Mohamed A. El-Erian – Economy Watch

Is Ireland Proof That Austerity Works?: Mohamed El-Erian

Mohamed A. El-Erian — Tue, 02 Jul 2013 03:45:25 +0000

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People on both sides of the austerity debate are trying to position Ireland as the poster child for their case. This tug-of-war illustrates the complex range of arguments in play – and highlights why conclusive economic policymaking is proving so elusive.

DUBLIN – Both sides of the austerity debate that is now gripping economists and policymakers cite Ireland’s experience as evidence for their case. And, however much they try to position the country as a poster-child, neither side is able to convince the other. Yet this tug-of-war is important, because it illustrates the complex range of arguments that are in play. It also demonstrates why more conclusive economic policy making is proving so elusive.

Here is a quick reminder of Ireland’s sad recent economic history. Lulled into complacency and excess by ample supplies of artificially cheap financing, Irish banks went on a lending binge. Irresponsible risk-taking and excessive greed outpaced prudential regulation and supervision. The banking system ended up fueling massive speculation, including a huge run-up in real-estate prices, only to be brought to its knees when the bubbles popped.

Unlike the many Irish households that lost jobs and part of their wealth, the banks were deemed to be “too big to fail,” so Ireland’s political elites intervened with state funding. But, by under-estimating both the domestic and international aspects of the problem, the authorities transformed a banking problem into a national tragedy.

[quote] Rather than restoring the banks to financial health and ensuring responsible behavior, the Irish economy as a whole was dragged down. Growth collapsed; unemployment spiked. Lacking opportunities, emigration increased – a vivid reminder of how economic crises have wreaked havoc on the country’s demographics throughout its history. [/quote]

Investors withdrew in droves from what was once deemed the “Celtic Tiger”. The government had no choice but to request a bailout from the “troika” – the International Monetary Fund, the European Central Bank, and the European Commission – thereby transferring an important component of national economic governance to an ad hoc, fragile, and sometimes feuding group of institutions.

While other struggling eurozone members also turned to the troika, Ireland stands out in at least two notable ways. First, two democratically-elected governments have steadfastly implemented the agreed austerity programs with little need for waivers and modifications – and thus without the associated political drama. Second, despite enduring considerable pain, Irish society has stuck with the program, staging few of the street protests that have been common in other austerity-hit countries.

[quote] All of this puts Ireland in the middle of three important issues raised in the austerity debates: whether orthodox policy, with its heavy emphasis on immediate budget cuts, can restore conditions for growth, employment gains, and financial stability; whether the benefits of eurozone membership still outweigh the costs for countries that must restructure their economies; and how a small, open economy should strategically position itself in today’s world. [/quote]

Austerity’s supporters point to the fact that Ireland is on the verge of “graduating” from the troika’s program. Growth has resumed, financial-risk premia have fallen sharply, foreign investment is picking up, and exports are booming. All of this, they argue, provides the basis for sustainable growth and declining unemployment. Ireland, they conclude, was right to stay in the eurozone, especially because small, open economies that are unanchored can be easily buffeted by a fluid global economy.

“Not so fast,” says the other side. The critics of austerity point to the fact that Irish GDP has still not returned to its 2007 level. Unemployment remains far too high, with alarming levels of long-term and youth joblessness. Public debt remains too high as well, and, making matters worse, much more of it is now owed to official rather than private creditors (which would complicate debt restructuring should it become necessary).

The critics reject the argument that small, open economies are necessarily better off in a monetary union, pointing to how well Switzerland is coping. And they lament that eurozone membership means that Ireland’s “internal devaluations,” which involve significant cuts in real wages, have not yet run their course.

The data on the “Irish experiment” – including the lack of solid counterfactuals – are not conclusive enough for one side to declare a decisive victory. Yet there is some good analytical news. Ireland provides insights that are helpful in understanding how sociopolitical systems, including economically devastated countries like Cyprus and Greece, have coped so far with shocks that were essentially unthinkable just a few years ago.

On my current visit, most of the Irish citizens with whom I have spoken say that the country had no alternative but to follow the path of austerity. While they appreciate the urgent need for growth and jobs, they believe that this can be achieved only after Ireland’s finances are put back on a sound footing. They also argue that, given the banks’ irresponsibility, there is no quick way to promote sustained expansion. They are still angry at bankers, but have yet to gain proper retribution.

Ireland’s accumulation of wealth during its Celtic Tiger period, when the country surged toward the top of Europe’s economic league table, has also been an effective shock absorber. This, together with fears about being left out in the geopolitical cold (despite the country’s historical links with Britain and America), dampens Irish enthusiasm for economic experiments outside the eurozone.

Indeed, Irish society seems remarkably hesitant to change course. Right or wrong, Ireland will stick with austerity. Efforts to regain national control of the country’s destiny, the Irish seem to believe, must take time. In some of Europe’s other struggling countries, however, citizens may well prove less patient.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

Mohamed A. El-Erian is the current CEO and co-CIO of PIMC0. Prior to his stint at PIMCO, he served as President and CEO of the Harvard Management Company for 2 years, while also working at the IMF for 15 years. In 2008, his book “When Markets Collide”, won the Financial Times award for Business Book of The Year in addition to being named as the one of the best business books of all time by The Independent.

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Have Central Banks Overstretched Their Brand Power and Influence?: Mohamed El-Erian

Mohamed A. El-Erian — Wed, 05 Jun 2013 07:40:28 +0000

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Western central banks have extended themselves well beyond their comfort zones and today face unusual brand management risks: Beyond inflation fighting, they have had to confront market failures, fragmented financial systems, clogged monetary-policy transmission mechanisms, and sluggish growth in output and employment – essentially pushing both their policies and influence to the limit. Are they better off reining in their hyper activism?

