitutional status quo would then be complete.

An EU exit might, paradoxically, be even more likely if a Labour-Liberal coalition comes to power in May. Though both parties are committed to keeping Britain in Europe, a weak Labour-Liberal government would face falling business confidence and possibly a sterling crisis. So it would be even more likely to fall in a snap election than a Tory-Nationalist coalition.

Meanwhile, the Tories, forced into opposition, would undoubtedly replace Cameron as leader with a more hard-line euro-sceptic — possibly Boris Johnson, the popular and populist mayor of London. If so, the snap election in 2016 or 2017 would probably result in a landslide for radically euro-sceptic Tories in alliance with the UK Independence Party. A quick referendum mandating the new government to negotiate an exit from the European Union would then become an odds-on bet.

All these scenarios can, of course, be qualified with numerous ifs and buts. Many political surprises will surely occur between now and 2017. In the end, the instinctive caution of the British electorate might well prevail — as it did in the Scottish referendum — preserving the status quo of British membership in the European Union.

But whatever ultimately happens, outbreaks of political panic are near-certain in the six months before the general election. Then again during the period of turmoil and ungovernability leading up to a snap election and EU referendum in 2017.

Investors and businesses in Britain are queuing up for a roller-coaster ride.


Flares are let off as police stand guard while pro-union protestors clash with pro-independence protestors during a demonstration at George Square in Glasgow, Scotland September 19, 2014. REUTERS/Cathal McNaughton

Britain’s Prime Minister David Cameron gestures as he delivers a speech at the Aberdeen Exhibition and Conference Centre in Aberdeen, Scotland September 15, 2014. REUTERS/Dylan Martinez

United Kingdom Independence Party supporters canvas for votes in Rochester, south east England, November 18, 2014. REUTERS/Paul Hackett

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Time for a ‘melt-up': the coming global boom Fri, 14 Nov 2014 07:21:54 +0000 European Central Bank Governor Mario Draghi speaks at a news conference during the World Bank/IMF annual meetings in Washington

Get ready for a “melt-up.”

Back in mid-October, as stock markets around the world plunged faster than at any time since 2011, many investors and economists feared a meltdown. But with the U.S. economy steadily expanding, monetary and fiscal policies becoming more stimulative in other parts of the world and the autumn season for financial crises now over, a melt-up seems far more likely.

There are many fundamental reasons for believing that stock markets may have embarked on a long-term bull market comparable to those in the 1950s and 1960s, or the 1980s and 1990s, and that this process is nearer its beginning than its end. Such arguments have been discussed repeatedly in this column over the past 18 months — ever since the Standard & Poor’s 500, the world’s most important stock-market index, broke out of a 13-year trading range and started scaling new highs in March 2013. Wall Street has been setting records ever since.

These are the four most important arguments for a structural bull market:

First and foremost, the worst financial and economic crisis in living memory has ended, and most parts of the world economy are enjoying decent, if unspectacular, growth. Second, economic and financial policies around the world, though far from perfect, are highly predictable and therefore unlikely to cause further market disruptions. Third, technology is continually advancing and innovation is creating new products, services and processes that stimulate both investment and consumer demand. Finally, inflation is almost nonexistent, at least in the advanced economies, meaning interest rates are guaranteed to stay low for a very long time.

Even in such benign conditions, minor corrections and panics are bound to happen. Financial markets always move in boom-bust cycles, as greed alternates with fear. We saw this in early October, when Wall Street fell by 10 percent in three weeks and equity prices in Europe plunged by almost 20 percent in relation to the U.S. dollar. Such setbacks, however, actually reinforce the uptrend if the fears that triggered them turn out to be illusory — or less daunting than they first appeared. That is exactly what has happened.

There were two obvious catalysts for last month’s stock-market retreat: a sudden drop in oil prices and a run of dismal economic figures from Europe and Japan. The first problem was never likely to prove more than a temporary hiccup because  falling oil prices are, on balance, beneficial to consumption and corporate profits — even if they hurt energy-producing companies and countries.

By contrast, the second problem — slumping economies in Europe and Japan — threatened investors with a genuine nightmare. No matter how well the U.S. economy might perform, global businesses could not shrug off a possible recession in Europe and Japan, especially if the governments or central banks in these countries refused to follow the U.S. model of fiscal and monetary stimulus to revive growth.

