World economy – the Three-way split

America, the euro zone and the emerging world are heading in different directions – Published on The Economist, Dec 9th 2010.

THIS year has turned out to be a surprisingly good one for the world economy. Global output has probably risen by close to 5%, well above its trend rate and a lot faster than forecasters were expecting 12 months ago. Most of the dangers that frightened financial markets during the year have failed to materialise. China’s economy has not suffered a hard landing. America’s mid-year slowdown did not become a double-dip recession. Granted, the troubles of the euro area’s peripheral economies have proved all too real. Yet the euro zone as a whole has grown at a decent rate for an ageing continent, thanks to oomph from Germany, the fastest-growing big rich economy in 2010 … //

… Reach for the stretch pants, Barack: 

America’s economy, too, will shift, but in a different direction. Unlike Europe’s, America’s macroeconomic policy mix has just moved decisively away from austerity. The tax-cut agreement reached on December 7th by Barack Obama and congressional Republicans was far bigger than expected. Not only did it extend George Bush’s expiring tax breaks for two years, but it also added more than 2% of GDP in new breaks for 2011 (see article). When this is coupled with the continued bond-buying of the Federal Reserve, America is injecting itself with another dose of stimulus steroids just when Europe is checking into rehab and enduring cold turkey.

The result of this could be that American output grows by as much as 4% next year. That is nicely above trend and enough to reduce unemployment, although not quickly. But America’s politicians are taking a risk, too. Even though their country’s long-term budget outlook is famously dire, Mr Obama and the Republicans did not even try to find an agreement on medium-term fiscal consolidation this week. Various proposals to fix the deficit look set to gather dust (see article). Bondholders, who have been very forgiving of the printer of the world’s chief reserve currency, greeted the tax deal by selling Treasuries. Some investors, no doubt, see faster growth on the way; but a growing number are worried about the size of America’s fiscal hole. If those worries take hold, the United States could even see a bond-market bust in 2011.

How much does this parting of the ways matter? The divergence between the world’s big three will compound the risks in each one. America’s loose monetary policy and concerns about sovereign defaults in the euro zone will encourage capital to flow to emerging economies, making the latter’s central banks reluctant to raise interest rates and dampen down inflation. Over the next five years emerging economies are expected to account for over 50% of global growth but only 13% of the increase in net global public debt. Rather than rebalancing, the world economy in the immediate future will skew even more between a debt-ridden West and thrifty East.

The West avoided depression in part because Europe and America worked together and shared a similar economic philosophy. Now both are obsessed with internal problems and have adopted wholly opposite strategies for dealing with them. That bodes ill for international co-operation. Policymakers in Brussels will hardly focus on another trade round when a euro member is about to go bust. And it bodes ill for financial markets, since neither Europe’s sticking-plaster approach to the euro nor America’s “jam today, God knows what tomorrow” tactic with the deficit are sustainable.

Of course, it does not have to be this way. Now they have splurged the cash, Mr Obama and Congress could move on to a medium-term plan to reduce the deficit. Europe’s feuding leaders could hash out a deal to put the single currency and the zone’s banking system on a sustainable footing. And the big emerging economies could allow their currencies to rise. But don’t bet on it. A more divided world economy could make 2011 a year of damaging shocks. (full text).

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