NEW YORK – The “branding” of modern central banking started in the United States in the early 1980’s under then-Federal Reserve Board Chairman Paul Volcker. Facing worrisomely high and debilitating inflation, Volcker declared war against it – and won. In delivering secular disinflation, he did more than change expectations and economic behavior. He also greatly enhanced the Fed’s standing among the general public, in financial markets, and in policy circles.

Volcker’s victory was institutionalized in legislation and practices that granted central banks greater autonomy and, in some cases, formal independence from long-standing political constraints. To many, central banks now stood for reliability and responsible power. Simply put, they could be trusted to do the right thing; and they delivered.

As any corporate executive will tell you, brands can be consequential drivers of behavior. In essence, a brand is a promise; and powerful brands deliver on their promise consistently – be it based on quality, price, or experience. In some cases, consumers have been known to act on the strength of brand alone, even purchasing a product with relatively limited knowledge about it.

Indeed, brands send signals that facilitate the task at hand. In some special cases – think of Apple, Berkshire Hathaway, Facebook, and Google – they have also acted as a significant catalyst for behavioral modification. In the process, they often insert a wedge that essentially disconnects fundamentals from pricing.

Building on Volcker’s success, Western central banks have used their brand to help maintain low and stable inflation. By signaling their intention to contain price pressures, they would alter inflation expectations – and thus essentially convince the public and the government to do the heavy lifting.

[quote] In the last few years, however, the threat of inflation has not been an issue. Instead, Western central banks have had to confront market failures, fragmented financial systems, clogged monetary-policy transmission mechanisms, and sluggish growth in output and employment. Facing greater challenges in delivering desired outcomes, they have essentially pushed both policies and their brand power to the limit. [/quote]

This is apparent in central banks’ aggressive emphasis on communication and forward policy guidance. Both have been used more widely – indeed, taken to extreme levels – to supplement the unconventional expansion of balance sheets in the context of liquidity traps.

Now, corporate executives will also tell you that brand management is a tricky affair. It is particularly hard to maintain or control your brand when popular sentiment overshoots.

This is what happened to Apple’s stock this year. As brilliantly explained by Guy Kawasaki in his book on the company, the brand essentially created “enchantment”. Extrapolating this into a market view that Apple could not only innovate continuously, but also fend off any and all competitors, investors took the company’s share price to dizzying heights.

Elsewhere in California, Facebook found its brand fueling enormous hype for the company’s initial public offering. Encouraged by investor excitement and indications of over-subscription, underwriters hiked the IPO’s price well above what they had first deemed reasonable. Issuing the stock to the public at an inflated price a year ago, the shares initially traded even higher.

In both of these cases, and in many others, brand power did more than lead to price behavior that was disconnected from fundamentals; it also caused a dangerous overshoot, which, when subsequently reversed, damaged the brand.

However powerful, brands cannot divorce pricing from fundamentals entirely and forever. Accordingly, and despite a significant market rally that has taken many individual stocks to record highs, Apple and Facebook currently trade at almost half their record levels. Their dominance and influence are no longer unquestioned.

Western central bankers should spend some time reflecting on these experiences. Some have actively encouraged markets to take the prices of many financial assets to levels no longer warranted by fundamentals. Others have stood by passively. Indeed, it seems that only retiring central bankers, such as Meryvn King of the Bank of England, are willing to raise concerns publicly.

This behavior is understandable. Central bankers are basically hoping that financial-market hype by itself can help pull fundamentals higher. The idea is that price action will trigger both the “wealth effect” and “animal spirits,” thus inducing consumers to spend more and companies to invest in future capacity.

Count me among those who worry about this situation. Far from a world of optimal policy, central bankers have been forced into prolonged reliance on imperfect approaches. From my professional vantage point, I sense a mounting risk of collateral damage and unintended consequences.

Market signals are more distorted, fueling resource misallocations. Investors are piling on more risk at increasingly elevated prices. Fundamentals-based investing is giving way to a frantic search for relative bargains in an increasingly overpriced financial world.

All this will not matter much if central banks live up to their reputation as responsible and powerful institutions that deliver on their economic promises. But if they do not – essentially because they are not getting the required support from politicians and other policymakers – then the downside will involve more than just disappointed outcomes. They will have materially damaged their standing and, consequently, the future effectiveness of their policy stance.

By extending well beyond their comfort zone, today’s central banks face unusual brand-management risks. Their prior ability to deliver on promises and expectations has made today’s financial markets take the forward pricing of the economy to levels that exceed what central bankers alone can reasonably deliver.

[quote] The implication is not that central banks should immediately halt their hyper-activism and unconventional measures. It is that they should be much more open about the inherent limitations of their policy effectiveness in current circumstances. [/quote]

Western central bankers need to become much more vocal and, one hopes, more persuasive in placing pressure on politicians and other policymakers. Otherwise, risking major brand damage, they will end up adding yet another item to an already-overloaded plate of challenges for the next generation.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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Curing Egypt’s Post-Revolution Blues: Mohamed El-Erian

Mohamed A. El-Erian — Tue, 21 May 2013 08:20:34 +0000

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The worsening economic situation in Egypt over the last few months have led many to blame the 2011 revolution for derailing a seemingly stable economy. Given the right reforms however, Egypt can still restore economic and financial stability; and fulfil the promises set out earlier by the revolution.

