Miles to go before markets can breathe
The US faces more serious challenges beyond the fiscal cliff while Europe, contrary to appearances, ended 2012 worse off. Growth may be the only way out but it comes with increasing risk.
Despite the compromise US politicians have cobbled together to avoid the recession-inducing impacts of tax increases and spending cuts that would otherwise automatically occur on New Year’s Day, the larger issue is encapsulated with the ‘next’ deadline, that mid-February date when the US runs into its legislated $US16.4 trillion debt ceiling.
The reality for the US, and the longer-term challenge that underpins the short-term wrangling over taxes and spending, is that its public debt levels are unsustainable. Somehow the US needs to develop a long-term plan to reduce its borrowings to more sustainable levels without undermining a central element of that plan – the ability of the US economy to grow – in the meantime.
More broadly, just as the US is still, after more than four years, wrestling with a response to the structural issues the global financial crisis laid bare – and indeed exacerbated – Europe is in even worse shape.
It might appear at face value that the eurozone ended 2012 in better shape than it started it. At the beginning of the year there were very real and well-founded fears that the eurozone would fracture, with horrific consequences.
It didn’t, which is a good thing. It remains extraordinarily fragile and held together, however, with band aids. It was the European Central Bank’s flooding of the markets with cheap liquidity and its declaration that it would do "whatever it takes," primarily through purchases of sovereign bonds, that calmed markets.
In reality, however, Europe has spent the past four years mainly just kicking an extremely battered can down a lengthening road. There has been little, if any structural progress and the deep fissures within the eurozone economies remain.
It was instructive that, more than four years after the crisis began, eurozone finance ministers were beating their chests in mid-December after agreeing a plan to hand control over their larger banks to a common bank supervisor. The ECB will supervise about 200 banks – from 2014.
One of the issues that has complicated Europe’s response to the crisis has been the level of entanglement between weak, under-capitalised banks and over-leveraged sovereigns, which created a self-reinforcing and quite destructive cycle.
Where the US "fixed" its banking system, at considerable initial cost to its taxpayers, the Europeans hoped that time and the ECB would repair their banks. Well, the banks aren’t fixed and under the plan for banking union the eurozone’s rescue funds can’t be directly injected into troubled banks until the new supervisor is firmly in place.
The ECB’s policies have bought time and eased the sense of panic and desperation that was abroad at the start of the year but the eurozone is no closer to dealing with the structural challenges of 17 different economies in 17 different conditions – most of them distressed.
With all of Europe sliding back into recession, its banking sector contracting in order to try to improve its balance sheet without raising massive amounts of new capital, and no answer to how to deal with the depressed condition of the southern European economies other than to try to continue to buy time, the eurozone is no closer to a structural solution to the issues laid bare by the crisis than it was a year, or two, or three ago.
A messy, increasingly tense political, social and demographic backdrop means it is almost inevitable Europe is going to remain in a parlous and dangerous condition for a very long time.
What the central banks’ policies in the US and Europe have done with their unconventional monetary policies is triggered a global currency war that penalises the stronger economies and, as they intended, created a global search for higher-returning – and higher risk – assets than government bonds in the hope that might stimulate some growth and lessen risk aversion.
That’s been good for global equity markets, which had a good 2013 (the US, European and Australian markets all chalked up double-digit gains) and was a factor in the flow of funds into Australian dollar assets.
Ultimately, however, the longer the loose money policies are sustained, the greater the likelihood of eventual unintended, but unpleasant, consequences. There are, however, no obvious policy alternatives and it is probable – indeed explicit in the US – that the monetary policy settings will remain in place for the foreseeable future.
In the absence of any real recovery and faced with negative real returns and devaluing currencies it is not surprising that institutions, companies and households remain wary and defensive.
That is, however, the other complicating factor for global regulators and the global economy.
While growth might be a path, indeed perhaps the only path, to reducing the scale of the fiscal challenges to something more manageable and creating something resembling stability within the major developed economies, the degree of risk aversion hasn’t significantly reduced and probably won’t until it becomes clear that policymakers in the US and Europe actually have policy pathways towards that longer-term stability.