At best the developed world faces a multi-year deleveraging process, which will constrain growth below potential levels. The challenge for policy makers is to reduce debt while maintaining as much growth as possible.
The recent Greek experience provides a stark example of how difficult this is. According to the BBC, the unemployment rate among young people in Greece is almost 50 per cent; 28 per cent of the population are in, or are at risk of, poverty; and the suicide hotline in Athens received twice as many calls in 2011 as in 2010.
The deleveraging adjustment path is not fixed; policy-maker actions make a difference. The problem is, there is no consensus on what the optimal policy actions are.
Studies of the Great Depression have showed that while this was a disaster and caused immense human suffering, there were differences across countries and some recovered faster than others. This is an important finding; it says that policy-makers’ decisions matter.
For Greece the extent of current social pain is comparable with the 1930s, when in the US unemployment reached 25 per cent, versus 21 per cent in Greece today. In both eras and in both countries the problems for policy-makers were that households and corporations were disinclined to spend or invest, and financial institutions were constrained and unwilling to lend with interest rates cut to zero already.
The response to this has been quantitative easing, particularly from the US and UK central banks, and more recently from the European Central Bank. While there appears now to be unanimity on the required monetary response, there is much less agreement on the right fiscal stance.
To illustrate this it’s useful to compare the differing fiscal stances of the US and the UK. Both cut interest rates to the bone and both have led the way with quantitative easing.
While the US has maintained a positive fiscal stance, both the eurozone and the UK, chastened by the bond vigilantes, have embarked on the oxymoronic policy of ‘expansionary fiscal contraction’.
The forlorn hope is that if the government spends less, the private sector will pick up the slack. The evidence is now coming in on the results of this experiment. The US economy is now creating jobs, while the UK job market continues to contract. US fourth quarter growth is estimated at +0.7 per cent and the UK at -0.2 per cent.
While the eurozone has been the epicentre of the crisis for the past year, its periphery needs real currency depreciation.
Currently it is trying to achieve this through deflation, which requires that prices and wages decline until competitiveness is restored. This is a prolonged and very painful process.
The alternative (assuming that the euro does not decline significantly) is to leave the European monetary union. This is dramatic; it carries contagion risks but it has the advantage of being fast.
Growth can be restored quickly – only if there is reform to remove entry barriers and other rigidities. However, for Greece, capital controls and probably freezing of deposit accounts will be required, and it will experience a massive devaluation of the ‘new drachma’.
A key point here is that to fix the problem you need to fix the cause – the euro tied together countries that didn’t fit without fixing the differences. Forcing proper integration now is extremely painful and it’s probably impossible for the Greeks at least to bear the pain.
More generally, the risks of a Greek exit lie in the contagion and risk aversion effects it creates. Eurozone policy-makers are now much better equipped to deal with such an eventuality. The willingness and ability of policy makers to act has increased markedly.
There is still a risk that the eurozone stubbornly takes the slow path and experiences a Japanese-style prolonged stagnation. This is more likely if the eurozone remains intact.
We regard a prolonged stagnation as very unlikely in the case of the US – this would require repeated policy mistakes. While not impossible, the US policy mindset is to try everything until they get it right. Also the flexibility of the US economy should not be underestimated.
Dr Susan Gosling is head of investment at MLC