NEWPORT BEACH – Some two years into Egypt’s grass-roots revolution, the country’s economy is in a worrisome downward spiral. A growing number of people, inside and outside of the country, are starting to blame the revolution itself for derailing an economy that was growing, reducing its external-debt burden, and maintaining a comfortable cushion of international reserves.

Blaming the revolution is the wrong approach to Egypt’s current economic woes. Yet its appeal to some is understandable, given that the country’s economic situation has continued to worsen over the last few months. Growth is anemic, unemployment is high, and new investment has fallen off dramatically – all of which complicate already-difficult financial, social, and political conditions. The result is a growing threat of several vicious circles at once.

Domestic supply disruptions are now fueling inflation and compounding the problems of a subsidy-laden national budget. They have also aggravated the weakness of external finances, contributing to a sharp drop in international reserves that has been contained only by exceptional loans and deposits from abroad.

Inadequate growth and higher inflation impose a particularly severe burden on Egypt’s most vulnerable. Public safety nets are overstretched, with too many poor people falling through. Moreover, other support networks – including income opportunities in tourism, the informal sector, and charitable and family support – are crumbling under the pressure of growing poverty.

This broad set of spiraling difficulties has led credit-rating agencies to slash Egypt’s rating. It is also discouraging foreign direct investment, as is the discrediting of Egypt’s police forces. As a result, still more sources of working and investment capital are disrupted, amplifying the impact of domestic capital flight.

[quote]None of this facilitates the political reconciliation and national unity that Egypt needs to complete the most difficult of all revolutionary pivots: from dismantling an oppressive past to building a better future. Indeed, having suffered from post-revolutionary institutional and political dysfunctions, economic decline is now itself fueling these destabilizers.[/quote]

To be fair, governments – first under the Supreme Council of the Armed Forces and now under the Muslim Brotherhood – have recognized the challenges. Their responses, however, have fallen short, following a familiar sequence that begins with waiting for an endogenous bounce and aspiring to self-reliance. When no miracle arrives, they opt for capital controls and consider asset sales and leases while courting those once viewed as having perpetuated the old order.

The post-revolutionary government’s initial narrative characterized Egypt’s economic malaise as temporary and self-correcting. Having overthrown Hosni Mubarak’s iron-fisted 30-year-old regime in a remarkably quick and relatively peaceful manner, Egypt’s revolutionary masses were to leave the streets and pursue an all-out drive for economic prosperity and social justice. Their efforts would be supported by the re-orientation of public institutions (and governance more broadly) away from benefiting the privileged few toward an ethos of service to all of the country’s citizens.

This narrative reflected (understandable) revolutionary exuberance rather than realities on the ground. It takes years to reform institutions. Economic and financial transmission lines cannot be rerouted quickly. Discredited businesses cannot be replaced overnight. Credible political parties are not easy to organize on the fly. And many of those who bravely fought for freedom had little political experience, placing an even greater premium on great leadership to channel Egyptians’ enormous energy – and their demands for greater social justice – into a shared vision and common purpose.

The resulting power vacuums were filled by those whose prior positions in society gave them an inside track at the time of the popular uprising. They assumed power with a set of ideas and operating procedures that had to catch up with the new Egypt.

As the economy struggled, optimism gave way to a more defensive and insular view that values self-reliance. Accompanied by creeping economic controls, the narrative became more nationalistic. Loyalty, rather than merit, drove key appointments, making policy management even more difficult.

With this approach offering no better chance at success, the country has been pushed back to pursuing measures that, at least in the mind of much of the public, are associated with the old regime. Securing a loan from the International Monetary Fund has become the principal objective of economic management, coupled with other anxious attempts to raise financing. But, absent a fundamental policy revamp, the most that this can deliver is a few months of relative financial calm, albeit at a cost for the subsequent future.

What Egypt needs today cannot be provided only by IMF loans and asset leases. That is the bad news.

[quote]The good news is that, as someone who has followed similar cases for more than 30 years, I can say with confidence that Egypt has all the components needed to restore economic and financial stability: resources, people, dynamism, entrepreneurship, location, and regional and global linkages.[/quote]

Egypt also has a powerful secret weapon that is yet to be fully deployed – a generation of young people who, after years of alienation and repression, believe that they can (and should) influence the country’s destiny. Already, some are making a notable difference on the ground, attracting widespread admiration.

Egypt is not a country where economic sectors and segments of the population can succeed despite the government. The government must provide the context to restart the engines of economic recovery; and policies should serve as growth accelerators by providing development gateways for the energetic young, the restive poor, and the pressured middle class.

This brings us back to the interactions between economics, politics, and finance, which are now fueling a tailspin that is harming Egypt’s citizens and threatening their children’s future. Appropriate political reforms must come first; when they do, Egypt’s economic and financial revival will surprise many with its buoyancy and speed.

Think of a car that can and should achieve great performance based on its strong internal engine. Egypt is capable of speedy economic growth and durable financial health. Without determined efforts at political progress and unity, however, it will remain stuck in neutral – and could slip into reverse.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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External Realities May Ruin Japan’s Economic Experiment: Mohamed El-Erian

Mohamed A. El-Erian — Mon, 06 May 2013 08:09:36 +0000

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Weeks into Japan’s paradigm shift in economic policy, optimism that the country may end a quarter-century of economic stagnation is balanced by fears that the authorities’ new approach may make things worse. And, while debate naturally focuses on Japan’s internal manoeuvres, the tipping point may lie abroad.