Luckily, the policy paralysis in Europe and Japan has now been broken and that, in turn, means that the risk of these vital regions falling back into recession is smaller than a month ago.

The most impressive sign of new policy dynamism came from Japan, with its dramatic Oct. 31 announcement that the Bank of Japan would substantially increase its already enormous monetary expansion, while the $1.2-trillion Government Pension and Investment Fund would more than double its allocation to equities and foreign bonds.

These stimulus measures have been supplemented by reports that Japanese Prime Minister Shinzo Abe might delay a tax increase planned for next October and could even call an early general election to give himself more freedom to pursue additional reforms. Abe seems to have reverted to full-scale stimulus policies after his misguided effort at fiscal tightening in April.

As a result, the favorable economic conditions of 2013 are likely to be restored in Japan next year. Investor pessimism caused by April’s tax hike has vanished — and rightly so. When the facts change, people should change their minds.

An equally surprising, though less decisive, shift toward active policy stimulus is taking place in Europe, revealed by two recent events: last Thursday’s European Central Bank meeting and the previous week’s announcement that the French and Italian governments would run bigger budget deficits than the European Commission had previously demanded under euro zone fiscal rules.

The European Commission, by accepting the two countries’ budget plans and ignoring German demands for tougher austerity, signalled the end of the fiscal tightening that has been a major obstacle to European economic recovery. The European Central Bank’s announcement was even more significant. European Central Bank President Mario Draghi explicitly committed himself for the first time to a 1-trillion euro expansion of the bank’s balance sheet and promised to take whatever measures were necessary to achieve this. This statement effectively meant that the central bank had finally agreed to implement large-scale quantitative easing — albeit employing different techniques from those used in the United States, Japan and Britain.

The fact that Europe and Japan are finally ready to follow the U.S. fiscal road map will not suddenly remove all the obstacles to growth in these economies. But it will make structural reforms easier and more effective. The prospects for a sustainable global expansion are therefore much brighter than expected a month ago.

This improvement in the global economic outlook is more than enough to justify the powerful rebound in stock markets since mid-October.

Even if economic conditions continue improving, equity prices are bound to fall sharply at some point, inflicting painful losses on investors. This is what happened in 1987, roughly five years into the last structural bull market. Boom-bust cycles are inevitable because improving economic conditions encourage speculative excesses, which are then blown away as greed gives way to fear.

But the bust cannot come before the boom — and global economic conditions suggest that a full-scale stock-market boom may be just starting.


PHOTO : European Central Bank Governor Mario Draghi speaks at a news conference during the World Bank/IMF annual meetings in Washington October 11, 2014. REUTERS/Joshua Roberts

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Why political gridlock works for the U.S. economy, but not for Japan or EU Fri, 07 Nov 2014 22:32:43 +0000 U.S. President Obama hosts a luncheon for bi-partisan Congressional leaders in the Old Family Dining Room at the White House in Washington

Is gridlocked government a betrayal of democracy? Or does it allow citizens to get on with their lives and businesses, unencumbered by meddlesome politicians?

This key question obviously comes out of the 2014 midterm elections. America’s founding fathers, well aware of potential tensions between politics and private initiative, deliberately installed big obstacles to overactive government in the Constitution.

That is why divided government in Washington has been the rule, not the exception. Presidents have historically been opposed by both houses of Congress in 32 out of the 70 years since World War Two, and by one house in another 14 years.

Whether the federal government’s deliberately engineered weakness has been causally related to America’s long-term economic success has been debated by historians and economists for decades, and will doubtless continue.

Meanwhile, political paralysis is now the norm in many democracies around the globe — especially in Europe. A big issue prompted by the U.S. midterm elections is how different countries and regions cope with political gridlock.

Draghi, President of the European Central Bank (ECB) smiles as he arrives for the ECB's monthly press conference in Frankfurt

The answer depends on whether significant reforms are needed to achieve acceptable economic and social outcomes? Or whether public policy is already well-positioned — in which case political gridlock is fine. The sharply differing economic conditions today in the United States, Europe and Japan exemplify this contrast.

For the United States, gridlock is not a problem. In fact, another two years of Washington paralysis may be just what the doctor ordered — at least from an economic standpoint.

In an ideal world, of course, Washington could do many things to improve U.S. economic and social environments. The tax code could be reformed, immigration rules rationalized, trade deals negotiated and approved, wasteful healthcare spending curbed and the many other dysfunctions of American society either fixed or ameliorated.

