G20 recipe for deflation, protectionism
It may be folly or it may be prudence, but the move to fiscal austerity and restraint will be deflationary, will be bad for risky asset prices and will raise further the threat of protectionism.
The weekend’s meeting of the Group of 20 wealthy nations in Korea ended in a muddle of policies, with the final communique appearing to praise fiscal retrenching, expansionary policy, tighter regulation and slower implementation of that tighter regulation all at the same time, and all in the same impenetrable thicket of euphemism, buzzwords and consultant-speak.
“The recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, growth-friendly measures, to deliver fiscal sustainability, differentiated for and tailored to national circumstances. Those countries with serious fiscal challenges need to accelerate the pace of consolidation. We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions. Within their capacity, countries will expand domestic sources of growth, while maintaining macroeconomic stability,” the communique issued at the conclusion of the meeting read.
For the perplexed, a gloss would be: “Europe having hit the fan, we can no longer agree on common policies to stimulate the wretched economy. Every man for himself! Well, except for the U.S., which should carry on buying all of the rest of our stuff.”
China is not taking serious steps to revalue its currency, deciding instead to fight inflation and an overheating property market at home. And over in Europe, if it isn’t French Prime Minister Francois Fillon praising the “good news” of a newly cheap euro it is German Chancellor Angela Merkel unveiling a package of budget cuts. Just as fiscal stimulus must be done in concert internationally, as some of the benefit of the money spent will “leak” through borders, so is austerity a bit of a communicable disease; you may be punished by markets if you are the one still expanding borrowing while others cut.
And if you are lucky enough to have a reserve currency, you end up with the unenviable job of U.S. Treasury Secretary Geithner, who will need to explain back home why the U.S. should be the world’s export-eating foie gras goose. He is likely to say brave words about how the strong dollar reflects U.S. robustness, but as mid-term elections near and a jobless recovery stays jobless that will sound increasingly hollow.
It is by no means a sure thing, but what starts with austerity programs can easily grow into beggar-thy-neighbor currency depreciations and trade barriers.
LITTLE BY LITTLE AND THEN ALL OF A SUDDEN
This is not to say that Europe, and Britain for that matter, are wrong to impose discipline on their budgets. Defenders of fiscal stimulus like to point out that, at current market rates, the cost of further borrowings is small, and that there is no sign, at least in the U.S., of anyone remotely resembling a bond market vigilante. To my mind that is a bit like looking at Lehman Brothers in 2006 with a highly levered and highly illiquid balance sheet and saying that, because the market is making it a good price in the short-term borrowing market, it is sound. Like the old joke about the guy going broke, that changed little by little and then all of a sudden. Losses of confidence in sovereign borrowers can be sudden and catastrophic, just as they can be for banks.
For euro zone members it was at first disquieting and then frightening as markets lost confidence in Greece. Seeing an emerging trend of distrust of France, Belgium and Austria must be terrifying. All three now cost more than 100 basis points to insure against default for five years and the market carried on marking up that cost for all three after the G-20 meeting.
On the face of it that is confusing because euro zone countries did not get roped into expanded deficit spending at the G-20, presumably making them better credits and more likely to repay their debts.
It is possible, only just but possible, that markets are moving precisely because the effect of the events at the G-20 will be deflationary and, as such, will worsen the situation of debtor nations. It is a lot harder to pay back your debt as your economy shrinks, and harder still to do it if inflation turns negative. A world which is only depending on a U.S. consumer to take the strain, and one who is supported by the spindly crutch of government support, is a world that much closer to having to reckon with its debts.
This will hurt growth and with it riskier assets.
This may be an avoidable disaster or it may simply be a step that must be taken, disastrous or not.