To the Point - 2010, December. Discussion on the economy, by the Chief Economist Cecilia Herrmansson.

1. To the Point
Discussion on the economy, by the Chief Economist December 21, 2010
Our wishes for 2011: From bounceback to
sustainable growth
The global recovery was stronger than we expected during 2010, and the growth
outlook is positive also for 2011, although somewhat weaker as developed
countries consolidate budgets and implement reforms.
The political risks for 2011 are in focus: how to solve the sovereign debt
problems in the developed countries, how to create better global institutions,
Cecilia Hermansson and how to “fix” the euro zone. Now is the time for strong political leadership.
Group Chief Economist
Economic Research Department Better growth than expected – but risks are building up
+46-8-5859 7720
cecilia.hermansson@swedbank.se Last year, my final To the Point had the title “Happy New Recovery Year!” I
concluded that the recovery during 2009 had been stronger than expected, and that it
was set to continue during 2010. The focus for 2010 would be on handling sovereign
debt and exit strategies. I had three New Year’s resolutions: reform the international
monetary and financial system, boost innovation, and step up microeconomic
reforms. One year later, the recovery during 2010 has not only continued as envisaged
but has also come out stronger, by a full percentage point on the global level ( 4 ½ %
instead of the expected 3 ½ %). Three groups in particular have performed better than
was forecast: Germany and northern Europe in general; China, India, and other parts
of Asia; and Brazil and other Latin American countries.
On the New Year’s resolutions, the reform of the financial system has been carried
out. Even if implementation takes several years, decisions have been made that,
although perhaps not bold enough, are steps in the right direction. There are many
issues left to discuss, such as the “too-big-to-fail” issue, moral hazard, and cross-
border regulations. Regarding the monetary system, there are many challenges, not
least of which the critique of quantitative easing in the US and increased currency
tensions among G20 countries during the autumn showed. Exit strategies have been
on the agenda, but, for many of the larger central banks, entry strategies have had
higher priorities. Sovereign debt issues have been focused on during 2010 and will
remain in focus during 2011, leaving little energy for innovation and microeconomic
reforms.
Also during 2011, global growth may surprise on the upside, mainly due to large
carryovers from 2010, which will lead to higher growth rates in the European
countries not affected by balance sheet crises - e.g., Germany, the Netherlands,
Sweden, and Finland. We foresee global GDP growth dampening somewhat to just
below 4% in 2011, taking into account decreased demand in the PIIGS countries and
continued low demand in the US, UK, and Japan, as well as weaker momentum in
most emerging markets.
Due to stimulus measures and inventory restocking, the recovery has been satisfactory
in some countries, but a bit slow in others (the US, for example). Countries with
balance sheet recessions will need more time to create growth rates that are high
enough to support labour market developments and also boost confidence.
Even if the growth climate is rather good for the world as a whole, with emerging
markets driving the global outlook, risks are building up in Europe and the US, as
well as in emerging markets, where overheating must be tackled. The world looks to
be in better shape, but risks for new disruptions are becoming more complex, not least
No. 8 the political risks, which are hard for economists to interpret and forecast.
2010 12 21

2. To the Point (continued)
December 21, 2010
Chart 1: The EUR/USD currency rate and its
mean during 1999-2010 Increased focus on the political risks
1.6
Analysing the risks for 2011, there are ordinary economic and financial risks linked
1.5
to, for example, commodity prices, labour markets, interest rates, and currencies.
Underneath, political decisions make a difference between sustainable and non-
1.4
sustainable growth – as always – but perhaps more so now than ever. Political
1.3
scientist Ian Bremmer developed the global political risk index (GPRI), together
EUR/USD
1.2
with Lehman Brothers (!), in 2001; it focuses mainly on emerging markets. Still,
1.1 Bremmer now acknowledges the US to be on the top 10 political risk list. Maybe
1.0 there is need to include more developed countries in the political risk analysis.
0.9 Below, I will list some reflections on institutional and political developments:
•
0.8
98 00 02 04 06 08 10 Global institutions have been created to handle crises and coordinate policies,
m ean
S ource: R euters E coW in such as the G20, the Financial Stability Board (FSB), and the European
Systemic Risk Board (ESRB); however, they are still weak when national
interests go against the global common best. As the room for monetary and
fiscal stimulus is disappearing, trade and currency tensions are rising that are
not easily reduced.
• In the US, it has been fairly easy for Republicans and Democrats to cooperate
on the issue of cutting taxes and increasing expenditures. It is unlikely,
however, that cooperation will remain good in a situation – which will need to
come sooner rather than later – when taxes have to be raised and expenditures
cut.
• Even if the new stimulus package is positive for US GDP growth, medium-
term risks of budget and financial market turbulence are building up. The bi-
partisan National Commission on Fiscal Responsibility and Reform
established to address these risks has made a first step in the right direction,
but by postponing medium-term fiscal consolidation plans, the US politicians
are taking a risk, affecting not only the US but also the global financial system
as a whole.
• Europe’s Economic and Monetary Union (EMU) is based on monetary and
economic foundations. The monetary part (ECB) is performing rather well:
prices are stable and the euro is still safeguarding purchasing power. The
economic part (national governments) is underperforming on the fiscal side,
and on structural reforms to improve competitiveness; most damaging,
however, is the failure of the Growth and Stability Pact. This institutional
framework has not been improved, as the chances to reform it a few months
ago by introducing more automatic sanctions were squandered. The target of a
3 % budget deficit should be replaced with a target of a balanced budget over
the business cycle, thereby increasing budget discipline in good times. In the
years to come, most crisis-struck countries need to have very large primary
surpluses to stabilise debt, let alone to start on the downward path to a debt
level of 60% of GDP.
• The European Union (EU) needs the EMU in order to develop and to compete
with the rest of the world. When EU President Herman Van Rompuy said that
“the debt crisis would put the survival of the union in question,” he was
probably right, but his statement, by spreading uncertainty, did not help.
Showing political leadership is important. The commitment to the EU and the
EMU is still high among politicians. The problem is that they are re-active
rather than pro-active towards the financial markets, which often need to be
surprised by larger measures than expected. The breakup of the EMU would
not make sense in a longer-term perspective, and not in the short term either to
peripheral euro zone countries experiencing increasing financial turbulence
and rising legal challenges; neither would it make sense to Germany, where
the currency would appreciate more than desired and capital inflows would
explode.
• The creation of the permanent European Stabilization Mechanism (ESM) is a
step in the right direction to find a sustainable medium-term solution. The
costs of future bailouts will be shared with bondholders on a case-by-case
basis, a proposal that seems reasonable. There is, however, no free lunch as
markets will move to a new equilibrium, with wider interest rate spreads
reflecting the higher default risks of some European countries.
2

