Misplaced optimism in Davos consensus

2013-02-13 01:35:57
Razeen Sally For The Straits Times

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THE mood in Davos late last month reflected the clear blue sky above the snow- capped peaks, where the chatter among 2,500 participants was mostly about Europe and the West, and less about the rest. The prevailing mood was more upbeat than at any time since the outbreak of the global financial crisis (GFC). This year's "Davos consensus" was that the worst was over: The euro zone crisis had receded, better times were ahead for Europe; the United States had averted its fiscal cliff; and Japan, with freshly minted "Abenomics", was dashing for growth. However, I remain very sceptical about this consensus. The Davos consensus was most pronounced on macroeconomic policy. Practitioners and experts displayed shades of grey on fiscal policy. International Monetary Fund (IMF) chief Christine Lagarde, reflecting the official IMF position, argued for fiscal "consolidation", though "paced" to prevent austerity-choking recovery. Others argued for looser fiscal policy. Hardly anyone held out for more stringent austerity to reduce public debt mountains in the West. The consensus was firmer on monetary policy. Luminaries favoured continued monetary expansion, applauding rock-bottom interest rates and massive quantitative easing (QE) by the US Federal Reserve and the European Central Bank (ECB), as well as expected QE by the Bank of Japan. Many saw room for much more QE. Some even held up Japanese Abenomics - coordinated expansionary fiscal and monetary policies - as a role model. I found this talk deeply worrying. Policymakers and macroeconomic experts are clearly willing to tear up the rulebook in which central-bank independence and inflation targets were adopted to defeat the scourge of inflation. Fiscal rules, such as a balanced budget over the economic cycle, were adopted to restore order to public finances. Escalating public debt (over 80 per cent of GDP in the European Union, over 100 per cent in the US and 220 per cent in Japan) is considered "manageable", as is the huge expansion in central banks' balance sheets. This is dangerous complacency, sending all the wrong signals for saving, investment and entrepreneurship - wealth-creating activity, in other words. Where does this leave Asia? The answer is, with the exception of Japan, in much better shape than most advanced economies. Generally, Asian countries have quite low budget deficits and low levels of public debt (under 30 per cent of GDP on average). They are growing strongly - at about 7 per cent, compared with 1.4 per cent for advanced economies, according to the latest IMF forecasts for this year. And they are enjoying a "shift to the East": The short-term divergence of economic performance is accelerating the long-term convergence of Asian emerging markets on the West. However, market reforms have stalled in most Asian countries. They still have repressive business climates that restrict domestic and foreign trade and investment, bloated public sectors, and especially restrictive markets in finance and energy. With the exceptions of Hong Kong and Singapore, not one Asian economy is in the top 10 of the World Bank's Doing Business Index. Only five others (South Korea, Taiwan, Malaysia, Thailand and Japan) are in the top 25. The rest are way behind. Generally, Asian economic institutions - public administration, enforcement of property rights and regulatory authorities, for example - are weak, and keep business costs high. Pervasive complacency on market reforms should temper sunny Asian optimism. Now to look beyond the short-term to the medium-term prospects of the world economy's Big Three: the US, the European Union (EU) and China. The new conventional wisdom is that EU leaders saved the euro. But this is a period of calm before another storm. Only the ECB's massive injection of liquidity into European banks, and its open-ended guarantee to buy distressed sovereign debt, saved the euro, and keeps it afloat. There are three reasons to doubt the euro's survivability. First, ECB firepower, in addition to bailout funds in the European Stability Mechanism, may not be enough, given governments' and banks' addiction to cheap money. Second, common fiscal rules will never be automatic. Inevitably, they will be bargained over and watered down to a low common denominator, and broken by countries unwilling or unable to stick to the rules. Third, fiscal union and other centralised policies may prove to be disastrous political hubris. This latest march of top-down integration could spark populist backlashes. The EU either faces perpetual firefighting to save a dysfunctional currency for many years ahead, or the euro breaks up sooner or later. Scant progress has been made on structural reforms, and Europe remains saddled with unsustainable debt, taxation and welfare-state entitlements. Like the EU, China has mounting structural economic problems that, if not addressed, presage a major growth slowdown, possibly a crash. China's promotion of state-owned enterprises (SOEs) has trumped market reforms. To combat the global financial crisis, there was a supercharged fiscal and monetary stimulus directed mainly at SOEs via state-owned banks. These measures have reinforced the public sector, which guzzles capital and energy but employs only 13 per cent of the workforce, at the expense of the much more productive, labour-intensive domestic private sector and multinational enterprises. China's "demographic dividend" is also coming to an end, as the percentage of the workforce in the total population declines. China's economy needs to "rebalance". Savings and investment need to decrease as a proportion of GDP, and the efficiency of investment needs to increase, as does private consumption. This demands supply-side reforms, mainly in "factor" markets for capital, labour, land and natural resources. But these reforms are elusive, much more difficult than previous product-market reforms - they strike at vested interests at the heart of China's party-state, particularly the nexus between SOEs, state-owned banks, and government and party officials. Substantial market reforms to rebalance growth and make it more sustainable are unlikely to materialise soon. China will likely face a major growth slowdown, perhaps down to 5 per cent to 6 per cent per annum, along with increasing conflict between a restless, marketised society and authoritarian politics. That leaves the US. The conventional view is that it has escalating public debt and a gridlocked political system. There is a giant question mark hanging over public debt. Nevertheless, the US has "deleveraged" more than Europe since the global financial crisis: Households and banks have sharply reduced their debt burdens. Also, the economy is undergoing three structural transformations: an energy revolution based on shale oil and gas; a manufacturing revolution based on advanced-materials technology; and a services revolution, which will allow US multinationals to serve the burgeoning middle class in Asia. These revolutions are not happening elsewhere. They are testament to the underlying dynamism of American society, based as it is on secure private property rights, free enterprise and the free circulation of ideas. In Thomas Mann's The Magic Mountain, main character Hans Castorp intends to stay at the sanatorium in Davos for three weeks - but ends up staying seven years. Much of the European economy will stay in the sanatorium for seven years or longer. The US has a good chance of checking out before that. China is not in the sanatorium, but it might end up there if it does not change bad habits. The writer is a visiting associate professor at the Lee Kuan Yew School of Public Policy and the Institute of South Asian Studies, National University of Singapore.