The Transatlantic Economy’s Summer of Discontent

Much of the orthodox analysis of the West’s recent economic travails puts the blame squarely on a failure of political leadership.

Reality requires a more complex narrative.

Yes, the US came inexcusably close to committing hari kari by failing to lift its debt ceiling with a balanced, timely, comprehensive programme for long term fiscal sustainability.

Yes, the European Union struggles to deal with the fallout from the inherent contradictions at the heart of its monetary union.

Certainly, political failure doesn’t help lift the pervading sense of crisis, and the uncertainty it breeds contributes to financial market volatility, but it is market failure, not political failure, that is at the root of our economic malaise.

In short, the West’s growth model is broken. On both sides of the Atlantic, cheap credit and the smoke-and-mirrors of financial innovation-speculation were the key drivers of growth since the bursting of the dot-com bubble.

Improvements in living standards for working people were largely illusory, a debt-fuelled consumption frenzy and asset bubbles belying ever-more-perverse income and wealth inequalities.

Private sector credit had exploded in both the EU and the US, most strikingly in Spain, Ireland, the US and the UK, which saw mind-blowing property bubbles.

As inevitably had to happen, the credit bubble burst, slowly at first in late 2007, then in spectacular fashion in 2008, exemplified by the Lehman collapse.

As credit contracted, the West was gripped by epoch defining recession, its banking system facing collapse. Governments reacted with unprecedented fiscal and monetary stimulus and bank bailouts. The net effect was the avoidance of a second Great Depression, but a spike in sovereign debt.

It is this public and private sector debt overhang that has the transatlantic economy rooted in the doldrums. If our economies were growing, wages and prices rising, the debt overhang would be challenging but manageable.

Financial markets have just collectively realized, however, that a return to robust growth is not imminent, and that this debt overhang will play havoc with prospects for recovery.

Indeed, Japan provides a cautionary tale. It’s property and equity markets peaked two decades ago, never to fully recover. Japan’s sovereign debt is more than 200% of GDP. It remains mired in a slow growth, low inflation trajectory.

So, what if the West’s current ‘crisis’ is the new normal? The answer to a debt-inspired crisis cannot be more debt, but neither can the answer be government withdrawal from the economy through aggressive austerity.

With western politicians hell-bent on slashing budgets, the Fed and the Bank of England have stepped into the breach by further loosening monetary policy. The ECB took the opposite approach. Having already slaughtered one sacred cow by buying the bonds of Eurozone sovereigns, however, it may only be a matter of time before it is forced to ditch monetary tightening as global growth slows.

Embracing moderate inflation may be part of the answer, but there may be no quick fix to the West’s economic malaise. We may well be faced with a decade of stagnation and high unemployment as firms, families and countries nurse their debt induced hangovers and rebuild their balance sheets.

For long-term recovery, we need a new global compact for balanced growth. For its part, the West must re-learn the virtues of thrift and delayed gratification. We need to invest in our infrastructure, in education, and in scientific research. These will be key to achieving holistic competitiveness and sustainable prosperity in the 21st century.

We need to learn that it is only through innovation – not through debt, consumption and speculation – that we can push back the frontiers of the global economy’s growth potential. The alternative is bigger booms and bigger busts.

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