NEWPORT BEACH – After years of tweaks, Japan has now initiated a major shift in its policy paradigm, with reactions ranging from great optimism that the country may finally be lifted out of a quarter-century of economic stagnation, to concerns that the authorities’ dramatic change of course may in fact end up making things worse. But, while debate naturally focuses on Japan’s economic, financial, and political manoeuvres, the tipping point could well lie abroad.

Prime Minister Shinzo Abe’s new government has embraced a revolutionary (rather than evolutionary) economic-policy approach that engages several initiatives, some of which were once deemed implausible, unthinkable, or even undesirable. From the doubling of the money supply to additional fiscal stimulus and wide-ranging structural reforms, the new policy paradigm is nothing less than one of the boldest economic-policy experiments in Japan’s post-war history.

To demonstrate their seriousness, Japanese officials moved quickly to commit to measurable metrics. On the policy input side, they have specified and begun to implement purchases of securities totalling $75 billion per month (three times as much, in relative terms, as the U.S. Federal Reserve currently purchases under its unconventional monetary-policy regime). On the output side, and after many years of persistent deflation (prices fell 0.5 percent last month), Japan is now targeting a 2 percent inflation rate within two years, thus underscoring its commitment to avoid a pre-mature withdrawal of monetary support for growth.

Already, financial markets have responded with alacrity. The Japanese equity market is up an impressive 55 percent since hints of the paradigm shift started hitting investors’ radar screens. At the same time, the Japanese yen has depreciated sharply, including by more than 20 percent against the struggling euro.

This response is part of the transmission mechanism for the Japanese government’s policies. The surge in the stock market benefits domestic investors, making them likelier to spend more (what economists call the “wealth effect”). This, in turn, should revive corporate “animal spirits,” leading to higher investment in new plants and equipment, together with higher wages and salaries.

These are, of course, the same mechanisms that the Fed has targeted for almost three years in its own efforts to stimulate higher growth in the U.S.. The macroeconomic outcomes have consistently fallen short of expectations, and there is reason to believe that it will be even more difficult in Japan for monetary policy alone to gain sufficient traction.

Japan’s aging population mutes the potential impact of both the wealth effect and animal spirits. Resource flexibility is lower than in the U.S.. Interest rates are already low. The experience of deflation is well entrenched. And, given Japan’s high level of public indebtedness, the risks of collateral damage and unintended consequences are potentially higher.

With gross overall government debt already at 238 percent of GDP, some worry that Japan would face the threat of economic and financial dislocation were a failed policy experiment to lead its private sector – which traditionally has displayed an enormous home bias – to disinvest from Japan.

[quote]This does not mean that Japan’s policy revolution will necessarily disappoint. But, critically, it does mean that even if you believe that the BOJ’s actions are necessary for Japan to emerge from its economic malaise, they certainly are not sufficient.[/quote]

Japan’s experiment requires meeting two additional conditions if it is to avoid going the way of previous failed policy initiatives: meaningful structural reforms that essentially change how segments of the economy respond and operate; and other countries’ continued acquiescence in the currency depreciation needed to boost the impact of slower-moving domestic dynamics through meaningful gains in global market share.

Meeting the first condition is in the hands of Japanese citizens and their elected representatives. The required reforms, though achievable, will test the government’s resolve and implementation capabilities, as well as the population’s willingness to face immediate disruptions in exchange for the promise of longer-term gains.

The second requirement is very different. It can be achieved only if other countries are willing to sacrifice output, either because they have no choice, or because they believe that, over the medium-term, a stronger Japanese economy will benefit them as the longer-term income effects offset the impact of immediate market disruptions.

But will the rest of the world accommodate Japan’s bold policy experiment, or will it take protective steps and thus impede the operation of a crucial policy transmission mechanism? While initial indications are encouraging, the jury is still out.

Many affected countries – including those hit by the trade effects (such as China, South Korea, Taiwan, and eurozone members) and those susceptible to the capital-flow channel (such as Brazil, Indonesia, and Mexico) – have not yet had enough time to react. Japan’s policy change was big and abrupt, and several of the countries on the receiving end have been focused on complex domestic challenges.

A few countries – particularly Brazil, China, and South Korea – have noticed. But their reactions have been generally muted by Japan’s success in getting a U.S.-led initiative at the G-20 to classify its policy response as constituting the use of “domestic tools” to pursue “domestic objectives.”

It is just a matter of time until the rest of the world catches up with the reality of how Japan’s experiment affects them. The hope is that, bolstered by evidence of Japan’s serious pursuit of structural reforms, they will accommodate the experiment in two ways: by not retaliating, and by undertaking their own domestic reforms that compensate for the output lost to Japan. In other words, a growing pie for all better accommodates all.

[quote]The fear is that neither Japan’s subsequent actions nor the affected countries’ domestic realities will justify the risk of lost market share, especially at a time when the global economy as a whole – and global policy coordination – is struggling. Here the risk involves currency wars and other beggar-thy-neighbour disruptions.[/quote]

There is currently insufficient data to predict either outcome confidently. As we await additional evidence, let us appreciate how rarely we witness, in real time, such a momentous policy shift.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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The Search for Growth in a Multi-Speed World: Mohamed El-Erian

Mohamed A. El-Erian — Thu, 11 Apr 2013 09:27:15 +0000

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The last few years have highlighted the declining potency of long-standing growth models. Today, some of the biggest world economies struggle to create ample, well-paid and secure jobs amid a secular re-alignment of the global economy. This is a challenge that will not be met easily or quickly. And, when it is met, the process will most likely be partial and uneven, accentuating differences and posing tricky coordination issues at the national, regional, and global levels.

