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To the Point, No. 8/2010

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To the Point - 2010, December. Discussion on the economy, by the Chief Economist Cecilia Herrmansson.

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To the Point, No. 8/2010

  1. 1. To the PointDiscussion on the economy, by the Chief Economist December 21, 2010 Our wishes for 2011: From bounceback to sustainable growth The global recovery was stronger than we expected during 2010, and the growth outlook is positive also for 2011, although somewhat weaker as developed countries consolidate budgets and implement reforms. The political risks for 2011 are in focus: how to solve the sovereign debt problems in the developed countries, how to create better global institutions, Cecilia Hermansson and how to “fix” the euro zone. Now is the time for strong political leadership. Group Chief Economist Economic Research Department Better growth than expected – but risks are building up +46-8-5859 7720 cecilia.hermansson@swedbank.se Last year, my final To the Point had the title “Happy New Recovery Year!” I concluded that the recovery during 2009 had been stronger than expected, and that it was set to continue during 2010. The focus for 2010 would be on handling sovereign debt and exit strategies. I had three New Year’s resolutions: reform the international monetary and financial system, boost innovation, and step up microeconomic reforms. One year later, the recovery during 2010 has not only continued as envisaged but has also come out stronger, by a full percentage point on the global level ( 4 ½ % instead of the expected 3 ½ %). Three groups in particular have performed better than was forecast: Germany and northern Europe in general; China, India, and other parts of Asia; and Brazil and other Latin American countries. On the New Year’s resolutions, the reform of the financial system has been carried out. Even if implementation takes several years, decisions have been made that, although perhaps not bold enough, are steps in the right direction. There are many issues left to discuss, such as the “too-big-to-fail” issue, moral hazard, and cross- border regulations. Regarding the monetary system, there are many challenges, not least of which the critique of quantitative easing in the US and increased currency tensions among G20 countries during the autumn showed. Exit strategies have been on the agenda, but, for many of the larger central banks, entry strategies have had higher priorities. Sovereign debt issues have been focused on during 2010 and will remain in focus during 2011, leaving little energy for innovation and microeconomic reforms. Also during 2011, global growth may surprise on the upside, mainly due to large carryovers from 2010, which will lead to higher growth rates in the European countries not affected by balance sheet crises - e.g., Germany, the Netherlands, Sweden, and Finland. We foresee global GDP growth dampening somewhat to just below 4% in 2011, taking into account decreased demand in the PIIGS countries and continued low demand in the US, UK, and Japan, as well as weaker momentum in most emerging markets. Due to stimulus measures and inventory restocking, the recovery has been satisfactory in some countries, but a bit slow in others (the US, for example). Countries with balance sheet recessions will need more time to create growth rates that are high enough to support labour market developments and also boost confidence. Even if the growth climate is rather good for the world as a whole, with emerging markets driving the global outlook, risks are building up in Europe and the US, as well as in emerging markets, where overheating must be tackled. The world looks to be in better shape, but risks for new disruptions are becoming more complex, not least No. 8 the political risks, which are hard for economists to interpret and forecast. 2010 12 21
  2. 2. To the Point (continued)December 21, 2010Chart 1: The EUR/USD currency rate and itsmean during 1999-2010 Increased focus on the political risks 1.6 Analysing the risks for 2011, there are ordinary economic and financial risks linked 1.5 to, for example, commodity prices, labour markets, interest rates, and currencies. Underneath, political decisions make a difference between sustainable and non- 1.4 sustainable growth – as always – but perhaps more so now than ever. Political 1.3 scientist Ian Bremmer developed the global political risk index (GPRI), togetherEUR/USD 1.2 with Lehman Brothers (!), in 2001; it focuses mainly on emerging markets. Still, 1.1 Bremmer now acknowledges the US to be on the top 10 political risk list. Maybe 1.0 there is need to include more developed countries in the political risk analysis. 0.9 Below, I will list some reflections on institutional and political developments: • 0.8 98 00 02 04 06 08 10 Global institutions have been created to handle crises and coordinate policies, m ean S ource: R euters E coW in such as the G20, the Financial Stability Board (FSB), and the European Systemic Risk Board (ESRB); however, they are still weak when national interests go against the global common best. As the room for monetary and fiscal stimulus is disappearing, trade and currency tensions are rising that are not easily reduced. • In the US, it has been fairly easy for Republicans and Democrats to cooperate on the issue of cutting taxes and increasing expenditures. It is unlikely, however, that cooperation will remain good in a situation – which will need to come sooner rather than later – when taxes have to be raised and expenditures cut. • Even if the new stimulus package is positive for US GDP growth, medium- term risks of budget and financial market turbulence are building up. The bi- partisan National Commission on Fiscal Responsibility and Reform established to address these risks has made a first step in the right direction, but by postponing medium-term fiscal consolidation plans, the US politicians are taking a risk, affecting not only the US but also the global financial system as a whole. • Europe’s Economic and Monetary Union (EMU) is based on monetary and economic foundations. The monetary part (ECB) is performing rather well: prices are stable and the euro is still