Dark, loweringfinancial and economic clouds are, it seems, rolling in from every direction:the eurozone, the United States,China,and elsewhere. Indeed, the global economy in 2013 could be a very difficultenvironment in which to find shelter.
For starters, theeurozone crisis is worsening, as the euro remains too strong, front-loaded fiscal austerity deepens recession inmany member countries, and a credit crunchin the periphery and high oil prices undermine prospects of recovery. Theeurozone banking system is becoming balkanized,as cross-border and interbank credit lines are cut off, and capital flightcould turn into a full run on periphery banks if, as is likely, Greece stages adisorderly euro exit in the next few months.
Moreover, fiscal andsovereign-debt strains are becoming worse asinterest-rate spreads for Spain and Italy have returned to theirunsustainable peak levels. Indeed, the eurozone may require not just aninternational bailout of banks (as recently in Spain),but also a full sovereign bailout at a time when eurozone and internationalfirewalls are insufficient to the task of backstoppingboth Spain and Italy.As a result, disorderly breakup of theeurozone remains possible.
Farther to the west, US economicperformance is weakening, with first-quarter growth a miserly 1.9% – well belowpotential. And job creation faltered inApril and May, so the USmay reach stall speed by year end. Worse,the risk of a double-dip recession next year is rising: even if what looks likea looming USfiscal cliff turns out to be only a smaller source of drag, the likely increasein some taxes and reduction of some transfer payments will reduce growth in disposable income and consumption.
Moreover, political gridlock over fiscal adjustment is likely topersist, regardless of whether Barack Obama or Mitt Romney wins November’spresidential election. Thus, new fights on the debt ceiling, risks of a governmentshutdown, and rating downgrades could further depress consumer and businessconfidence, reducing spending and accelerating a flight to safety that would exacerbate the fall in stock markets.
In the east, China,its growth model unsustainable, could be underwaterby 2013, as its investment bust continuesand reforms intended to boost consumption are too little too late. A newChinese leadership must accelerate structural reforms to reduce nationalsavings and increase consumption’s share of GDP; but divisions within theleadership about the pace of reform, together with the likelihood of a bumpy political transition, suggest that reformwill occur at a pace that simply is not fast enough.
The economic slowdownin the US, the eurozone, andChina already implies amassive drag on growth in other emerging markets, owing to their trade andfinancial links with the USand the European Union (that is, no “decoupling”has occurred). At the same time, the lack of structural reforms in emergingmarkets, together with their move towards greater state capitalism, is hampering growth and will reduce their resiliency.
Finally, long-simmering tensions in the Middle East between Israel and the USon one side and Iranon the other on the issue of nuclear proliferationcould reach a boil by 2013. The currentnegotiations are likely to fail, and even tightened sanctions may not stop Iranfrom trying to build nuclear weapons. With the USand Israel unwilling toaccept containment of a nuclear Iranby deterrence, a militaryconfrontation in 2013 would lead to a massive oil price spike and global recession.
These risks arealready exacerbating the economic slowdown: equity markets are falling everywhere, leading to negative wealth effects on consumption and capitalspending. Borrowing costs are rising for highly indebted sovereigns, credit rationing is undermining small and medium-sizecompanies, and falling commodity prices are reducing exporting countries’income. Increasing risk aversion is leadingeconomic agents to adopt a wait-and-see stancethat makes the slowdown partly self-fulfilling.
Compared to2008-2009, when policymakers had ample space to act, monetary and fiscalauthorities are running out of policy bullets(or, more cynically, policy rabbits to pull out oftheir hats). Monetary policy is constrained by the proximity to zerointerest rates and repeated rounds of quantitativeeasing. Indeed, economies and markets no longer face liquidity problems, butrather credit and insolvency crises.Meanwhile, unsustainable budget deficits and public debt in most advancedeconomies have severely limited the scope for further fiscal stimulus.
Using exchange ratesto boost net exports is a zero-sum game at a time when private and public deleveraging is suppressing domestic demand incountries that are running current-account deficits and structural issues arehaving the same effect in surplus countries. After all, a weaker currency andbetter trade balance in some countries necessarily implies a stronger currencyand a weaker trade balance in others.
Meanwhile, theability to backstop, ring-fence, and bail out banks and other financial institutionsis constrained by politics and near-insolvent sovereigns’ inability to absorbadditional losses from their banking systems. As a result, sovereign risk isnow becoming banking risk. Indeed, sovereigns are dumpinga larger fraction of their public debt onto banks’ balance sheet, especially inthe eurozone.
To prevent adisorderly outcome in the eurozone, today’s fiscal austerity should be muchmore gradual, a growth compact shouldcomplement the EU’s new fiscal compact, and a fiscal union with debtmutualization (Eurobonds) should be implemented.  In addition, a fullbanking union, starting with eurozone-wide deposit insurance, should be initiated,and moves toward greater political integration must be considered, even as Greece leavesthe eurozone.
Unfortunately, Germanyresists all of these key policy measures, as it is fixatedon the credit risk to which its taxpayers would be exposed with greatereconomic, fiscal, and banking integration. As a result, the probability of aeurozone disaster is rising.
And, while the cloudover the eurozone may be the largest to burst,it is not the only one threatening the global economy. Batten down the hatches.