NEWPORT BEACH – What is the most urgent economic priority shared by countries as diverse as Brazil, China, Cyprus, France, Greece, Iceland, Ireland, Korea, Portugal, the United Kingdom, and the United States?

It is not debt and deficits; and it is not dealing with the aftermath of irresponsible lending and borrowing. Yes, these are relevant and, in a handful of cases, urgent. But the number one challenge facing these countries is to develop growth models that can provide more ample, well-paid, and secure jobs amid a secular re-alignment of the global economy.

For both theoretical and practical reasons, this is a challenge that will not be met easily or quickly. And, when it is met, the process will most likely be partial and uneven, accentuating differences and posing tricky coordination issues at the national, regional, and global levels.

The last few years have highlighted the declining potency of long-standing growth models. Some countries (for example, Greece and Portugal) relied on debt-financed government spending to fuel economy activity. Others (think Cyprus, Iceland, Ireland, the UK, and the US) resorted to unsustainable surges in leverage among financial institutions to fund private-sector activities, sometimes almost irrespective of underlying fundamentals. Still others (China and Korea) exploited seemingly limitless globalization and buoyant international trade to capture growing market shares. And a final group rode China’s coattails.

Recent data from the International Monetary Fund highlight these models’ simultaneous loss of effectiveness. Global growth averaged only 2.9 percent in the most recent five-year period, well below the level for virtually any such multi-year period going back to 1971. While emerging economies have out-performed developed countries, both have slowed. Growth has been virtually flat in developed economies and, at 5.6 percent in the emerging world, is well below the 7.6 percent average in the previous five-year period.

Highly leveraged systems in finance-dependent economies were the first to hit a wall, surprising many who had uncritically bought into the “Great Moderation” – the idea that macroeconomic and asset-market volatility had eased permanently. The bold policy action that countered the initial disorder prevented a global depression, but it encumbered public-sector balance sheets.

As a result, highly indebted governments were the next to hit the wall. Some were pushed there by the high cost of containing the damage from banks’ irresponsible behavior. Facing immediate credit rationing and large output contractions, they could be stabilized only by exceptional official financing from abroad, and, in some extreme cases, by defaulting on past commitments (including to bondholders and, most recently, bank depositors).

For other countries, including the US, medium-term issues came to the fore. But, rather than catalyzing sensible policy discussions, these issues played into polarized and polarizing politics, creating new and more immediate headwinds to economic growth.

Meanwhile, a highly interdependent and (now) less dynamic world economy has been limiting the scope for external growth drivers. Accordingly, even countries with sound balance sheets and manageable leverage have experienced a growth slowdown.

The consequences have become painfully clear, especially in Western countries. With insufficient growth to deleverage safely, social costs have been considerable. Alarmingly high youth unemployment, shrinking social safety nets, and under-investment in infrastructure and human capital are burdening current generations and, in a growing number of cases, will adversely affect future generations as well.

In the process, inequality has risen further. And yet, despite the urgent need for major policy adaptations at the national level, and much better regional and global coordination, progress has been disappointing.

With the political context undermining the right mix of short- and longer-term measures, national policymaking has stumbled into partial approaches and unusual experimentation. The focus has been on buying time, rather than on implementing a sensible transition to a sustainable policy stance. And potential national outcomes would be less uncertain if excessive inequality were not treated as an afterthought.

The regional and multilateral dimensions are similarly inadequate. The absence of well-articulated common analyses and policy coordination has accentuated legitimacy deficits, encouraging leaders and publics to opt for partial narratives and eroding confidence in existing institutional structures.

[quote] Given these trends, the search for more robust growth models will take much longer and be more complicated than many recognize – especially as the world economy pivots away from unfettered globalization and high levels of leverage. [/quote]

We should expect countries like the US to benefit from dynamic bottom-up entrepreneurship and traditional cyclical economic healing. Notwithstanding a dysfunctional Congress, the private sector will increasingly convert a paralyzing uncertainty premium, which impedes much investment, into a less disruptive risk premium. But, without a short-term economic turbo-charger, the recovery in growth and jobs will remain gradual, vulnerable to political and policy risks, and disproportionately beneficial to those with favorable initial endowments of wealth and globalized talents.

Governments’ role will be different in countries like China, where officials will guide a shift from dependence on external sources of growth to more balanced demand. As this requires some fundamental domestic re-alignments, the rebalancing will be both gradual and non-linear at times.

The outlook for other economies is more uncertain. Undermined by a lack of policy flexibility, it will take a long time for countries like Cyprus to overcome the immediate shock of crisis and revamp their growth models.

Left to their own devices, these multi-speed dynamics would translate into higher global growth overall, coupled with larger internal and cross-country disparities – often exacerbated by demographics. The question is whether existing governance systems can coordinate effective intervention to counter the resulting tensions.

Simultaneous progress on both substance and process is needed. Parliaments and multilateral institutions must do a better job at facilitating cooperative policy implementation, which will require a willingness to reform outmoded institutions, including political lobbying.

No one should underestimate the growth challenge facing today’s global economy. The stronger sectors (within countries and across them) will continue to recover, but not enough to pull up the global economy whole As a result, weaker sectors risk being surpassed at an ever-faster pace. These trends will become more difficult to reconcile and keep orderly if governance systems fail to adjust.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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Central Bank Policies – On Borrowed Time?: Mohamed El-Erian

Mohamed A. El-Erian — Fri, 22 Mar 2013 06:22:42 +0000

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Expansionary central bank policies have, in recent months, helped investors shrug off troubling political uncertainties in order to spark a recovery in global financial markets. Nonetheless, some have called the market rally “one of the most unloved” in history – as any fresh geopolitical shock or political breakdown could negate central bank efforts’; and send financial markets once more down a spiral.