safeguarding purchasing power. The economic part (national governments) is underperforming on the fiscal side, and on structural reforms to improve competitiveness; most damaging, however, is the failure of the Growth and Stability Pact. This institutional framework has not been improved, as the chances to reform it a few months ago by introducing more automatic sanctions were squandered. The target of a 3 % budget deficit should be replaced with a target of a balanced budget over the business cycle, thereby increasing budget discipline in good times. In the years to come, most crisis-struck countries need to have very large primary surpluses to stabilise debt, let alone to start on the downward path to a debt level of 60% of GDP. • The European Union (EU) needs the EMU in order to develop and to compete with the rest of the world. When EU President Herman Van Rompuy said that “the debt crisis would put the survival of the union in question,” he was probably right, but his statement, by spreading uncertainty, did not help. Showing political leadership is important. The commitment to the EU and the EMU is still high among politicians. The problem is that they are re-active rather than pro-active towards the financial markets, which often need to be surprised by larger measures than expected. The breakup of the EMU would not make sense in a longer-term perspective, and not in the short term either to peripheral euro zone countries experiencing increasing financial turbulence and rising legal challenges; neither would it make sense to Germany, where the currency would appreciate more than desired and capital inflows would explode. • The creation of the permanent European Stabilization Mechanism (ESM) is a step in the right direction to find a sustainable medium-term solution. The costs of future bailouts will be shared with bondholders on a case-by-case basis, a proposal that seems reasonable. There is, however, no free lunch as markets will move to a new equilibrium, with wider interest rate spreads reflecting the higher default risks of some European countries. 2
  3. 3. To the Point (continued)December 21, 2010 • Thorough discussions still have not been held on such medium-term issues asChart 2: Interest rate spreads between a fiscal union, a euro bond, and better surveillance between countries. TheseGerman and other EU countries’ 10 year are key questions that need more time to be explored, considering thebonds challenges of moving from the national to a European perspective. 10 • There is a lack of crisis management to deal with this ongoing and acute 9 Greece situation. Solving the medium-term issue is important, but so is alleviating the 8 current crisis. By focusing on burden sharing at this point, the crisis has 7 worsened for Ireland, Portugal, and Spain. By finding that the temporary fund 6 (EFSF) has not been used up, the question of increasing it would be postponed Ireland Percent 5 until the situation becomes acute and the financing costs have increased more 4 Spain Portugal than necessary. Yes, a larger fund may signal that bailouts of Spain and 3 Italy perhaps also Italy are inevitable, but financial markets are concerned anyhow, 2 and, if the German constituency were faced with the costs and benefits of the 1 various options, it might find the larger fund acceptable, not least since the 0 UK France Belgium risk of losing taxpayers’ money is rather small. -1 • jan apr jul okt jan apr jul okt jan apr jul okt 08 09 10 Source: Reuters EcoWin The authorities must continue the fiscal consolidation in the euro zone while trying to safeguard the recovery. More efforts are needed on the national level to increase effectiveness and productivity, and to become more competitive. While the financial sector is being re-regulated, there are many product markets and also labour markets that need further deregulation. • In Europe, there has been a dividing line between the West and the East. More and more, a dividing line between North and South is becoming noticeable. Political leadership must work towards keeping the EU together, as this will most likely be a benefit when competing against other regions in the world. However, freezing the EU budget will again widen the East-West gap. Poland and other eastern European countries would be the main losers from such a measure. It may seem reasonable to cut back or stabilise the budget when many countries are experiencing problems, but if negotiations were settled between France (by maintaining its agricultural support from the EU budget) and the UK (by keeping its contribution to the EU budget at a minimum), this would represent a suboptimal decision-making process in the EU: it might be better for the Union as a whole to transfer support to the Eastern part in order to speed up convergence rather than to uphold large subsidies in general to the agricultural sector. • Political risks surround the handling of terrorism (suicide bombers), military decisions (the Korean peninsula tensions), and riots (peripheral euro zone). The internal devaluation process has just started in parts of Europe (even if the Baltic countries have experience of it by now) and the dampening of demand could give way to nationalist and populist movements. To remain an open society with high tolerance for globalisation and immigration is especially important in Europe, where demographics and shortages of labour will be challenges that must be overcome in order to achieve sustainable growth in the medium and long term. The bounceback period was great with higher than expected growth rates, and to support the economy with stimulus measures was not the most difficult task for politicians. Moving ahead, however, challenges are rising: How to sustain growth rates despite budget consolidation and deleveraging, and not least how to sustain political stability in a weaker economic climate. Lastly, let me wish you a Happy New Year, and especially to politicians in the world’s most crisis-struck countries – you certainly need it! 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 any ek.sekr@swedbank.com 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 the Legally responsible publishers Point. Cecilia Hermansson +46-8-5859 7720 3

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