2011 to bring recovery, inflation, more euro-pain

December 23, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are his own

In 2010, little more than a year after celebrations of the euro’s 10th birthday, the very survival of the currency of the world’s largest economic bloc came under threat – a reminder that the world’s economic foundations are never completely stable. So a prediction that the world will do better than expected in 2011 comes with big caveats.

It has taken extreme measures, primarily ultra-loose monetary policy and much debt creation in the United States and Europe, to recover from the Great Recession. In the process, the seeds of future crises may have been sown — perhaps even in China, the bastion of growth through the recent crisis.

As the year turns, the edges of the euro zone remain the world’s central economic drama. Greece and Ireland have received bailouts. Portugal is making efforts to cut its fiscal deficit, but its very poor trade position – with a current account deficit that is close to one tenth of GDP — and weak banks make an Iberian bailout a near-certainty early in 2011.

Spain may need one, too. It suffers from big government spending and trade deficits. Madrid’s repair efforts are complicated by the autonomy enjoyed by regional governments and unemployment of 20 percent. If a Spanish bailout happens, Italy and Belgium could be next. But these countries should be more resilient. They have stronger industrial sectors, lower external financing needs and higher savings levels.

Despite continuing upheaval, the euro zone will still grow in 2011. Germany’s pick-up in growth reflects the world’s. France and Italy aren’t in such bad shape, either. German exports are again growing fast and will receive further impetus from a weak euro. That’s likely given ongoing uncertainty and low European Central Bank interest rates. A substantial drop to a level of, say, $1.10 by the end of 2011 isn’t impossible.

The dollar, meanwhile, should be on the recovery road. Money-printing by the Federal Reserve and ultra-low Treasury yields have weakened it. Both should end in 2011. After three years the U.S. consumer will stir – cheered by a housing market that appears to have bottomed. A virtuous circle of falling unemployment and rising consumer spending looks possible. U.S. growth may be stronger than markets expect.

That will help Asia’s exporters, led by Japan and China. Chinese growth looks set to remain strong, even though the government is trying to reduce the pace of money supply growth. India, too, is racing ahead, despite high inflation and rising interest rates. New consumers are emerging in Asia. The demand for food, copper, cement, electricity and oil keeps growing. So the commodity price inflation seen in the second half of 2010 may continue and could worsen. Inflation is already a big problem in some emerging economies. It’s likely to break out soon in the West.

In the United States, inflation – especially coupled with accelerating growth – would force the Fed to consider raising interest rates. Though it seems unlikely now, that could happen before the end of 2011. Bond markets that prospered through the deflationary crisis would be hit. Stock investors would have to weigh higher growth against more expensive money.

The result: a resuscitated world, but not a wholly healthy one. In almost every major economy, government deficit and debt will have climbed steeply. The United States will have shown its great capacity to borrow, but even Uncle Sam will have to shift towards unaccustomed austerity. Until that happens, the U.S. consumer and a mammoth trade deficit of some $40 billion a month will again be one side of the world’s imbalances.

For its part, China has maintained growth by permitting soaring foreign exchange reserves and money supply while increasing exports. The Middle Kingdom’s controlled currency is another cause of global economic imbalances. The government might allow the yuan to appreciate sharply if it finds inflation rising fast, which may well happen. But the leadership will also be wary of damaging the export sector and its jobs.

The structure of China’s economy and the staggering money supply growth everywhere during the Great Recession might stoke future crises. But faster global recovery and the return of inflation should be 2011′s main themes, punctuated by euro zone aftershocks. Not to mention the inevitable unforeseen surprises, both good and bad.

Comments

The US should: Drill all our own oil (we need the hundreds of billions & jobs), make 25% of the government jobs PT or temp (like the private sector), speed up the patent process (spur innovation) and change to a flat/fair tax (too complex, too much favortism and too many tax evaders)! Embrace this kind of change and the economy will rebound and home prices will firm up! Or, ask what your country can do for you, remain in denial and prepare for violent civil unrest and finacial disaster! Do the math-our deficit, debt, housing defaults, wars/war on terror, student loan defaults, unfunded entitlements, state deficits, etc etc etc! No brainer!

Posted by DrJJJJ | Report as abusive
 

Your prediction about the Fed raising interest rates is looking like a premature statement. In late 2010, I would have agreed with your hypothesis, and today I wish it were correct. But now that we’re almost half way into the year, things aren’t looking like they will change before the fourth quarter – last year’s fourth quarter finished out the largest annual growth in six decades. Prices are steadily increasing, especially as turmoil is rearing its head in the Middle East and natural disasters are affecting Asia and even other emerging and developed countries.

While it makes sense to say that the economy is growing and inflation is rising, so interest rates should rise, Bernanke is stuck in a dilemma of choosing between preventing a depression by stimulating the economy through monetary easing, and preventing higher inflation, thus major depreciation of the USD with this huge increase in circulation of the dollar…as a result of this monetary easing.

Where is the balance? The dollar has been the safe-haven currency for the world for decades and, contrary to speculation stating otherwise, will most likely remain as such for the foreseeable future. This being said, the Fed has made the world stock of US reserves less and less valuable by keeping rates near zero – the lowest of all industrial countries. This has repercussions that we’ve begun to see with U.S.-Chinese negotiations over the overvaluation of the RMB. This currency debate has Bernanke in this peculiar position – to raise rates or not to raise rates. So far, he has chosen the latter. And today, the United States, and the world for that matter, is stuck with the lowest valued dollar in 15 months, oh! and not to mention inflation too.

Three years after the beginning of this financial crisis, the U.S. seems to be in a better position domestically to raise rates to stem inflation and devaluation. While the Fed is in the process of buying $600 billion of bonds by its June 2011 deadline, I don’t see them then raising interest rates. In my opinion, inflation will increase and exchange rates will decrease a little while longer before the Fed abandons QE2 policies. Hopefully countries with large USD reserves will be able to hang in there while we’re all taken on this ride. The chairman, I think, is waiting to see sustainable growth before it makes an interest rate change, which makes sense, but what side affects will the American people and the world see in the meantime?

Posted by VanessaRozier | Report as abusive
 

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