First posted on:
Bloomberg View, 27 January 2016
Amid one of the worst market routs on record, a chorus of reassuring economic commentators insists that global fundamentals are sound and investors are overreacting, behaving like a panicked herd. Don’t be so sure.
Consider, for example, how wrong economists have been about the effects of the 2008 financial debacle. In April 2010, the IMF declared the crisis over and projected annualized global growth of 4.6% by 2015. By April 2015, the forecast had declined to 3.4%. When the last quarter’s weak results are released, the reality will probably be 3% or less.
Economists are used to linear models, in which changes follow a relatively gradual and predictable path. But thanks in part to the political and economic shocks of recent years, we live in a highly non-linear world. The late Danish physicist Per Bak explained that after long absences, earthquakes come in quick succession. A breached fault line sends shockwaves that weaken other fault lines, spreading the vulnerabilities.
The subprime crisis of 2007 breached the initial fault line. It damaged US and European banks that had indulged in its excesses. The Americans responded and controlled the damage. Euro-area authorities did not, making them even more susceptible to the Greek earthquake that hit in late-2009. Europeans kept building temporary shelters as the banking and sovereign debt crisis gathered force, never constructing anything that would hold as new fault lines opened.
Enter China, which briefly held the world economy together amidst the worst of the crisis. Just in 2009, the Chinese pumped in credit equal to 30% of gross domestic product, boosting demand for global commodities and equipment. Germans benefited in particular from the demand for cars, machine tools, and high-speed rails. This activated supply chains throughout Europe.
But China is becoming more a source of risk than resilience. The number to look at is not Chinese GDP, which is almost certainly a political statement. The country’s imports have collapsed. This is troubling because it is the epicentre of global trade. Shockwaves from China test all the global fault lines, which makes China a potent source of financial turbulence.
Only China can undo its excesses. Its vast industrial overcapacity and ghost real estate developments must be wound down. As that happens, large parts of the financial system will be knocked down. The resulting losses will need to be distributed through a fierce political process. Even if the country’s governance structure can adapt, the required deep-rooted change could cause China’s slowdown to persist for years.
Beyond China, Europe remains the most serious fault line. Italian banks are saddled with bad loans. As in much of the euro area, authorities had hoped the banking problems would go away. Now, though, the government will need to bear some of the losses, weakening Italy’s already fragile public finances. At 134% of GDP, the country’s sovereign debt is barely sustainable. Worse, the economy is stagnant: per capita GDP is lower today than in 1999, when Italy adopted the euro. A country that does not grow cannot repay its debts.
Briefly out of sight, Greece and its creditors are engaged in an endless war of attrition. The creditors remain mindlessly committed to fiscal austerity, which the battered Greek economy will no longer bear. German Finance Minister Wolfgang Schäuble has renewed discussion of a Greek exit from the euro area. If that happens, the entire currency union could unravel.
As in China, Europe’s fundamental problem is an obsolete political and governance structure. Managing so many nations in a semi-hierarchical system under German hegemony can no longer work. The continuing tragedy of the refugee crisis may be the unanticipated but final blow.
One reason the tremors have persisted so long, and are inflicting so much damage, is that the primary driver of better living standards—productivity growth—has been exceedingly weak. In turn, persistent economic distress is weighing heavily on vulnerable populations, fomenting anger and forcing sometimes disruptive political change.
Financial markets often do get things wrong. But they are better than economists in sensing non-linearities, the critical junctures where fundamental shifts occur. Politics, economics, and finance are threatening to move the tectonic plates. This is a bad moment to look the other way.