Global weakness: Are we out of policy tools?

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  • Makin estimates 1 in 4 chance euro will not survive the summer.

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  • Two-thirds of global economy is either shrinking or slowing; major global recession ahead?

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  • Year-end US "fiscal cliff" is bad news for US and global economies.

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Global weakness: Are we out of policy tools?

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Despite a promising start to 2012, the global economy is now experiencing a deep and unsettling retraction that threatens to precipitate a new recession. The causes are manifold, but chief among them is instability in the eurozone: failed austerity programs and the probability of Greece’s exit from the monetary union are edging the crisis into Spain and Italy. Added to that is the uncertainty generated by both the US “fiscal cliff”—the set of sharp tax increases and spending cuts scheduled for the end of the year—and economic slowdowns in the world’s major developing economies. Some actions could still be taken to reverse the crisis, but with political considerations hindering proper economic responses to the downturn, the situation is dire.

Key points in this Outlook:

  • With nearly two-thirds of the global economy either shrinking or slowing, the 2008 economic and financial crisis is back with a vengeance and threatens to bring on a recession that engulfs the world’s major economies.
  • A convergence of factors—including an intensifying European financial crisis, a slated year-end US tax hike, and increased slowing of major developing economies—have increased uncertainty in the global economy.
  • The recession may slow if Europe takes appropriate measures to stabilize its banking system and adjust its monetary policy and if the Greek election produces a cooperative government—however, these outcomes are unlikely, meaning the euro system may not survive the summer.


Just five years after the global economic and financial crisis began with the collapse of a Bear Stearns mortgage hedge fund early in June 2007, it is back with a vengeance. Economic growth is slowing almost everywhere as financial stress is again intensifying rapidly in Europe and spreading to financial markets worldwide. By June 1, US stocks had lost all of their year’s gain, while stocks elsewhere, especially in Europe, had fallen considerably further. (See figure 1.) A reliable indicator of investors’ search for safety, the yield on US ten-year bonds, which falls as stress rises, has dropped from 3 percent a year ago to 1.5 percent early in June. (See figure 2.) That is well below the low yields reached in 2008 after the Lehman collapse precipitated a rush for safety. German ten-year yields are even lower, at 1.2 percent, suggesting that the desperate search for safety in Europe with its recession and intensifying financial crisis is even more intense than the search for a safe-haven asset in the United States.

The message of slowing global growth was sharply reinforced on June 1 by a sharp drop in US employment growth. In the world’s largest economy, which was supposed to have provided some steady growth to cushion negative growth in Europe and slowing growth in Asia, the rise in employment slumped to a paltry 73,000 per month average in April and May 2012 after rising at an average of 226,000 per month during the first quarter, when the economy was growing at a tepid 1.9 percent annual rate. Beyond that, the unemployment rate rose from 8.1 to 8.2 percent. Second-quarter US growth range estimates will have to be cut from a currently optimistic 2.5 percent rate to 1 percent or lower. With Europe already in recession and China, India, and Brazil slowing, adding in a US slowdown means that nearly two-thirds of the global economy is either shrinking or slowing. A recession that engulfs most of the world’s major economies is not out of the question.

How, after such a fortuitous start to 2012, which saw low stock indices rising by over 10 percent during the first quarter, did we reach a point where investors are so desperate for safety that they are willing to accept virtual zero returns on “safe” (US, German) short-term sovereign notes and just 1.5 or 2 percent on ten-year bonds? Remember that the US notes and bonds have been issued by a government with large budget deficits and rising ratios of government debt to GDP that have been deemed “unsustainable” for years by leaders in government and the marketplace—and the “unsustainable” moniker was applied when yields on sovereigns were substantially higher (prices were lower) than they are now. What has driven the recent panic that has led investors to buy much-maligned government securities? And why is the global economy slowing so rapidly?

The short answer is that a great many things have gone wrong in recent months that have together served to boost uncertainty to a level where decision makers are frozen. More specifically, Europe has already slipped into a recession that has precipitated a far more intense financial crisis that could cause the entire European monetary system to collapse, dragging the European economy deeper into recession and bringing the rest of the world closer to outright recession. Beyond that, US growth has slowed rapidly as a looming year-end “fiscal cliff” with tax increases and spending cuts equivalent to about 4 percentage points of GDP boosts uncertainty and threatens to push the US economy into recession at year end, if not before. This unprecedented collection of bad news has come after most policymakers had thrown virtually every available measure into containing Europe’s financial crisis and sustaining US growth.

Simultaneously, China’s cautious efforts to stabilize an overheating housing sector have resulted in a sharper overall economic slowdown that will probably take Chinese growth through 2012 from an initially estimated 9 percent down closer to 7 percent. The sense of futility among policymakers is growing with the realization that their ability to contain further crises may be largely spent.

