The year 2012 turned out to be as bad as I thought. Therecession in Europe was the predictable (and predicted) consequence of itsausterity policies and a euro framework that was doomed to fail. America’s anemicrecovery – with growth barely sufficient to create jobs for new entrants intothe labor force – was the predictable (and predicted) consequence of political gridlock, which prevented the enactment of PresidentBarack Obama’s jobs bill and sent the economy toward a “fiscal cliff.”
The two main surprises were the slowdown in emergingmarkets, which was slightly sharper and more widespread than anticipated, andEurope’s embrace of some truly remarkable reforms – though still far short of what is needed.
Looking to 2013, the biggest risks are in the US andEurope. By contrast, China has the instruments, resources, incentives, andknowledge to avoid an economic hard landing – and, unlike Western countries,lacks any significant constituency wedded to lethal ideas like “expansionary austerity.”
The Chinese rightly understand that they must focus more onthe “quality” of growth –rebalancing their economy away from exports and towarddomestic consumption – than on sheer output. But, even with China’s change infocus, and despite adverse global economic conditions, growth of around 7%should sustain commodity prices, thereby benefiting exports from Africa andLatin America. A third round of quantitative easing by the US Federal Reservecould help commodity exporters as well, even if it does little to promote USdomestic growth.
The US, with Obama re-elected, is likely to muddle on, much as it has for the past fouryears.  Inklings of recovery in thereal-estate market will be enough to discourage dramatic policy measures, likea write-down of principal on “underwater” mortgages (where the outstanding loanexceeds the market value of the house). But, with real (inflation-adjusted)house prices still 40% below the previous peak, a strong recovery for realestate (and the closely related construction industry) seems unlikely.
Meanwhile, even if Obama’s Republican opponents do not pushthe country over the fiscal cliff of automatic tax increases and spending cutson January 1, they will ensure that America’s own form of mild austerity willcontinue. Public-sector employment is now roughly 600,000 below its pre-crisislevel, while normal expansion would have meant 1.2 million additional jobs,implying a public-sector jobs deficit of almost two million.
But the real risk for the global economy is in Europe.Spain and Greece are in depression, with no hope of recovery in sight. Theeurozone’s “fiscal compact” is no solution, and the European Central Bank’spurchases of sovereign debt are at most a temporary palliative.If the ECB imposes further austerity conditions (as it seems to be demanding ofGreece and Spain) in exchange for financing, the cure will only worsen thepatient’s condition.
Likewise, common European banking supervision will not suffice to prevent the continuing exodus of funds from the afflictedcountries. That requires an adequate common deposit-insurance scheme, which thenorthern European countries have said is not in the cards anytime soon. WhileEuropean leaders have repeatedly done what previously seemed unthinkable, theirresponses have been out of synch with markets.They have consistently underestimated their austerity programs’ adverse effectsand overestimated the benefits of their institutional adjustments.
The impact of the ECB’s