BARCELONA – In recent months, the dichotomy between booming financial markets, on the one hand, and sluggish economies and dysfunctional politics, on the other, has loomed large. Yet insufficient attention is being devoted to a critical factor – time, and who controls it – that could well mean the difference between an orderly global resolution of today’s growing inconsistencies and a return to a more troubled phase.

Markets have been understandably buoyant in the first quarter of 2013. Most economic data confirm that, after the trauma caused by the global financial crisis, the United States’ economy is healing, and doing so in an accelerated fashion.

The sequence is now well established. It started with large multinational companies, which are on as solid a financial footing as I can remember. Smaller firms are gradually recuperating; banks have rebuilt their capital cushions and reduced their dubious assets; the housing sector has stabilized; and a growing number of households are reestablishing healthier balance sheets, especially as employment gradually picks up.

This private-sector recovery is helping government finances. The US budget deficit has been on a downward trend for now, helped by both higher revenues and lower pressure on spending (for example, payments to the unemployed have fallen as joblessness has declined).

The healing process is also evident in Europe, though, unfortunately, it is effectively limited only to sovereign-bond markets. The real economy remains under enormous pressure in several countries, as economies contract and unemployment remains alarmingly high.

After flirting with disaster last July, interest-rate spreads for eurozone bonds have generally been subdued, and financial segmentation has been slowly reversed (that is, at least before European officials embarked on the controversial path of trying to impose losses on guaranteed bank deposits in Cyprus). Moreover, as Ireland’s highly successful €5 billion ten-year bond issue in mid-March demonstrated, some countries are in the process of restoring normal access to capital markets.

[quote]The impact on markets of these trends has been turbocharged by central banks, which are risk markets’ best friends. This is not because they wish to play that role; rather, it is because higher asset prices are essential if central bankers stand any chance of delivering the desired economic outcomes of higher growth and stronger job creation.[/quote]

This is most evident in the US, where markets love the Federal Reserve’s trifecta of near-zero policy interest rates (negative in real terms), aggressive forward policy guidance, and asset purchases – all of which push investors to take more risk. Markets also welcome the fact that the Fed’s hyperactive experimentation is forcing other central banks around the world to pursue more expansionary policies.

Indeed, from the Bank of Japan’s dramatic policy U-turn to the Bank of Mexico’s surprise interest-rate cuts, the Fed’s approach is affecting central banks in a growing number of countries. Pushed further away from best-case scenarios, they are unable to ignore the global liquidity impact of the Fed’s policies, yet they lack the right policy tools to address it.

The mix of endogenous healing and strong central-bank tailwinds, including from a “whatever it takes” European Central Bank, has also helped markets shrug off troubling political uncertainties. Be it the US Congress’s paralyzing polarization or Italy’s protest vote against the established political order, politicians are being given time to overcome their dysfunction, thereby minimizing any immediate disruptive impact.

The Time & Risk Factor

Understandably, investors have interpreted all of this as a green light to take more risk. And with the hype this month over eight successive records for the Dow Jones index (and many other records around the world), excitement induces more investors to enter riskier asset markets.

The excitement is not anxiety-free, however, and rightly so. Investors worry about the longer-term consequences of political dysfunction, another year of European economic contraction, disastrously high unemployment, unprecedented – and thus untested – central bank policies, and increasing global tensions. And the recent bungling of the Cyprus rescue does not help. No wonder some have called the recent market rally “one of the most unloved” in history.

This mix of excitement and anxiety is, in fact, a sign of the looming crossroads that faces investors. One road, involving a relatively orderly handoff from policy-assisted recovery to self-sustaining growth, offers the possibility of even greater financial rewards, as rapidly improving economic and political conditions validate current artificial pricing and drive it higher.

The other road is a lot less attractive. With insufficient endogenous healing and no economic escape velocity, the effectiveness of central banks’ policies wanes and political dysfunction increases, leading to financial losses, volatility spikes, and huge risk-management challenges.

Given current policy and political uncertainties – and the multiple equilibria that they entail – it is difficult to predict with a high degree of confidence which road eventually will be taken and when. Those who claim otherwise may well fail to appreciate fully the exceptional nature of the current situation.

In these circumstances, timing may not be everything, but it may prove to be a key determinant of the probabilities. If the journey to the crossroads is accelerated by a large geopolitical shock (originating in, say, the Middle East or North Korea) and/or a serious political breakdown in Europe (for example, a meltdown in Cyprus or prolonged political paralysis in Italy), the probability of taking the adverse path rises to an uncomfortably high level. If, however, central banks can contain domestic and global inconsistencies long enough, the combination of endogenous healing and eventual political progress would significantly improve the probability distribution.

[quote]Have no doubt: today’s markets rely heavily on the old adage that “time heals all wounds.” The timekeepers are central banks. But their control of the clock is less than perfect; and it will become increasingly ineffective if economic improvement faces additional political headwinds in the months ahead.[/quote]

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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Will the Transatlantic Free Trade Pact Materialise?: Mohamed El-Erian

Mohamed A. El-Erian — Thu, 07 Mar 2013 07:20:28 +0000

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The promise of freer transatlantic trade is potentially transformational and comes at a time when the West is increasingly dragged down by short-term disruptions and continued policy inertia. But its implementation prospects are far from promising – its challenges highlight how the proposal is subject to the dulling forces of 20^th century mindsets and institutions that are too slow to adapt to 21^st century challenges and opportunities.

