To the Point, No.3 - March 30, 2012

To the PointDiscussion on the economy, by the Chief Economist March 30, 2012 It’s the politics, stupid!  Man-made political and economic institutions underlie a nation’s economic success. After the financial crisis and recession, many of these institutions need to be rebuilt in the US and Europe, and it is important this be done in a truly democratic environment.  Financial markets have pressured Europeans to speed up budget consolidation, and the US cannot rule out the same treatment in a few years time. Politicians need to set the deleveraging agenda before the financial markets do, with potentially high costs to the US and the global economy and societies. Cecilia Hermansson Group Chief Economist The US and Europe should rebuild institutions democratically Economic Research Department +46-8-5859 7720 The title of this month’s version of To the Point is a “snowclone”: of Bill Clinton’s cecilia.hermansson@swedbank.se “It’s the economy, stupid,” often heard during his campaign against George Bush in 1992. Even if Bush was seen as the experienced candidate in terms of foreign policy, he had not talked sufficiently about the economy, and the recent recession. Two decades later, it is only natural that the state of the economy will decide who wins this fall’s election. If unemployment continues to fall, President Obama has a good chance, but if it rises again, as more people re-enter the labour force and growth slows, the Republican candidate, most likely Mitt Romney, has a better chance. Even so, the way politics is carried out and institutions are built up is the most important factor determining why nations fail or succeed. This is the message, taking both the short term and the very long, of the recently published book “Why Nations Fail”, by Daron Acemuglu and James Robinson, two distinguished economists, who cover more than 400 years of global history. Their conclusion: it is not culture, nor the weather or geography. It is not even ignorance of what the right policies are. It is man-made political and economic institutions that underlie economic success. The message is, of course, important to developing countries, where living standards have stagnated or risen slower than in the more developed world. However, political leaders in the US and Europe can also learn from this book. Two key institutions are at stake in these two parts of the world: the health care system in the US, and the Economic and Monetary Union (EMU) in Europe. How they are developed will matter to the success of these economies and their well-being. Also, regulations of business and banking, tax reforms, education reforms, etc., etc., are at a cross roads without a clear agreement on how to proceed forward. Many people feel more removed from decision making than ever before. This is particularly true in Europe, where top meeting after top meeting is called and where decisions are made in a less transparent way than in national parliaments. In the US, the political agenda is shorter than normal because it is an election year, and all major decisions have to wait until after the election. This means that the world’s largest economy slows every fourth year, whilst the rest of the world continues to move forward. Also, the current political gridlock could very well continue next year. It is important to continue on the democracy road that Europe and the US have travelled for hundreds of years, and not turn to the authoritarian methods China and No. 3 Russia use. Even if authoritarian growth seems high now, it will not lead to sustained growth, supported by truly inclusive economic institutions and creative destruction. 2012 03 30 The financial crisis and the global recession have made politics more difficult to pursue, but the institutions that are at stake will best be developed in a democratic system.

To the Point (continued)March 30, 2012 Financial markets – a cure or a curse for politicians?Chart 1: 10 year government bond rates 8 German Chancellor Angela Merkel and Italian Prime Minister Mario Monti live under the threat of financial markets’ mood, while governments in the US and 7 the UK seem to have more degrees of freedom. 6 Italy It is evident that when creditors no longer wanted to finance Greek or Italian 5 debt without a high risk premium, the budget consolidation and reform processPercent 4 intensified. Compared to the US, European countries have speeded up to get UK 3 their houses in order. Deleveraging in the public sector has started, while the US USA administration is still on a path where the federal debt is rising to towards 2 infinity. G any erm 1 Japan UK, with experiences from market punishment in the early 1990’s has chosen 0 the European road as well, something that made the Nobel Laureate Peter jan m sep jan m sep jan m sep jan m sep jan aj aj aj aj Diamond at the policy conference arranged by National Association of Business 08 09 10 11 12 Source: Reuters EcoWin Economics (Nabe) the other day to declare: “Britain is a mistake!”Source: Ecowin. The question is where mistakes are made: in Europe or in the US? Of course, it would have been better to back-load than front-load measures in the UK to not risk the recovery given that we know market confidence is being upheld. The cost, however, to the society of much higher interest rates at a time when debt burdens are around 100 % of GDP is high. Also for the US, the point whereChart 2: Inflation rates in major economies more action is needed is approaching. 1 ,5 7 We know that financial markets are not always rational. Behavorial finance 1 ,0 5 In ia d teaches us that herding, anchoring, heuristics are just some examples of why markets make systemic errors. In the process of understanding the sovereign 1 ,5 2 debt crisis in the euro zone, there have been market misunderstandings and 1 ,0 C in 0 ha exaggerations on the way, but the main message is that the combination of thePercent current set up of the EMU and increasing public debt no longer works. Since 7,5 politicians, including the German and French, made major mistakes diluting the B zil ra Stability and Growth Pact around 2005, the return to discipline had to come 5,0 from outside pressure. In a democratic society that pressure could have come 2,5 UK from the opposition, the media, the justice system, etc., but their incentives to US G rmn e ay help to correct these mistakes were small. Instead, the investors, who had put 0,0 their money at stake, delivered the verdict, signalling the importance of the -2,5 Ja a pn linkages between financial markets and politicians in a market economy. 08 09 10 11 So what about the US? Financial markets are starting to ask the pertinent questions: Will the US be able to grow itself out of the debt burden? Will S u e R u rsE o in o rc : e te c W budget consolidation start in time to calm markets? Will the Federal ReserveSurce: Ecowin allow more inflation so that the debt burden shrinks in real terms? Or will market confidence get lost on the way, raising interest rates 400-500 basis points, thus contributing to a new economic crisis and a possible global meltdown? Most policy makers in the US would say that the public debt deleveraging will have to start soon, and that growth rather than inflation will do the trick. It may be possible, but if the political gridlock remains and even worsens after the election, at the same time as other important decisions are hard to take, e.g. the health reform, banking and housing regulations, etc., then market confidence can disappear sooner than expected. And that is the problem, as a nation you have the financial markets’ confidence until you no longer have it, and the time span between these two stages can be short, very short indeed. Cecilia Hermansson Economic Research Department To the Point is published as a service to our customers. We believe that we have used reliable SE-105 34 Stockholm, Sweden sources and methods in the preparation of the analyses reported in this publication. However, we Telephone +46-8-5859 1000 cannot guarantee the accuracy or completeness of the report and cannot be held responsible for ek.sekr@swedbank.com any error or omission in the underlying material or its use. Readers are encouraged to base any www.swedbank.com (investment) decisions on other material as well. Neither Swedbank nor its employees may be held responsible for losses or damages, direct or indirect, owing to any errors or omissions in To Legally responsible publishers the Point. Cecilia Hermansson +46-8-5859 7720 2

To the Point, No.3 - March 30, 2012

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To the Point, No.3 - March 30, 2012 Document Transcript