There are no easy solutions to all the problems threatening the world economy in 2012. A closer look at the underlying sources of the problems in Europe, the United States, and emerging markets—especially China—is the only way to identify possible approaches to mitigate the crisis.

Europe’s Problems

Greece has played the role in minimizing the seriousness of Europe’s intensifying financial crisis that subprime mortgages played in initial efforts to minimize the 2007–08 US financial crisis. Recall that, during much of 2007, many saw the problems of the US financial system as tied to subprime mortgages that, while deteriorating, amounted to “only” about $1.5 trillion. A 30 percent write-off, it was said, would only produce losses of about $450 billion, a painful but manageable amount. A combination of inadequate policy responses and heavy bank exposure to housing and the mortgage securities market resulted in a full-blown mortgage meltdown by the summer of 2008 and eventually to the Lehman collapse.

Europe’s response during the lead-up to its current full-blown financial crisis was first focused in 2010 on Greece, with a flawed program that demanded austerity in exchange for short-term loans. The result was to weaken the economy so much that Greece’s debt-to-GDP ratio rose as a result of the austerity program aimed at reducing it. (See the May Economic Outlook.[1])

"The heightened risk of a full, disorderly European monetary system collapse has depressed financial markets."The Greek crisis reintensified during 2011, leading to another austerity-laced rescue package in March of 2012. This time, the additional austerity measures resulted in election losses by the government coalition that had agreed to implement them. The probability of a Greek exit from the European monetary union increased rapidly, and the crisis spread to Spain as the political cohesion in Europe’s approach to its financial crisis slipped away. There, heavy bank exposure to a collapsed real estate bubble and an unsuccessful government effort to recapitalize one of Spain’s largest banks sharply intensified fears that the financial crisis in Europe would spread beyond Greece into Spain and possibly on into Italy. The heightened risk of a full, disorderly European monetary system collapse has depressed financial markets. Negative feedback effects on economic activity have compounded the harmful results of Europe’s financial problems and slowed European, US, and Chinese economic growth as we approach midyear.

One of the most disconcerting aspects of the 2012 reemergence of the European financial crisis has been the failing of a dramatic policy change by the European Central Bank (ECB) to prevent it. In December 2011 and February 2012, the ECB offered unlimited three-year loans to European banks to ensure their access to liquidity. This extra monetary easing by the ECB contributed—in a global context—to the extra easing that had been offered by the US Federal Reserve to boost financial markets and expected growth late in 2011 and early in 2012. Even the Bank of Japan chimed in during February with an offer to increase its bond purchases in an effort to end deflation in Japan. All together, extra easing by central banks contributed to the rally in stock and high-yield bond markets during the first quarter of 2012.

US Economic Problems Return

The rapid weakening of the US economy, highlighted by the previously mentioned weak employment data, has multiplied the negative impact of the European recession and the European financial crisis on the global economy. Coming as it did after substantial monetary and additional fiscal stimulus, the new slowdown has clearly indicated that monetary policy in developed economies has reached the limit of its ability to stimulate economic activity and cushion financial markets. Interest rates have been pushed to zero by policymakers and extra reserves for banks do not produce more lending, so the traditional channels for monetary policy have become largely clogged. Add to this problem the fiscal stringency being applied in Europe, and we have a toxic combination of ineffective monetary policy and tighter fiscal policy. It is little wonder that Europe has headed toward recession and its financial crisis is intensifying, with negative spillover effects for the US economy and financial markets. The resulting additional weakness of the euro may help German exporters, but not by nearly enough to stabilize Europe.

The US economy has been growing at an annual rate just below 2 percent, largely because, unlike Europe’s, its fiscal policy is still modestly expansionary. Extra monetary stimulus administered late in 2011 and early in 2012 has probably had only a limited effect on the economy. Unfortunately for the continuation of even modest US growth, the United States is scheduled for a huge tax increase—dubbed the “fiscal cliff” by the media—at the end of 2012.

Current law (what was Congress thinking?) mandates tax increases and spending cuts equal to nearly 4 percent of GDP all coming simultaneously at the end of 2012. (See table 1.) Because the law will have to be changed to avoid the fiscal cliff, politics matters a lot. Congress may attempt to modify the law, but disagreements about whether or not to maintain all of the so-called Bush tax cuts will probably prevent action prior to the November elections. Households, businesses, and investors will be left to ponder how various election outcomes will affect chances of rescinding massive fiscal drag in a lame-duck Congress.

