If synchronized budget austerity is the order of the day across the developed world, major central banks will be forced to shoulder the burden of economic support for far longer than many had bargained on.
Back in January, financial commentators talked at length about this year being the year of the exit strategy — when massive economic stimuli from governments worldwide would have been removed as resulting global recovery gained traction.
In truth, most focused on the likelihood of monetary exits — if not interest rate rises in the US and Europe, then at least the wind-down of extraordinary “quantitative easing” or effective money-printing. The politics of budget retrenchment, it was thought, might take a good bit longer.
Yet, panicked by financial market convulsions over the sustainability of debts in Greece and other euro zone countries, governments are heading for the other exit first and en masse.
If they’re not careful, the world economy could get caught in the crush.
“The fact that all major economies face the need for fiscal retrenchment at the same time means that the global cyclical recovery that has been in place for the past year is vulnerable to tightening fiscal policies in several economies at once,” HSBC economists warned last week.
Others take a stronger line.
In a typically provocative research report, Lombard Street economist Charles Dumas last week talked of the “Anglo-German Stupidity Shoot-Out” and warned Europe risked turning recession to depression with lock-step draconian budget cuts.
What’s for sure is the collective scale of the retrenchment planned in Germany, France, Britain, Italy and Spain alone — five of the world’s top 10 economies which account for more than 20 percent of global output — means interest rates are not going up any time soon. And, egged on by the G20 leading economies, budget surgery will not be confined to Europe, even if the prospect of staggered cuts elsewhere is of some relief.
The world’s two biggest economies, the US and Japan, look slower in laying down plans to rein in their bloated debts and deficits — partly for electoral reasons — but the size of their tasks from next year is no less daunting.
“Those countries with serious fiscal challenges need to accelerate the pace of consolidation,” G20 finance chiefs wrote in a communique after meeting in South Korea this month.
And so, the monetary taps stay on.
At the start of this year, economists polled by Reuters had expected the US Federal Reserve, European Central Bank (ECB) and Bank of England to be lifting interest rates by the end of this year.
Less than six months later, interest rate futures show little chance of a Fed move this year; no Bank of England move before next March at least; and ECB rates on hold until 2012.
Economists at JPMorgan have crunched the numbers to show developed economies’ budget deficits as a share of their GDP deteriorated by more than 6 percentage points between 2007 and last year to a post-World War II record shortfall of 8 percent of GDP. Total net debt levels skyrocketed by more than 20 percentage points to 62 percent of GDP.
Joseph Lupton and David Hensley reckon that as long as the recovery holds up, deficit levels could be halved as soon as 2013 in what would be the biggest fiscal consolidation in 40 years.
However, even that would still fall short of “debt sustainability,” they said.
One obvious conclusion for central banks is this squeeze will at least slow the world economy substantially if not smother it completely, as Lombard Street suggests of Europe.
Also, there will be the ongoing pressure to avoid triggering a fiscal heart attack by raising official interest rates and aggravating capital market borrowing rates — currently at historically low levels.
Facilitating the huge buildup of debt in the first place, average interest rates paid on developed market government debt plunged more than 5 percentage points to 3.3 percent since 1982. The pressure from here is likely more up than down.
And putting all the pressure on Western interest rates has its consequences around the globe, not least for those who fret about so-called global imbalances in national accounts and capital flows. With developing economies seeing much faster growth and inflation rates and without the same fiscal overhang, interest rates there have already started to rise.
Brazil, India and Israel have all hiked rates in the first half of this year. Tension and volatility surrounding Europe’s debt crisis has kept frightened Western capital at home for now and lifted the dollar in the process, but the widening interest rate gap between developed and emerging markets may reopen floodgates.
Fresh capital surges to developing markets risk refueling imbalances, bubbles and reserve recycling that were arguably at the root of three years of financial turmoil in the first place.
As South Korea showed last week, capital and currency controls are only a short step from that. G20 needs to be wary.
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