Tuesday, January 17, 2012

The European Economy - Is It All Over But the Tears?

Now that Standard & Poor's has, not surprisingly, downgraded the debt held by the EFSF, I thought that it is quite timely to look at a recent news release and speech covering the state of the European economy.

First, let's take a look at the report by the British-based Centre for Economics and Business Research (CEBR).  In this news release, CEBR forecasts that, in Q1 2012, the United Kingdom economy is already in a recession and probably was in Q4 of 2011.  CEBR has downgraded its previous forecast economic growth rate of 0.7 percent for all of 2012, a very tepid rate at best, to a decline of 0.4 percent.  If Europe's problems are worse that it appears now (which they most likely are), CEBR projects that the U.K. economy will shrink by 1.1 percent over the coming year as shown on this graph:

Projecting forwards, CEBR expects growth of only 0.9 percent in 2013 followed by 1 percent in 2014, hardly stellar growth rates.  United Kingdom unemployment is expected to increase to about 3 million people over the next 18 months, compared to 2.64 million or 8.3 percent of the workforce in October 2011.  The most recently released data shows that the unemployment rate was the highest since 1994 as shown on this graph:

The CEBR also predicts that the Bank of England will undertake a further round of quantitative easing in 2012, bringing the total to £400 billion, up from about £275 billion in early 2012.  This is all in an attempt to keep interest rates further along the curve low on top of keeping the base rate at 0.5 percent until at least 2016.  Interestingly, as I posted here, at least one Federal Reserve Bank President feels that it is entirely possible that long periods of ultra-low interest rates may have the opposite effect on the economy than what is intended.  Rather than stimulating growth through cheap credit, the lowered rates could be creating a Japanese-style "lost decade" with low or no growth and deflationary pressures, as has been Japan's experience after a decade of QE by the Bank of Japan.  Perhaps this is at least partly to blame for the rather moribund U.K. economy as well as the rather tepid economic growth around most of the developed world since the "end" of the Great Recession.

With Germany releasing poor economic data last week, my suspicion is that we are in for a slew of grim economic growth figures over the coming quarters with constant revisions downward as we move forward.

On another note, David Lipton, First Deputy Managing Director of the IMF, recently gave a speech at the Asian Financial Forum entitled "Strengthening the Asia/IMF Relationship in a Highly Uncertain Global Environment".  In this speech, he outlines how the issues facing Europe are posing a threat to the Asian economy.  Before we take a closer look at Mr. Lipton's speech, I would be remiss if I didn't remind you that the IMF totally missed predicting the Great Recession, despite their ample arsenal of economic big thinkers as I posted here.  By their own admission, they were caught in a classic case of clusterthink and allowed themselves to be lulled into a false sense of economic well-being.

Mr. Lipton opens by noting that several months previously, the IMF had warned that the global economy was entering "a dangerous new phase".  The pace of global economic expansion is weakening, save that of the United States, largely because of the escalating Eurozone crisis.  Banks are not lending and they are being forced to sell assets to clean up their balance sheets.  Interest rates on sovereign bonds are hitting new highs for many European nations.  These factors are now acting in concert, driving both European and global economic growth downward.  As an aside, I find it most interesting that, while not the topic of his speech, he completely neglects to mention the rising level of United States federal government debt as a pending hindrance to world economic growth.

Mr. Lipton suggests the following solutions to all that ails Europe:

1.) More liquidity for both banks and sovereign nations.

2.) More fiscal consolidation (i.e. austerity measures) that does not impact short-term economic growth.

3.) More growth by putting more capital into banks to ease credit.

4.) More fiscal and financial integration to ensure the viability and stability of the Eurozone monetary union.

The ECB has already undertaken what could ultimately be a rather controversial step; they have dumped hundreds of billions of euros into the European banking system in an attempt to free up Europe's credit markets.  Mr. Lipton also notes that Eurozone leaders have agreed on a mechanism to ensure that future fiscal discipline among Member States is maintained, although, a 3 percent deficit-to-GDP cap and a 60 percent debt-to-GDP cap have been in place since the inception of the Eurozone and they have failed miserably.  Perhaps it is as Albert Einstein so famously said, "Insanity is doing the same thing over and over again and expecting different results.".

Here are the last two paragraphs of the first section of Mr. Lipton's speech:

"The stakes are high. Without bold action, Europe could be swept into a downward spiral of collapsing confidence, stagnant growth, and fewer jobs.

And in today’s interconnected global economy, no country and no region would be immune from that catastrophe."

Mr. Lipton assures his audience that the IMF is working with Europe to "restore market confidence, rekindle growth and ensure the integrity of the common currency.".  The IMF will be making a case to increase their lending capacity to augment the resources that Europe requires to tackle its problems.  The IMF is looking for a stronger partnership between Asian nations and the Fund (i.e. begging hat-in-hand for a "donation" to a very worthy cause) with Japan and China now being the second and third largest IMF shareholders overall, after the United States.   With the 2010 plan to double the size of the Fund to $755.7 billion, the fine folks at the IMF will need all of the help that they can get from China and their multi-trillion dollar foreign reserves, in particular.

We should now all pause for a moment's silence and recall that it was the IMF who was largely responsible for the world's largest sovereign debt default back in 2001.  Perhaps Europe's confidence in an IMF bailout is rather misguided but only time will tell.

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