But in a democracy so deeply divided over attitudes toward inequality, religion, immigration, sexuality and even crime and violence, it is probably appropriate, as well as inevitable, that reforms in these areas must await more consensus.

Some significant economic objectives may even be advanced by the election results. Republican senators have generally been far more moderate and willing to strike deals with the White House than their House colleagues. And now that their party is in control of the entire Congress, the Republicans need to show their ability to govern and not just to oppose — especially with the 2016 presidential election approaching.

The implication should be a more responsible attitude toward politics and an end to such economic sabotage as last year’s debt-ceiling confrontation and government shutdown. The first test will come in mid-December, when Congress is supposed to pass 2015 spending bills. There is a second, more important, milestone in March, when the Treasury debt ceiling will need to be raised.

More generally, both Republicans and Democrats are now eager not to do any damage to an economic recovery that is gradually accelerating and becoming more sustainable. As a result, U.S. macroeconomic policy will almost certainly remain unaffected by the election results. The federal budget is in good shape, as confirmed by the unprecedented reduction of the deficit announced this week by the Congressional Budget Office.

As for monetary policy, there is unlikely to be any need for major changes in the next year or two. If unexpected events do call for a monetary response, the Federal Reserve Board will be able to take whatever action it deems necessary without any regard to the election outcome. Washington gridlock guarantees the Fed a genuine political independence that other central banks can only dream of.

In this respect, as in many others, a political stalemate has very different implications for Europe or Japan. Both, in contrast to the United States, desperately need radical reforms in monetary, fiscal and structural policies.

Japan's PM Abe reviews members of JSDF during the JSDF Air Review to celebrate 60 years since the service's founding at Hyakuri air base in Omitama

In Japan, these reforms were impossible for almost 20 years — until the December 2012 election of a strong government under Shinzo Abe. Abe’s “Three Arrows” program of monetary, fiscal and structural reflation started to transform the Japanese economy last year. But then it was paralysed by inter-ministerial bureaucratic conflict — Japan’s equivalent of U.S. gridlock.

Last week, however, the Abe program was dramatically revived with a further big monetary stimulus from the Bank of Japan and a huge stock-market boost from the $1 trillion Government Pension Investment Fund. These actions are only possible under a strong government with a clear sense of purpose.

If the euro is to survive in the long term, Europe requires coordinated policy reforms comparable to Japan’s Three Arrows program. The misguided fiscal rules written into the 1989 Maastricht Treaty, and then aggravated under German pressure during the 2012 euro crisis, will now have to be rewritten by European governments.

The European Central Bank will have to follow the Fed, Bank of Japan and Bank of England in vastly expanding its balance sheet by buying government bonds — despite powerful political pressure, again from Germany, not to. Though the ECB has strict political independence theoretically guaranteed by the European Union treaties, in practice it has been far more subservient to politicians than the Fed or even the Bank of Japan.

In fact, the ECB has recently been frozen like a rabbit in the headlights of German politics — seemingly unable to implement the decisions of its Governing Council or even to control its own balance sheet without German Chancellor Angela Merkel’s consent. Meanwhile, national leaders in France, Italy and Spain must adopt tough structural reforms that can only be implemented and made to work with the help of aggressive fiscal and monetary expansion.

Unfortunately, there seem to be no European politicians able or willing to take controversial monetary, fiscal and structural decisions. Gridlock may be perfectly acceptable in Washington these days. But Europe, like Japan, now badly needs strong political leadership.


PHOTO (TOP): President Barack Obama hosts a luncheon for bipartisan congressional leaders in the Old Family Dining Room at the White House in Washington, Nov. 7, 2014. From L-R are House Speaker John Boehner, Obama and Senate Minority Leader Mitch McConnell. REUTERS/Larry Downing

PHOTO (INSERT 1): Mario Draghi, President of the European Central Bank smiles as he arrives for the bank’s monthly press conference in Frankfurt, Nov. 6, 2014. REUTERS/Kai Pfaffenbach

PHOTO (INSERT 2): Japanese Prime Minister Shinzo Abe attends the Japan Self-Defense Force Air Review to celebrate 60 years since the service’s founding at Hyakuri air base in Omitama, northeast of Tokyo Oct. 26, 2014. REUTERS/Toru Hana

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The takeaway from six years of economic troubles? Keynes was right. Fri, 31 Oct 2014 03:57:24 +0000 Protesters clash with police during an anti-austerity rally in Athens

Now that the Federal Reserve has brought its program of quantitative easing to a successful conclusion, while the French and German governments have ended their shadow-boxing over European budget “rules,” macroeconomic policy all over the world is entering a period of unusual stability and predictability. Rightly or wrongly, the main advanced economies have reached a settled view on their economic policy choices and are very unlikely to change these in the year or two ahead, whether they succeed or fail. It therefore seems appropriate to consider what we can learn from all the policy experiments conducted around the world since the 2008 crisis.