3. To the Point (continued)
December 21, 2010
• Thorough discussions still have not been held on such medium-term issues as
Chart 2: Interest rate spreads between a fiscal union, a euro bond, and better surveillance between countries. These
German and other EU countries’ 10 year are key questions that need more time to be explored, considering the
bonds challenges of moving from the national to a European perspective.
10 • There is a lack of crisis management to deal with this ongoing and acute
9
Greece
situation. Solving the medium-term issue is important, but so is alleviating the
8 current crisis. By focusing on burden sharing at this point, the crisis has
7 worsened for Ireland, Portugal, and Spain. By finding that the temporary fund
6 (EFSF) has not been used up, the question of increasing it would be postponed
Ireland
Percent
5
until the situation becomes acute and the financing costs have increased more
4
Spain
Portugal than necessary. Yes, a larger fund may signal that bailouts of Spain and
3
Italy perhaps also Italy are inevitable, but financial markets are concerned anyhow,
2
and, if the German constituency were faced with the costs and benefits of the
1
various options, it might find the larger fund acceptable, not least since the
0
UK
France Belgium risk of losing taxpayers’ money is rather small.
-1
•
jan apr jul okt jan apr jul okt jan apr jul okt
08 09 10
Source: Reuters EcoWin
The authorities must continue the fiscal consolidation in the euro zone while
trying to safeguard the recovery. More efforts are needed on the national level
to increase effectiveness and productivity, and to become more competitive.
While the financial sector is being re-regulated, there are many product
markets and also labour markets that need further deregulation.
• In Europe, there has been a dividing line between the West and the East. More
and more, a dividing line between North and South is becoming noticeable.
Political leadership must work towards keeping the EU together, as this will
most likely be a benefit when competing against other regions in the world.
However, freezing the EU budget will again widen the East-West gap. Poland
and other eastern European countries would be the main losers from such a
measure. It may seem reasonable to cut back or stabilise the budget when
many countries are experiencing problems, but if negotiations were settled
between France (by maintaining its agricultural support from the EU budget)
and the UK (by keeping its contribution to the EU budget at a minimum),
this would represent a suboptimal decision-making process in the EU: it
might be better for the Union as a whole to transfer support to the Eastern part
in order to speed up convergence rather than to uphold large subsidies in
general to the agricultural sector.
• Political risks surround the handling of terrorism (suicide bombers), military
decisions (the Korean peninsula tensions), and riots (peripheral euro zone).
The internal devaluation process has just started in parts of Europe (even if the
Baltic countries have experience of it by now) and the dampening of demand
could give way to nationalist and populist movements. To remain an open
society with high tolerance for globalisation and immigration is especially
important in Europe, where demographics and shortages of labour will be
challenges that must be overcome in order to achieve sustainable growth in
the medium and long term.
The bounceback period was great with higher than expected growth rates, and to
support the economy with stimulus measures was not the most difficult task for
politicians. Moving ahead, however, challenges are rising: How to sustain growth
rates despite budget consolidation and deleveraging, and not least how to sustain
political stability in a weaker economic climate. Lastly, let me wish you a Happy
New Year, and especially to politicians in the world’s most crisis-struck countries
– you certainly need it!
Cecilia Hermansson
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Cecilia Hermansson
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