Born out of necessity in the dark days of late 2008, the G20 is starting to show some cracks. Developed and developing nations were united when confronted with the collapse of world trade and the shrivelling of industrial output, but are finding it harder to keep the show on the road now that the immediate crisis is over.
The communiqué from last weekend’s meeting is easily summed up: Do your own thing. The Americans cannot persuade the Europeans to hold off from fiscal tightening until the recovery is assured; the Germans and the British think the risks of a sovereign-debt crisis are far more serious than the possibility of a double-dip recession.
That was not the only contentious issue. Canada, Australia, China, India and Japan were unhappy with the idea that their banks, which proved resilient during the financial crisis, should have to pay the levy backed by Washington, Berlin, Paris and London. Again — go your own way.
Meanwhile, the summit danced around a long-standing cause of friction: China’s unwillingness to allow its currency, the yuan, to appreciate to a level that might help reduce its trade surplus with the US.
In one sense, the public manifestation of these differences should come as no surprise. They were buried during the period of maximum danger (September 2008 to April 2009) but the G20 no longer believes the world economy is about to descend into a second Great Depression. For the super-optimists, the return of diplomatic “business as usual” might even be seen as a good thing to the extent that it means normality has returned.
That, though, is a perverse way of looking at things. The G20 was meant to be rather more than a crisis-resolution body. It was meant to be an institution that, through the inclusion of China, India and Saudi Arabia, could better deal with the chronic imbalances in the global economy that caused the crisis in the first place. On the evidence of Toronto, it will take a second, perhaps even bigger, crisis to lead to such an outcome.
A second crisis could already be brewing. But it’s worth sketching out a couple of alternative scenarios. One is that the full effects of the colossal stimulus administered 18 months ago have yet to be felt. Growth will surprise on the upside over the coming months, so policymakers should be fretting about the risks of inflation. Andrew Sentance, the Bank of England monetary-policy committee member who voted for an increase in British interest rates this month, is from this camp.
Unless the recovery is far stronger and broader than it appears, it is unlikely the global economy could withstand a synchronised rise in interest rates, prompted by an inflation shock. Even if it could, there would only be a small sweet spot before old problems resurfaced: ever bigger surpluses in the export-dependent countries and ever bigger deficits in the US.
A second scenario is the one the British finance minister George Osborne envisages for Britain: a long and relatively joyless period of cold turkey after the excesses of the early and mid-Noughties. The UK Treasury view of the world envisages consumer spending growing only modestly, with investment and exports the main engines of growth.
The Germans, the Greeks, the Irish and the Spanish — not to mention Japan, the US and the fast-growing emerging nations — all see their economic future in much the same way. Just how every country in the world can enjoy export-led growth has not yet been explained.
The risks of a period of sub-par growth are acknowledged but deemed a price worth paying to keep the financial markets happy. Governments are terrified they will be punished severely if they fail to take deficit reduction seriously; investors will demand a higher price for buying the bonds that have to be sold to finance the deficit, which in turn drives up long-term interest rates for those home-buyers with fixed-rate mortgages and businesses with bank loans. Better to slash spending and raise taxes so that monetary policy can remain loose. That is the advice Osborne has been getting from Mervyn King, governor of the Bank of England. Jean-Claude Trichet at the European Central Bank thinks the same way.
There are two points here. The first is that King and Trichet, eminent though they may be, are not infallible. King voted to keep UK interest rates above 5% in mid-2008, even though the economy was already in recession and the strains in the financial system that culminated in the collapse of Lehman Brothers were already evident. Trichet seemed oblivious to the threat posed to the whole of the eurozone by the crisis in Greece.
As for the markets, it is certainly true that sovereign debt is their concern this month. But next month they may be getting in a lather about the slow growth caused by the austerity programmes they themselves have necessitated.
The risk is that satisfying the whims of the financial markets leads to policy error and the doomsday scenario. Even before the sovereign debt crisis erupted, there were tentative signs that the recovery that began in late 2009 was losing momentum. The US has just revised down its growth for the first quarter and has yet to see a pick-up in the labour market. Europe’s expansion was barely perceptible. China has been pounding along, but also seeks to tighten credit conditions after 2009’s laxity.
The sluggish recovery has meant that core inflation in the US and eurozone is already below 1% — one recession away from deflation, perhaps not even that. There is so much spare capacity in the West’s labour markets that a slowdown in activity, rather than falling output, would do the trick.
Central banks are terrified by the prospect of deflation, not least because none of them (bar the Bank of Japan) has any experience of coping with it. They should be worried. Deflation raises real debt; it hurts consumers, businesses and banks.
Having barely survived the near-death of the global financial system in October 2008, central banks have no desire for a repeat. They must prevent a deflationary spiral but, with interest rates already hovering just above zero, could only do so through quantitative easing (QE): creating electronic money through the banking system. To have an impact this would need to be aggressive. The trouble is that central banks know very little about the effects of QE and the chances of getting it wrong would be high. Attempts to cure deflation could easily turn into the opposite problem: hyperinflation.
It would pan out like this:
- Sharp slowdown in US and European growth in the second half of 2010.
- Pressure on heavily indebted banks intensifies as deflation becomes a reality in the first half of 2011.
- Second leg of the financial and economic crisis in the second half of 2011.
- G20 gets serious in early 2012.
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