The main lesson is that government decisions on taxes and public spending have turned out to be more important as drivers of economic activity than the monetary experiments with zero interest rates and quantitative easing that have dominated media and market attention. Fiscal decisions on budget deficits, taxes and public spending have mostly been debated as if they were largely political choices, with much less influence than monetary policy on macroeconomic outcomes such as inflation, growth and employment. Yet the reality has turned out to be the opposite. While every major economy in the world has followed essentially the same monetary policy since 2008, their fiscal policies have been very different and the divergence in outcomes, especially when we compare the United States and Europe, has been exactly the opposite to what was implied by the rhetoric of most politicians and central banks.

Countries that took emergency measures to reduce public borrowing have mostly suffered weaker growth, as in the case of Britain from 2010 to 2012, Japan this year and the United States after the 2013 “sequester” and fiscal cliff deal. In more extreme cases, such as Italy and Spain, fiscal tightening has plunged them back into deep recession and aggravated financial crises. Meanwhile countries that ignored their deficit problems, as in the United States for most of the post-crisis period, or where governments decided to downplay their fiscal tightening plans, as in Britain this year or Japan in 2013, have generally done better, both in terms of economics and finance. The one major exception has been Germany, where budgetary consolidation has managed to coexist with decent growth, largely because of a boom in machinery exports to Russia and China that is now over, pushing Germany back into the recession its stringent fiscal policy suggested all along.

Thus the six years since 2008 have provided strong empirical support for the supposedly outmoded Keynesian view that government borrowing is more powerful than monetary policy in stimulating severely depressed economies and pulling them out of recession. In a sense, it is odd that the power of fiscal policy has come as a surprise – or that it continues to be categorically denied by the German government and the U.S. Tea Party. The underlying reason why fiscal policy is so important in recessions, and has now come to dominate over monetary policy, is a matter of simple arithmetic that should not be open to debate.

Recessions generally occur when private business and households decide to spend less than their incomes in order to reduce their debts or increase their savings. If this process of “deleveraging” is happening in the private sector, which it clearly has been, then simple arithmetic shows that economic balance can only be restored if some other sector of the economy spends more than its income – and such excess spending is only possible if that “other sector” is willing to increase its debts. Disregarding the role of exports and imports, which must sum to zero for the world as a whole, the government is the only possible candidate to play the crucial balancing role as the “other sector.” It is therefore a mathematical certainty that governments must increase their borrowing whenever businesses and households decide to boost their savings by spending less than they earn.

Despite this indisputable arithmetic, there has been surprisingly little interest in the macroeconomic impact of budgetary policies in contrast to the endless debates about every twist and turn of monetary policy. The explanation lies in the monetarist theories that came to dominate standard economic models of the pre-crisis period – and the related institutional changes that elevated central bankers above finance ministers as the supreme arbiters of economic policy.

Monetarism overturned the Keynesian fiscal consensus that prevailed from the 1930s to the 1970s, by introducing one simple assumption into the models that guided governments and central banks. The case for Keynesian fiscal stimulus in deep recessions was simply assumed away by asserting that interest rates could always be reduced sufficiently to stimulate private investment, discourage private savings and so restore growth. As a result, the private sector as a whole would never suffer for long from a shortfall in spending. Therefore government borrowing would never be needed to balance inadequate private demand.

As a result of these assumptions, interest rate decisions by central banks came to be seen as the only effective tool of macroeconomic management, while fiscal policy was relegated to a microeconomic supporting role. Tax structures and public spending levels were seen as supply-side issues influencing incentives and resource allocation, but the demand impact of government borrowing was largely ignored. Whether government borrowing expanded or contracted, interest rates would rise or fall to offset the Keynesian demand effects. Independent central bankers would manage macroeconomic demand with monetary policy, leaving governments to set taxes and spending plans to achieve political or supply-side objectives.

