Thursday, December 29, 2011

Four Hard Truths for 2011 – Risks for 2012

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

History is the science of things which are never repeated (P. Valery)

 

The year 2011 was supposed to be the year that broke the back of the global crisis.  However, the crisis is still with us as the North Atlantic banking part of the crisis morphed into the Eurozone crisis.  The persistence of the European sovereign debt crisis risks moving toward a full-blown banking crisis.  The impact of slower growth in the advanced countries now threatens emerging economies.  Olivier Blanchard, the chief IMF Economist, looks at some of these issues in a VOXEU communique called “Blanchard on 2011’s four hard truths” dated December 23rd.

 

The global economy entered 2011 in a recovery mode, although weak and unbalanced.  However the issues appeared tractable: dealing with excessive US housing debt, adjustment of countries on the periphery of Europe, how to handle volatile capital flows to emerging markets and to improve financial sector regulation.  It was a long agenda, but appeared within reach.  As the year draws to a close, a number is issues remain unresolved: the recovery in many advanced countries is at a standstill, the implications of a potential breakup of the Eurozone and the possibilities that conditions could deteriorate.

 

The four main lessons that Blanchard sees: the global economy is in a state of self-fulfilling outcomes of pessimism or optimism with major macroeconomic implications.  The self-fulfilling attacks can lead to bank runs which reduce the distance between a sovereign debt crisis and a full-fledged banking crisis.  Government entities have provided liquidity to ensure market interest rates remain reasonable.  The main risks remain for banks in Europe and the rollover of sovereign debt.

 

Secondly, incomplete or partial policy measures can make things worse.  We have seen how perception got worse after high-level meetings in Europe promised a solution, but delivered only half without details.  The announcement was made with great fanfare, but turned out insufficient with potential obstacles.

 

Thirdly, financial investors are schizophrenic about fiscal consolidation and growth.  Investors react favorably to positive news on fiscal consolidation, but tend to ignore lower growth which can lead to increase, not a decrease, on risk spreads on government bonds.  Fiscal consolidation is required to reduce debt to prudent levels, but not to produce stagnation “slow and steady wins the race”.

 

Lastly, perception molds reality.  This was the case of conditions in Europe.  Once Italy was considered as a risk, the perception did not go away.  The concern about the viability of the European economy led to concerns about the possible breakup for the Eurozone.

 

If you put the four factors together, you can explain why entering into 2012 why macroeconomic risks have increased.  It will be harder for officials to put the recovery back on track than it was a year ago.  Fiscal consolidation is required without causing growth stagnation.  Central banks and governments will be required to provide liquidity as a backstop to prevent a bank runs and avoid multiple equilibria.  It will require plans not only announced, but implemented with full disclosure and effective collaboration among all involved.

 

We have to learn from our mistakes in 2011, otherwise 2012 is going to be a period of higher risks.  The alternative is just too unattractive.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7475

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