NEWPORT BEACH – After instant and seemingly coordinated fanfare in Europe and the United States, the proposal for a European Union-US free-trade area has been generating little media attention. There are three reasons for this, and all three highlight broader constraints on good national economic policymaking and productive cross-border coordination.

In his “State of the Union” address in February, US President Barack Obama proposed a “comprehensive Transatlantic Trade and Investment Partnership” with Europe based on trade that is “fair and free.” His administration regards this as part of a comprehensive approach to generating “good-paying American jobs.”

Obama’s bold proposal received an immediate and enthusiastic reception in Europe. Taking to the airwaves within hours, European Commission President José Manuel Barroso and European Council President Herman Van Rompuy called the proposal “ground-breaking.” Arguing that it could increase Europe’s annual economic growth rate by half a percentage point, they declared that formal negotiations would start quickly.

[quote] At first, there was quite a bit of general interest, and understandably so. The proposal involves the world’s two largest economic areas, with national, regional, and global implications. Yet, despite the realization that an agreement could fundamentally alter the nature of global trade and production networks, it only took a few weeks for interest to drop off. [/quote]

One reason is rooted in initial conditions that limit direct gains from increased trade while widening the scope for tension and conflict. Free-trade agreements that promise the greatest benefits are those that link economies characterized by high tariffs, low levels of trade, and little overlap in consumption and production patterns. This is not the case for the EU and the US. Average tariff levels are only 3 percent. The EU already accounts for almost 20 percent of US imports, and the US for 11 percent of EU imports. And, given similar per capita income levels and cultural orientations, overlaps in production and consumption are considerable.

Having said this, there would be immediate upside potential, owing to better resource allocation, more harmonized investment regimes, stronger standards, and the elimination of outdated non-tariff and regulatory barriers. Aerospace, auto manufacturing, biotechnology, cosmetics, and pharmaceuticals are among the sectors that stand to gain. There is also the potential for reforming inefficient approaches to food and agriculture, particularly in Europe.

The second reason for waning attention to the proposed partnership speaks to a broader issue: A seemingly endless stream of short-term political dramas has made it extremely difficult for both Europe and the US to focus for long on any secular and structural initiative.

In Europe, broad-based discussion was undermined by the outcome of the Italian election – just the latest sign of how frustrated citizens in a growing number of countries are rejecting conventional political parties and the political status quo. With that, it becomes more difficult to pursue longer-term policy objectives, which merely adds further uncertainty about the precise path of European economic and financial integration.

In the US, the disruption took the form of yet another fiscal mini-drama. With a dysfunctional Congress again letting down the American people, the country is now on the receiving end of a budgetary sequester – another self-manufactured headwind to economic growth, job creation, and progress on reducing income and wealth inequalities.

Put the two together and you get a barrier to EU-US trade negotiations – one that renders ambitious (though not entirely unrealistic) the two-year timeline that has been set for completing the deal.

The third reason concerns the poor state of global policy dialogue, notwithstanding all the happy talk about global challenges and shared responsibilities. Last month’s G-20 meeting ended up as yet another expensive summit lacking sufficient content and follow through. Rather than catalyzing constructive policy coordination, it has inadvertently encouraged complacency.

All three reasons are highly regrettable. They underscore the West’s seeming inability to break out of a short-term mindset in order to respond to the risks and opportunities related to historic national and global re-alignments.

The real promise of freer transatlantic trade consists in its potential to transform global trade, production networks, and multilateral organizations to the benefit of all. At the most general level, it would act to rationalize the current system of four poorly functioning blocs – centered on China, Europe, the US, and the rest – to three, and eventually (and perhaps quite quickly) to two better-functioning blocs that would have little choice but to work well together: one dominated by China, and the other by the EU/US.

Such a global structure has the potential to encourage better medium-term alignments to reduce trade barriers, set proper standards, and enhance mutually beneficial cooperation. It would facilitate coordination on stronger global rules and principles, including those pertaining to intellectual-property rights and trade in services. And it would force multilateral organizations to reform if they wish to retain even the limited relevance that they have now.

The proposal for freer transatlantic trade is potentially transformational. It comes at a time when the West is increasingly being dragged down by short-term disruptions and continued policy inertia. Yet the implementation prospects are far from promising. The proposal has the capacity to act as a catalyst for adapting policy approaches to current realities; but it is subject to the dulling forces of twentieth-century mindsets and institutions that are too slow to adapt to twenty-first-century challenges and opportunities.

By Mohamed A. El-Erian

Copyright: Project-Syndicate, 2013

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Can Egypt’s Elite Plug Its Growing Credibility Gap?: Mohamed El-Erian

Mohamed A. El-Erian — Fri, 08 Feb 2013 04:50:19 +0000

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In the past, a growing gap between what Egypt’s governing elites delivered and the population’s legitimate aspirations would have been addressed by imposing further repression. The new Egypt will not allow this. The empowerment of ordinary Egyptians has fundamentally changed things. Egypt’s political elites do not have unlimited time, and current economic trends are making the need to act increasingly urgent.

NEWPORT BEACH – Facing a turbulent political situation and recurrent street protests, Egypt’s political elite would be well advised to focus on the economic implications of the current turmoil, whether they are in government or in opposition. Doing so would lead them to recognize seven compelling reasons why a more collaborative approach to solving Egypt’s problems is in the country’s collective interest, as well as in their own individual interests.

