As we prepare for 2014, the world economic scene is evolving yet again with stronger growth potential in the U.S. and U.K., China encouraging market forces, and the European banking system still dragging down the continent. On the whole, the world is seemingly on a stronger growth path, even with a few potential bumps.
To explore the issues and challenges for the coming year, I had the pleasure last week of speaking to a packed audience for a breakfast discussion hosted by the London Campus of the Booth School of Business of the University of Chicago with Chris Cummings of TheCityUK moderating. Going by region, these are some of the issues we took on.
The key birth defect when the euro was born was the failure to address the need for pan-European banking supervision rather than – as usually cited – the lack of a common fiscal policy. There are numerous examples of successful common currency areas in which the regional jurisdictions operate with varying degrees of independence and different fiscal policies, not the least of which would be the United States. Fiscal policies from Louisiana to Illinois, and from South Carolina to California, could not be more different, with no negative effects on the success of the currency union.
Since currency unions are all about using a common form of money, what really matters is whether the banking system has uniform supervision and regulation. When the euro was launched the countries of the Eurozone agreed to allow banks to treat the sovereign debt of any participating country as the same credit risk for bank regulatory purposes as any other participating country’s debt. This all worked well and to the benefit of the weaker countries in the first phase of the euro’s launch, as it encouraged bond yields on sovereign debt to converge to the benefit of Spain, Italy, Portugal, Greece, etc. In turn, many national banking systems became over-exposed to the sovereign debt of the weaker countries. When the financial crisis hit, however, the fallacy of treating Greek debt on par with German debt was exposed, and the banking system has been in retreat ever since.
The problem for 2014 is that the EU leadership, five years after the crisis, is still struggling with how to spread the burden of a failed bank. While that issue seems close to some kind of compromise, the real challenge for the next five years has not even been addressed and it probably will not be, at least in 2014. The forward-looking challenge is how to get the banking system in the Eurozone functioning so that it can support economic growth instead of being a drag.
Economies simply do not grow if not supported by a well-capitalized and healthy financial system. The Eurozone requires strong political leadership to put in place the kinds of reforms that would assist the banks in becoming better capitalized and able to increase lending. Germany is not in a good position to lead. It took Chancellor Merkel three months after winning a strong vote – but not a parliamentary majority – to put together a coalition government, with the compromises that were needed likely to restrict her more than she might like. And Germany typically likes to lead with a partner, and for now with President Hollande of France sinking in opinion polls, there is not an obvious partner in sight.
Europe may not shrink in 2014, but stronger growth may have to wait for more aggressive actions from the European Central Bank to get the financial system back on track to support growth. And Europe’s continuing struggles with system-wide banking reforms provide strong comparative advantages for London’s role as a global financial center versus potential competitors.
Our discussions of China centered on the embrace by the new leadership of market forces. China’s state-run infrastructure spending model that led to high growth and rapid modernization for decades has hit the point of diminishing returns. The new leadership appears to have embraced this view and seeks a more domestic-oriented growth model. That means giving more flexibility to consumers and businesses, including encouraging market reforms, and allowing more and freer financial interactions with the rest of the world. Even changes such as relaxing the one-child policy and making it easier for migrants from the rural sector to urban areas to obtain residency permits support this new focus on embracing markets. What this may mean for the future is a faster pace of currency normalization, with benefits to offshore trading centers, such as London.
Embracing more market reforms, however, will not necessarily arrest the deceleration of economic growth that has been occurring. One needs to consider the deceleration of annual real GDP growth from the 10 percent area down to 7.5 percent and perhaps a little lower in 2014 and beyond as the natural process of a successful modernization program in transition toward the longer-term sustainable growth rates of a more mature country.
The U.S. Federal Reserve (Fed) seems set to eliminate its asset purchase programs, known as quantitative easing (QE), during 2014. My perspective has been that this is a very positive development for the U.S. economy. The debate will rage for years, or decades, as to the efficacy of quantitative easing. What has changed at the Fed is their message. The ending of QE comes with a much more optimistic view of the U.S. economy, as opposed to the need for QE which was justified on a view that the economy was so sick as to require emergency measures. Our view is that had the Fed not been so aggressive in cautioning about the weaknesses of the US economy, then economic growth would have been much stronger in 2012 and 2013 even without QE. Regardless of how that historical debate plays out, though, the forward-looking outlook is excellent.
U.S. fiscal drag is diminishing. Indeed, the U.S., which ran a federal budget deficit of about 9 percent of GDP ($1.4 trillion) in FY-2009 at the height of the recession, may be poised for a budget deficit of only 3 percent of GDP in FY-2014 – meeting the original standards for the Maastricht Treaty. And, even more impressive, the U.S. federal budget may be in balance or mildly positive on an operating basis (before interest expense) in FY-2015, before President Obama leaves office. With monetary policy remaining highly accommodative with near-zero short-term interest rates coupled with a positive forward-looking view from the Fed, and with fiscal stability at hand, the U.S. economy is poised for robust growth in 2014, perhaps around 3.5 percent in real GDP terms.
Even with Europe pulling up the rear, the change in leadership in China and the embrace of greater interaction with world markets, and the more robust view of the US economy, puts global financial markets on an improved footing for 2014. Indeed, the bright lights for the coming year may be asset classes that did poorly in 2013, such as emerging market currencies and equities. Much more than they might like to admit or prefer, emerging market countries need the foundation of more robust growth in the industrial economies to sustain higher growth in their own regions. That foundation is finally being rebuilt, piece by piece, and setting up a more optimistic 2014.