The substantial uncertainty attached to the US fiscal cliff, even if it is ultimately bypassed in 2013, has begun to penalize US economic growth in 2012. Add to that the increased uncertainty attached to the European financial crisis, and tepid US growth will slow further. Third-quarter growth could be zero or negative if efforts to address the fiscal cliff result in a congressional fiasco this summer akin to last summer’s debt-ceiling battle fiasco and, simultaneously, Europe’s financial crisis drags on. The sharp weakening of the US labor market that has already been reported only underscores the chance that a US recession may emerge alongside a European recession late this year.

Emerging Market Problems

As if the problems in developed countries were not daunting enough, major developing economies are slowing rapidly too. As I hinted in the April Economic Outlook,[2] the weakness in China’s private-sector estimates of the March Purchasing Managers Index (PMI) did portend a broader slowdown of China’s growth rate for 2012. Now, with the release of still more weak Chinese data, including another weaker PMI, estimates of Chinese growth for 2012 have been reduced from 9 percent to 7 percent as weaker exports to Europe and elsewhere, along with some slippage of growth in domestic demand, have produced a less sanguine outlook. China’s growth could slow further if US and European growth rates continue to weaken.

Alongside China’s slowing growth, growth rates in the other major emerging markets, Brazil and India, are also slowing. What policymakers there—like those in the developed world—are discovering is that stimulative measures produce only positive effects on growth that eventually wear off. In the case of India, and to some degree Brazil, evidence of rising inflation pressures is also forcing policymakers to end monetary stimulus.

What Next?

So here we are, approaching the middle of 2012, a presidential election year. Europe is in recession, and its financial crisis is growing worse. The US economy may well be heading into another recession. China, India, and Brazil, are all slowing, and the European financial crisis, with its threat to the global financial system, is intensifying. In the face of all this, no additional policy measures, save those that require running larger budget deficits and piling up more debt and have only temporary stimulative effects, are available. Given this dire situation, policymakers’ primary aim should be to reduce uncertainty and provide some guidance as to what measures will be most effective. Europe’s situation is the most urgent, given that it is already in a recession and facing a rapidly intensifying financial crisis.

Three steps are urgently needed: (1) Europe’s banking system must be stabilized to end runs from depositors withdrawing funds, (2) Europe must articulate clearly a framework for rapid evolution toward fiscal union, and (3) the policy mix that includes additional fiscal stringency in return for rich loans to Europe’s periphery must be softened. The ECB can help calm markets and reduce uncertainty by signaling its support of more accommodation, including a system of deposit insurance for European banks and could cut interest rates by fifty basis points and undertake another round of extra lending to ensure ample liquidity to banks.

Unfortunately, the probability of all of these measures being successfully undertaken is quite low—well below 50 percent, in my opinion. In any case, the ability to undertake all these measures is conditional on Greek’s electing a coalition government willing to cooperate with Europe’s core countries to move toward a true monetary and fiscal union. The probability of such an outcome for the Greek elections is, in my opinion, no better than 50 percent.

"Cash and near cash are the places to be, which is why interest rates on US and German government notes are so close to zero."

So we have a 50 percent probability of a cooperative outcome from the Greek election on June 17, and conditional on that, a 50 percent probability that Europe will be able to move forward in a timely manner to enact a more credible monetary and fiscal union. The joint probability of these events is 25 percent at best, meaning there is only a one in four chance that the euro system will survive through the summer. Should the more likely outcome—an acute European financial crisis—emerge, the United States will be forced to act to prevent serious damage to its financial system and economy.

Another Fed quantitative easing program where the central bank buys more government bonds will not help because rates on those instruments have already collapsed on fears of another global financial crisis and economic slowdown. The Fed will have to get more creative and start buying other things, including mortgage securities and other financial assets, although stock purchases are not permitted. Direct unsterilized purchases of foreign exchange constitutes another option, although that would result in protests from other countries. Another US fiscal package will be required that includes rescinding all of the currently legislated tax increases and perhaps enacting even further stimulus, tilted toward tax cuts that encourage investment and growth. This combination is also unlikely and probably politically impossible before the November elections. Both the United States and China are engaged in political transitions in 2012 that reduce their ability to provide the decisive measures they offered in 2008 to help cushion the global impact of the Lehman crisis.

Perhaps the very reality that the consequences of inaction in Europe and the United States along the lines sketched here are so dire will mean that compromises will be made and rough but workable solutions will be hammered out in the few months’ time left to avoid disaster. That is what the game theoretic approach to conflict resolution suggests. That outcome is the best hope, but meanwhile cash and near cash are the places to be, which is why interest rates on US and German government notes are so close to zero.

John Makin ([email protected]) is a resident scholar at AEI.

1. John Makin, “The Euro End Game,” AEI Economic Outlook (May 2012),
2. John Makin, “Is China Slowing Down?,” AEI Economic Outlook (April 2012),

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