In the era of high inflation when monetarism was introduced, the idea that interest rates could always be cut by enough to revive private economic activity was reasonable enough. After all, when inflation is running at 5 percent, an interest rate of 1 percent is equivalent to minus 4 percent in real terms, imposing a massive tax on savers and offering a big subsidy to private investors. But this argument fails completely when inflation falls to negligible levels or disappears completely, as in the euro-zone and Japan.

Ironically, therefore, the very success of monetarism and central banking in conquering inflation now means that the era of monetary dominance is over. Keynesian fiscal thinking has triumphed and finance ministers are again more important than central bankers, even though most of them have not yet noticed. Once interest rates fell to zero, traditional monetary management lost its ability to provide further stimulus. And now that central banks are providing “forward guidance” which commits them to very low interest rates for years ahead, monetary policy has also lost its ability to offset fiscal easing and restrain demand.

As monetary policy has lost traction, fiscal policy has automatically gained power. With interest rates at or near zero, private demand cannot be simulated with further rate cuts and this means that monetary easing can no longer offset fiscal tightening. As a result, any reduction in budget deficits becomes unambiguously deflationary, which is why the French and Italian governments were right to resist enforcement of the German-inspired fiscal compact in the euro-zone. Conversely, fiscal expansion now provides an unqualified economic stimulus because there is no risk of interest rates rising significantly in the next year or two – and perhaps not until the end of the decade. In short, the world has returned to a period of fiscal dominance, as in the 1950s and 1960s.


PHOTO: Protesters clash with police during an anti-austerity rally in Athens April 1, 2014. Protesters marched through the streets of the capital to protest austerity measures as European Union Finance Ministers meet in Athens. REUTERS/Alkis Konstantinidis

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Europe’s economic and political future will be determined in the next few days Fri, 24 Oct 2014 04:10:28 +0000 A candidate dressed as Darth Vader and representing the Internet Party of Ukraine which runs for parliament, stands on the top a vehicle as he leaves after a meeting with his supporters and voters in Kiev

Europe is at a make or break moment. Two very different events on Sunday, occurring at opposite ends of Europe, will largely determine the entire continent’s direction for years ahead: the parliamentary election in Ukraine and the bank “stress tests” and Asset Quality Review conducted by the European Central Bank. Before explaining the significance of these two events, and their unexpected linkage, I need to mention a third announcement, due next Wednesday: the European Commission’s verdict on the budget for 2015 submitted last week by the French government.

The Commission will next week have to come up with a Solomonic judgment that somehow reconciles the French government’s determination to stimulate its economy by cutting taxes with the German-imposed “fiscal compact” that former-President Nicolas Sarkozy rashly accepted in a moment of desperation in the 2012 euro crisis and which requires France to raise taxes or drastically cut spending in order to reduce its budget deficit to 3 percent of GDP. The fiscal compact rules, if applied literally, would make economic recovery in France a mathematical impossibility. Yet bending these rules will provoke a German public backlash, and perhaps even a constitutional court challenge, that could even force Angela Merkel to renege on her commitment to support the rest of the euro-zone.

Depending on how these three events turn out, Europe will either be on the road to a moderate economic recovery next year or it will condemned to permanent stagnation, possibly leading to the break-up the euro or even the European Union as a whole.

Why are the stakes suddenly so high? With most of Europe sliding back into recession over the summer as a result of the war in Ukraine and the failure to implement the sort of policies of monetary and fiscal stimulus that revived the U.S., Japanese and British economies, Europe now has an obvious choice: stick to the failed policies which are almost certain to perpetuate economic stagnation or to change course.

When faced with this choice, the German guardians of the euro’s monetary and fiscal rule-book defend the status quo, no matter how dismal. Germany’s Bundesbank and Constitutional Court are steeped in the tradition of Ordnungsliberalismus which insists that rules must be obeyed at all costs and that following the letter of the law is more important than observing its spirit or achieving a desired outcome. But this legalistic philosophy is now running run up against the even more inexorable laws of mathematics, democracy and geopolitics.

What if it is mathematically impossible for governments in France and Italy to abide by EU budget rules, because raising taxes and cutting public spending would crush economic activity and thus widen budget deficits instead of reducing them? What if electorates refuse to accept a decade of austerity and stagnation simply for the sake of preserving the EU monetary and fiscal rules? And what if Ukraine’s absolute sovereignty and territorial integrity just cannot be re-established without risking an all-out war with Russia that Western democracies will not tolerate?

