Will global economies ever recover from the financial crisis?
This was supposed to be the year economies the world over got back on track. After the mire caused by the financial crisis, governments looked forward to leaving the dangers of recession and depression behind them and to shepherding in a new age of transparency, accountability and a reining in of excessive spending.
Unfortunately, the reality hasn't quite turned out that way.
The eurozone is dogged by the debt levels of its peripheral nations, while the US has twin concerns of high unemployment and low consumer confidence to contend with, and the UK recovery seems to have stuttered to a halt.
Back in 2008, when the global banking system was crumbling around them, Western policymakers were forced to unite in their attempts to avoid complete meltdown. But, as time has marched on, the demands pressed on these governments by domestic politics and the individual characteristics of their respective economies have seen them narrow their perspectives again.
The result has been a divergence in both monetary and fiscal policies, which is all the more marked following a period of relative harmony. So which government, if any, is following the right path and should we expect different policies as countries try to resume 'service as normal'?
Since the coalition was formed last year, the buzzword in British politics has been 'austerity'. Prime Minister, David Cameron, and his chancellor, George Osborne, insist the time has come to pay for the party years of Labour's reign and cut the public spending and borrowing allowed to rampage during the 13 years at the helm.
To compensate for the squeeze felt by consumers at the hands of fiscal tightening, the Bank of England (BoE) has opted to maintain ultra-loose monetary policy for over two years now and shows no signs of raising interest rates before the end of the year. Governor of the BoE, Mervyn King, has made it clear the central bank will support the government's intention of eliminating the budget deficit by 2015/16 by using accommodative policy to ease the pain.
In Europe, there is also a tight fiscal position, particularly in peripheral nations where governments have been forced to show a credible effort towards reducing debt levels or face credit downgrades by rating agencies. The eurozone is widely considered to be at the beginning of a tightening cycle in monetary policy as well, after the European Central Bank (ECB) leapt ahead of the BoE and Federal Reserve to raise interest rates in April. The central bank has held off making subsequent hikes, but President Jean-Claude Trichet has announced the bank will be vigilant in its response to inflationary pressures.
US growth through stimulus
Across the Pond, the US has eschewed austerity and gone for growth through stimulus. There is currently no sign of a concerted fiscal plan to reduce public borrowing and the Federal Reserve has promised interest rates will remain low for some time to come. First-quarter GDP figures for the US showed growth of 1.9%, down from an increase of 3.1% in the fourth quarter of 2010. But although growth has slowed, supporters of America's second round of quantitative easing will argue at least it hasn't stalled altogether.
Trevor Greetham, director of asset allocation at Fidelity International, says: "It's unusual to see what appears to be a very marked divergence in policy. The UK felt like it was leading a lot of the response to the crisis through things like using public money to rescue the financial system and buying up government bonds. Then we look at the last year and a half and I wouldn't say there was such a huge difference on the monetary side, but on the fiscal side there's quite a difference."
Fiscally, the UK government has one of the tightest policies around, according to Greetham, and unsurprisingly the government's opposition maintains the cuts are happening too hard and too fast. But leading economists have also criticised the heavy handed approach, saying it threatens the fragile state of the recovery.
Waning support for Osborne's cuts
At the beginning of June, former supporters of the Tories' cuts signed a letter to the Observer warning Osborne it was time to look for a plan B. Jonathan Portes, director of the National Institute of Economic and Social Research and former chief economist at the cabinet office, was reported saying "you do not gain credibility by sticking to a strategy that isn't working". Other high-profile experts were also quoted saying the government shouldn't be too inflexible, since growth this year had disappointed to the downside and recent data releases pointed to a continuation of the slowdown.
But John Gieve, adviser to GLG Partners and former deputy governor of the Bank of England, says the government didn't really have an option and the UK could easily have been alongside Greece and Portugal if it hadn't taken such strict measures. He adds that the markets matter and by taking a tough stance the coalition has calmed market fears surrounding the UK.
"My own view is there will not be many years of stagnation and the UK in five years time will end up in a stronger fiscal position than the US," he says.
US political deadlock
The fiscal situation in the US has become something of a political deadlock, with Congress threatening not to raise the debt ceiling, which limits the amount of money the government can borrow. Republican politicians are effectively using the debt ceiling as a bargaining chip to try and get the ruling Democrats to take steps towards cutting the booming deficit. If a deal is not reached by August the world's superpower may well default on debt obligations, which in turn could lead to a loss of its AAA credit rating.
Gieve thinks the time has come for the US government to take some tough decisions: "If the US keeps pumping money into its economy until unemployment reaches its 'desired number' it will have no fiscal policy and high inflation in five years."
Stuart Cowley, head of fixed income at Old Mutual Asset Management, thinks the American policy is 'grotesque'. "They are addicted to spending other people's money; they have become happy with the idea that other people will lend them money forever. But that is not the case, global diversification is going on," he says.
The Greece effect
Cowley believes the situation in Greece has served as a deflection from problems in the US and the UK, and once a solution is found by European authorities (which he says is bound to happen) attention will switch back to what is going on closer to home. He adds that not enough cuts have been made in the UK and the markets will only give it the benefit of the doubt for so long.
Indeed, it seems politicians in Greece and the rest of Europe are getting closer to a resolution on its debt problem and traders that have been focused on the situation in the eurozone will have to look elsewhere for fundamentals to inform their positions. What they will see when they switch their attention to the UK and US remains under question.
Greetham doesn't think the fate of these economies is on such a knife edge: "No one really knows how to do this," and Gieve agrees: "We don't really know how it's going to work out."
But one certainty is that interest rates across the developed world will have to rise. "It's easy to forget quite how relaxed monetary policy is," says Gieve, "When we [the BoE] set out on this we thought it was necessary to prevent a spiral into depression. It's pretty clear it did stop this but we are hanging on and I think that has got to be a risk."
Francis Hudson, Global Thematic Strategist at Standard Life, agrees that interest rates should be higher, but is concerned with the effect increased rates will have. She doesn't think it is necessarily negative that the US, UK and Europe are following different policy paths: "The worst thing for everybody would be if all three had pursued the same policy - one slows down global growth and the other gives us inflation. So diversity is not a problem to me."
Hudson points out that US GDP is now back at its pre-crisis level and the UK's is at 95% of its pre-crisis level. Put like that, initiatives taken to drag these economies back from the precipice don't seem quite so ineffective. The main laggard comes from three years of lost growth, which she says these countries can't make up for.
Instead, she recommends they adjust their long-term target growth rate lower and accept the days of robust growth driven by high liquidity and feckless speculation are long gone.
Investors might just have to accept that, too.
This article was written for Interactive Investor
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
The total money value of all the finished goods and services produced in an economy in one year. It includes all consumer and government consumption, government spending and borrowing, investments and exports (minus imports) and is taken as a guide to a nation’s economic health and financial well being. However, some economists feel GDP is inaccurate because it fails to measure the changes in a nation's standard of living, unpaid labour, savings and inflationary price changes (such as housing booms and stockmarket increases).