As we enter 2011, the mature economies of the world seem headed toward the doldrums once more. Hopes of a quick rebound are fading, especially in the United States, while in Europe the fiscal crisis in peripheral countries is threatening to spread to the core. Only Germany has performed well, thanks to the external stimulus received from emerging markets imports of its goods, while Japan remains mired in political indecisiveness after two decades of gradual decline, hastened by the global financial crisis.
Looking forward, we see the European Union’s policy rudder firmly set on fiscal consolidation and the design of the Stability Pact 2.0, sustained by a European Fund. A major political focus will be the design of a permanent framework for dealing with sovereign crises, which will be undergoing an “on the road” test with Ireland’s collapse and contagion to Portugal and Spain. So it is unlikely that much stimulus for global growth will come from the Old Continent.
But the main uncertainty hangs over the US economy. Since taking office, President Barack Obama’s administration has essentially followed the strategy conceived by his predecessor and has skirted policy actions that would tackle the fundamental causes of the crisis: lagging productivity, crumbling infrastructure, poor education, declining innovation and financial imprudence. The indecisiveness and the stalemate with Congress on fiscal and structural policies, compounded by the setbacks in Afghanistan, have generated a malaise that is deterring investments.
Following the midterm elections, in which the Republicans took the House of Representatives, the confrontation on economic policy is likely to escalate, starting with the extension of the tax cuts enacted by former President Bush. With major policy decisions and regulatory reforms on standby, the task of reviving the economy has been taken up by the US Federal Reserve. As interest rates are already near zero, the strategy conceived for the next few months hinges on a second round of ‘quantitative easing’ or, as the media dubs it, QE2.
The Fed will inject money by purchasing long-term government bonds, in the hope that the financial institutions will lend the money to corporates and savers will spend on goods and services.
Printing money to pay for government liabilities is hardly an original move. It was a widespread habit in Latin America when the continent was experiencing double, and occasionally triple, digit inflation in the 1970sand 1980s. In more recent history, from March 2001, it was adopted by the Bank of Japan to counter deflation and stagnation, with scant success. During the acute phase of the financial crisis, as interest rates moved close to zero, QE became popular in many of the advanced economies including the US, the Euro zone and United Kingdom. As a lifeline to banks it has worked, but as a stimulus it had, at best, a limited effect.
The US embarked on the second round of QE in November. The Federal Reserve’s meeting on November 3 outlined that, “economic conditions…are likely to warrant exceptionally low levels for the federal funds rate for an extended period” and “the committee intends to purchase a further $600billion of longer-term treasury securities by the end of the second quarter of2011, a pace of about $75 billion per month.”
The statement indicated that the Fed is keeping the door open for additional purchases if necessary, noting that the Federal Open Market Committee (FOMC) will “adjust the program as needed to best foster maximum employment and price stability.”
The Fed touted this measure even before the formal announcement, so long-term interest rates and the dollar exchange rate had plunged in reaction. Then the Irish crisis provoked a flight to the safety of US Treasury bills, thereby reversing the currency movements.
It is rather worrisome that for the next six months, while the Obama administration deals with the new Congress, monetary policy will be the only ingredient in the policy kitchen. The case for QE rests on the hopes that monetary policy and ultra low interest rates will induce corporations to invest.
But doubts abound. Professor of economics at New York University’s Stern School of Business and chairman of Roubini Global Economics, Nouriel Roubini, for example, pointed out that banks already have close to US$1trillion in excess reserves, yet they refuse to lend while earning only 25basis points. More liquidity will not help. He argues that there is a “continued credit crunch on the supply side, exacerbated by the comatose state of the securitization system.”
Furthermore, the private sector is still de-leveraging while corporations are holding hundreds of billions of dollars in cash and up to $2trillion according to some estimates. It is very unlikely that they will be induced to invest by even lower interest rates. In essence, it is the uncertainty over the future direction of policy, the fiscal measures to stabilize the public debt and the persisting troubles in real estate that holdback market forces.
The counterargument, espoused by the Nobel Laureate economist Paul Krugman, holds that higher inflation will induce companies that are sitting on cash to invest, while the real burden of the public debt will shrink. However, inflation is essentially a tax on money holders and those whose salaries are fixed; plus it represents transfer of wealth from creditors to debtors. It is highly uncertain where such a gamble could end, and in fact, historically, inflationary policies have been hard to reverse.
In today’s interlinked world, the impact of QE will not be limited to the US economy: it will also cause excessive liquidity in emerging markets, including the Middle East and North Africa (MENA) region. Freely floating currencies have already appreciated in response to capital inflows from investors seeking higher returns. Warnings of a bubble in emerging market assets were rife even before the announcement of QE2. Now the red lights are flashing in front of many senior policy makers.
South Korea’s finance ministry announced that it would consider limits to capital flows, while Brazil and Thailand already raised taxes on foreign investment in government bonds. Thailand’s Finance Minister Korn Chatikavanij acknowledged “discussions with central banks of neighboring countries, which are ready to impose measures together, if needed, to curb possible speculative money flowing into the region.”
QE2 will have an even greater impact on those economies that have a fixed peg to the dollar and allow free capital movements, such as the Gulf Cooperation Council (GCC) countries or Lebanon. In fact, the central banks would not be in a position to tighten monetary policy to cool down the economy while the dollar depreciation will spur imported inflation, especially if the weak dollar translates into higher food commodities prices.
Furthermore, speculative investments induced by cheap money expose the receiving country to a sudden outflow if global risk aversion rises. So, for the Middle East and the GCC, two kinds of scenarios could occur in2011. One is a more benign one, where anemic growth in mature economies will be offset by the push from emerging Asia and public investments. In such a case the real growth rate in the GCC would not be too far from the average growth rate in countries from the Organization for Economic Cooperation and Development (OECD) and emerging Asia, (i.e. 3 to 4 percent).
The less benign scenario will be dominated by currency instability, bouts of risk aversion and international credit market frictions. It is hard to predict which one will prevail because the second scenario would be ignited by a traumatic event, such as a sovereign default, which depends crucially on political developments rather than purely economic ones. In essence, the usual cloud of uncertainty is unusually thick because the precarious historical phase we are experiencing has no precedent that can provide guidance.
There are no easy prescriptions for these testing times, but economies that are developing an internal capacity to grow through major infrastructure upgrades and expansion of capacity are better placed to withstand shocks. In other words, medium-term policy efforts should be concentrated on decoupling from the performance of the mature economies.
In this context we should welcome the successful bid to host the FIFA World Cup in Qatar, which will offer a major boost to economic activity in the entire Middle East.
FABIO SCACCIAVILLANI is director of microeconomics and statistics, and AATHIRA PRASAD is an economist at the Dubai International Financial Center Authority