While politicians prefer to dodge these dilemmas, the fact is that Europe has now reached a point where some of its rules will have to be changed or reinterpreted and some of its principles compromised. The only real question is whether Europe arrives at the necessary compromises through conscious political decisions or waits for them to be imposed chaotically by economic and electoral upheavals.

Which brings us back to the three big events next week and some reasons for optimism. Starting with the Ukrainian election, a victory for President Poroshenko’s moderate party should allow EU leaders to launch a genuine peace process that recognises the loss of Crimea as irreversible and acknowledges Russia’s vital interests in maintaining the military neutrality of its immediate neighbours. Once these basic conditions are satisfied, a rapprochement with Russia should become possible, allowing sanctions to be gradually dismantled or at least confirming that sanctions will expire by mid-2015, as currently legislated. Removing the threat of war or further sanctions in eastern Europe will have a major beneficial effect on businesses in Germany and Italy, which been hurt much more by the confrontation with Russia than European leaders expected.

Sunday’s completion of the AQR has always looked like a necessary, though not sufficient, condition for a substantial improvement in monetary policy. This is because the ECB wants to stimulate private borrowing, as Britain did with the sub-prime mortgage subsidies it announced in March 2013, rather than supporting public debt, as in U.S. and Japanese quantitative easing. For this plan to work, European banks must be recapitalized and cleaned up, which the AQR is designed to achieve. If Sunday’s AQR plan proves convincing (admittedly still a big “if”) the stage will be set for the ECB to announced some serious monetary stimulus at its next meeting on Nov. 6.

Finally, a U-turn on fiscal austerity is highly probable when the Commission delivers its verdict on the French budget on Oct. 29, or failing that, in mid-November after a symbolic “re-negotiation” leading to some cosmetic strengthening of French structural reforms.

Putting these three events together, Europe has a decent chance of breaking out in the next few weeks from its vicious circle of policy failure and economic stagnation. Whether policymakers seize this chance is, of course, open to question given Europe’s long record of doing too little, too late. If Europe again disappoints expectations, the recession will deepen, with no serious hope of economic recovery next year. In that case, public opinion will veer onto a course of political nationalism and economic disintegration, not just in Greece and Italy but also in France and Germany. By next year it may be too late to reverse this. That’s what is meant by a make-or-break moment.

PHOTO: A candidate presenting himself as “Star Wars” villain Darth Vader and representing the Internet Party of Ukraine leaves a meeting of his supporters in Kiev, Oct. 22, 2014. REUTERS/Valentyn Ogirenko

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Why markets ignore good news from U.S. to focus on bad news from Europe Thu, 16 Oct 2014 04:51:41 +0000 A trader watches the screen at his terminal on the floor of the New York Stock Exchange in New York

What’s spooking the markets?

One thing we can say for sure is that it is not the slightly weaker-than-expected retail sales that triggered the mayhem on Wall Street on Wednesday morning. Most U.S. economic data have actually been quite strong in the month since Wall Street peaked on Sept. 19.

So to find an economic rationale for the biggest stock-market decline since 2011, we have to consider two other explanations.

The first is the collapse of oil prices, down almost 30 percent since late June in response to Saudi Arabia’s apparent decision to wreck the economics of U.S. shale oil. Falling oil prices are generally beneficial for the world economy — and for most businesses outside the energy sector.  But investors now fleeing from natural-resource stocks will take time to recycle their money into other industries, such as airlines, retailers and auto manufacturers. Until this rotation happens, broad stock-market indices are dragged down by the plunging oil shares, a process visible almost every day in the past two weeks, especially in the last hour of trading.

A trader watches the screen at his terminal on the floor of the New York Stock Exchange in New YorkIf falling oil prices were the main causes of the market setback, it would not be a big problem. There is, however, a far more worrying explanation: Europe. Not just the obvious weakness of the European economy, but the inability or unwillingness of European Union policymakers to agree on a sensible response.

Europe’s economic weakness was already evident several months ago when the Ukrainian crisis and Russian sanctions broke the momentum of German industrial growth, which had been a rare bright spot in the continent’s economic outlook.

But investors and business leaders were not too worried by the prospect of a sanctions-related slowdown in Germany because they assumed that Europe’s politicians and central bankers would respond with stimulative policies similar to the ones that had pulled the U.S. economy out of several “soft patches” in the past five years.  Because of this confidence in policy stimulus, global and U.S. stock markets were able to keep hitting new records in the summer, despite bad news from Europe.

