The great divergence still firmly in place

The July 2012 issue of Perspectives is now available for reading and downloading. Today we preview the macroeconomics section of the magazine.

Over the past twelve months or so, we have regularly referred in this publication to the phenomenon we have dubbed the ‘Great Divergence’. We define this as the increasingly divergent trajectories being taken since the early 1980s by the size of public debt in the developed world and countries’ economic growth rates.
Since 2008, the predominant dynamics in developed nations have been unmistakable: too steep an increase in debt matched by too sluggish economic growth, resulting in countries running up huge debts and becoming de facto or potentially insolvent. In this climate of anaemic growth, Herculean efforts in terms of monetary, fiscal and political measures will have to be mustered to reverse this Great Divergence.

Indebtedness and slowdown: a deadly duo

The global macroeconomic landscape remains dominated by two overriding trends: (1) the eurozone debt crisis and (2) the slowdown in the world economy. Tensions in the debt crisis were temporarily eased by decisions taken at the nineteenth EU summit on 28/29 June which had crisis resolution top of its agenda. Despite this, the evidence suggests yet again that only the symptoms of the eurozone patient’s ills have been treated and that curing the real root cause of the malaise has been yet again postponed.

In particular, the twin bailout funds (the European Financial Stability Facility and the European Stability Mechanism that will succeed the EFSF) are still not big and potent enough compared to the future needs of the banking sector and governments in peripheral eurozone member states. Likewise, the concept of a fiscal union with a joint and collective financing system (Eurobonds) has still not evolved into a developed enough form to ease financial markets’ longer-term fears. It also seems fanciful to believe the so-called ‘Compact for Growth & Jobs’ will be sizeable enough to get to grips with the Great Divergence and narrow the widening gulf between the rising trend on government debt and the flat or declining trend on economic growth.
The slowdown has been confirmed in both the eurozone and the emerging world. Even China whose economy averaged growth of roughly 10% over the past two decades has seen growth slow noticeably below that tempo: our core scenario envisages the rate in China steadying around the 7%-8%-mark by the latter half of the year. As China today accounts for half of the growth in the global economy, the impact of it slowing cannot be overlooked. On the plus side, the US economy has been displaying some resilience: although its rate of expansion has dipped from 4% a few months ago to about 2% at present, we remain confident it will regain momentum towards 2%-2¼% by the year-end.

US: Operation Twist extended

Numbers published recently have confirmed encouraging upswings in US residential construction work, house sales and property prices – although those are the only real sources of satisfaction as regards the US economy. The good news stops right there. Other economic data have continued to point towards a distinct slowdown after a surprisingly robust start to 2012. The downswing in growth in consumer spending seen in April-May is a particular concern. Happily, the recent fall in petrol prices does offer some glimmers of optimism for future developments.

GDP growth in the US in Q2 2012 is likely to have dropped slightly short of 2% yet again (+1.9% in Q1 2012), and worries over the economy’s robustness in H2 2012 have noticeably mounted. We remain moderately upbeat, continuing to forecast that growth in the second half should outpace that seen in the opening six months. The warm welcome from financial markets to measures agreed at the 28/29 June EU summit would seem to lend a little weight to that particular scenario.

On 20 June, the US Federal Reserve announced that it was extending Operation Twist, its programme geared to lengthening the duration on its portfolio of US Treasury bonds. Operation Twist had been due to finish at end-June, but it has been extended to the end of the year. The decision means monetary easing will continue, but no significant extra impact on the economy should be expected. In tandem, the Federal Open Market Committee downgraded its growth forecasts and would appear to have adopted a decidedly more expansionary bias. The likelihood of a third round of quantitative easing (QE3) has undoubtedly increased, but we continue to believe the Fed will prefer to keep this particular powder dry just in case the impact of more restrictive fiscal policy in early 2013, referred to as the ‘fiscal cliff’, is greater than the 1%-1.5% being predicted.

European Council buys itself some time and breathing-space

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At its latest summit on 28/29 June, the European Council adopted a series of measures to move things along in the right direction. But a very long, arduous road still lies ahead before a lasting solution is found to the eurozone crisis. The need to break the toxic link between public deficits and banks’ balance sheets has nudged the EU some way towards setting up a banking union. It was decided to centralise supervision at the eurozone level. Specifics still have to be defined, but, in any event, the European Central Bank will have a part to play. The Council also took the significant decision to allow the future European Stability Mechanism (ESM) to be able to recapitalise banks directly without having to go through the channels of the relevant sovereign state.

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