For most of the period since 2008, Europe’s miserable economic performance did not seem to bother investors — as long as the U.S. economy was doing all right. Even at the height of the euro crisis, global stock-market performance has been more influenced by the gyrations of U.S. economic statistics and Federal Reserve policy than by anything happening in Greece, Italy or the European Central Bank.

European Central Bank (ECB) President Mario Draghi looks on at the monthly ECB news conference in FrankfurtIn the past few weeks, however, bad news from Europe seems suddenly to be having far more impact than the generally positive news from the United States, where economic growth is accelerating and expectations of interest rate hikes have been pushed back from next spring to September or beyond.

Why has this happened?

In previous columns, I have explained the lockstep gyrations of the U.S. economy and global stock markets by the demonstration effects of U.S. monetary and fiscal policy. Because the United States pioneered the policy responses to the 2008 economic crisis — quantitative easing, near-zero interest rates and unprecedented budget deficits — investors assumed that the success or failure of these policies in the U.S. economy today would eventually spread to the rest of the world.

When the U.S. economy seemed to be moving toward a sustainable expansion, it seemed reasonable to suppose that the rest of the world would follow, with a lag of a year or two. When, however, U.S. growth suffered an unexpected setback — as it did last winter and in the summers of 2011 and 2012 — investors and businesses would turn pessimistic around the world.

After all, if the United States was unable to pull convincingly out of recession after $3.5 trillion of quantitative easing, five years of near-zero interest rates and budget deficits worth 10 percent of gross domestic product, what hope could there be for other countries implementing half-hearted versions of the same program?

A  traders works on the floor of the New York Stock ExchangeOnce each of these U.S. growth scares turned out to be just a temporary aberration, bullish sentiment returned. Not only on Wall Street, but also in Europe and emerging markets, on the view that if monetary and fiscal stimulus were shown to be working in the U.S. economy, other governments and central banks would eventually follow similar policies and achieve similar results.

Now it appears that this linkage may have broken. The European Central Bank bitterly disappointed investors who had expected the bank to follow the Federal Reserve’s example and announce dramatic monetary measures, combined with a convincing recapitalization of the European banking system, at European Central Bank President Mario Draghi’s press conference on Oct. 2.

The rout in global stock markets began the day after. Meanwhile, the German government has continued to demand immediate spending cuts from France and Italy while hobbling German industries with Russian sanctions — despite the evidence that both its European austerity drive and diplomatic policies were economically damaging and counterproductive.

It has begun to look as if Europe may stubbornly refuse to follow the U.S. roadmap for economic recovery. If that happens, the improving U.S. economy can no longer be treated as a leading indicator of European recovery.

With this, the prospects for the global economy would be much diminished. While the chances of a renewed financial crisis in the euro zone are greatly increased.

Many investors are starting to assume that, even if the U.S. economy moves into a self-sustaining expansion, Europe will condemn itself to permanent stagnation or recession. Then prospects for the world economy, and for globally exposed companies, will be far weaker than expected a few months ago, when Europe looked like it was following the U.S. policy game plan. But will Europe really be so foolish?

The answer should soon be clear. The European Commission will publish its review of the French and Italian budgets on Oct. 29, Ukraine’s election on Oct. 26 will provide an opportunity to start dismantling the self-destructive sanctions and on Nov. 6 the European Central Bank will hold its next policy meeting.

We should therefore know within a month whether Europe will save itself or sabotage the world economy by ignoring U.S. policy lessons. These decisions in Europe will probably determine whether the current market setback turns into a buying opportunity or a 1987-style meltdown.


PHOTO (TOP): A trader watches the screen at his terminal on the floor of the New York Stock Exchange in New York, October 15, 2014. REUTERS/Lucas Jackson

PHOTO (INSERT 1): A trader bites his nails as he watches the screen at his terminal on the floor of the New York Stock Exchange in New York, October 15, 2014. REUTERS/Lucas Jackson

PHOTO (INSERT 2): European Central Bank President Mario Draghi looks on at the bank’s monthly news conference in Frankfurt, March 6, 2014. REUTERS/Ralph Orlowski

PHOTO (INSERT 3): A trader works on the floor of the New York Stock Exchange, October 15, 2014.  REUTERS/Brendan McDermid

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