First, if the social and political disorder persists, Egypt’s economy will end up with crippling inflation, severe balance-of-payments problems, and a budgetary crisis. The risk of a vicious, self-reinforcing downward spiral would rise sharply.

[quote]But, rather than collapse (in the style of Asian and Latin American economies during the debt crises of old), Egypt’s economy would risk a return to stifling controls and black markets. Economic efficiency, investment, and employment would take a significant hit, while slower growth would be accompanied by higher prices, including for basic food items.[/quote]

Most segments of society would be harmed, with the poor, the unemployed, and the young suffering disproportionately. With that, the legitimate objectives of the revolution that began on January 25, 2011 – inclusive growth, social justice, and human dignity – would prove even more elusive.

Second, no durable economic and financial solutions are possible without cooperatively addressing the country’s political quagmire. No matter how well intentioned and gifted, technocrats cannot ensure proper policies and deliver optimal outcomes. They need the backing of a unifying national vision, credible leadership, and citizens’ support.

Third, faced with chronic economic disorder and political instability, Egyptians increasingly lament the “hijacking” of the revolution, fueling mistrust of the country’s governing elites. Empowered by their success in ousting former President Hosni Mubarak, and then sending the country’s armed forces back to the barracks, many are readily returning to the streets to hold leaders accountable.

Fourth, repeated street protests, combined with a weak police force, fuel small pockets of criminal activity. Opportunistic thugs foment fear and chaos – real and perceived – that far exceed their number and power, amplifying the country’s general sense of malaise.

Fifth, external financial assistance cannot postpone the day of reckoning forever. Emergency support from a few friendly governments has so far limited the erosion of Egypt’s foreign-currency reserves at a time of mediocre tourism earnings and growing imports of food and other basic necessities. Facing external payments obligations, and with the currency under pressure, the government will again seek a proposed $4.8 billion loan from the International Monetary Fund and co-financing from other multilateral and bilateral sources. But securing this financing is becoming more complicated.

[quote]Sixth, the Egyptian economy’s potential, given the proper political context, should not be underestimated. Current conditions are keeping economic performance well below potential. This could be addressed promptly; while eliminating inefficiencies and re-orienting institutions that were co-opted by the old system to serve the few rather than the many would increase potential output significantly.[/quote]

Examples For Egypt

Finally, the country’s political leaders can learn from other countries. Egypt is not the first country to struggle in the critical revolutionary pivot from a repressive past to a better and more just future. Nor is it the first country to combine an uncertain political transition with worrisome economic and financial conditions.

It is tempting to dismiss other countries’ experiences, particularly after Egypt’s youth-led grassroots movement delivered something that no one thought possible (toppling in just 18 days a president that had ruled with an iron fist for 30 years). And some countries do indeed differ from Egypt to such an extent as to make potential lessons misleading.

There is no single transition country that offers a guiding light for Egypt. But there may be a group of four countries – South Africa, Brazil, Indonesia, and Turkey – whose combined experience is relevant and would resonate among many segments of the Egyptian population when it comes to orderly economic and political transitions.

Each of the four faced what many deemed overwhelming odds. Yet, by responding properly to their economic and political challenges, they all delivered poverty reduction, greater social justice, and expanded civil liberties.

South Africa under President Nelson Mandela illustrated the upside of channeling popular sentiment away from retribution toward national renewal. While no single Egyptian leader can credibly convey Mandela’s message of “forgive but don’t forget,” together – working collaboratively and cooperatively – they can help to shift the country’s focus from the rear-view mirror to the road ahead.

Brazil under President Luiz Inácio Lula da Silva demonstrated how basic reforms can be implemented in the context of turmoil caused by a major domestic political transition, fleeing investors, and an inhospitable global context. In 2004-2008, Brazil, which had been perennially known as the country of the future – as in “always has been and always will be” – recorded 5.5 percent annual average GDP growth. It reduced the proportion of citizens living in poverty from some 40 percent to under 25 percent. And it improved the 100-point Gini coefficient of income inequality by a full five points.

Finally, both Indonesia (after the Asian financial crisis of 1997) and Turkey (after its 2001 crisis) are recent examples of Muslim-majority countries that decisively overcame economic mishaps while dealing with major domestic political transitions.

[quote]The longer Egypt’s current disarray persists, the more its political elites will lose the battle for the hearts and minds of a population whose basic aspirations are summed up by four well-founded demands: bread, dignity, social justice, and democracy. But, with enlightened leadership and constructive cooperation, Egypt can overcome its current troubles.[/quote]

In the past, a growing gap between what the country’s governing elites delivered and the population’s legitimate aspirations would have been addressed by imposing further repression. The new Egypt will not allow this. The empowerment of ordinary Egyptians has fundamentally changed things. Egypt’s political elites do not have unlimited time, and current economic trends are making the need to act increasingly urgent.

By Mohamed A. El-Erian

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Will 2013 Mark The Start Of A New, More Dangerous Currency War?: Mohamed El-Erian

Mohamed A. El-Erian — Wed, 23 Jan 2013 08:34:34 +0000

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Unlike the old days, the threat of a looming currency war will not be directly related to trade imbalances and balance-of-payments crises. Rather, the main driver has been major central banks’ pursuit of experimental measures – in order to compensate for policy inadequacies and political dysfunction elsewhere.

NEWPORT BEACH – Not many countries nowadays seek a strong exchange rate; a few, including systemically important ones, are already actively weakening their currencies. Yet, because an exchange rate is a relative price, all currencies cannot weaken simultaneously. How the world resolves this basic inconsistency over the next few years will have a major impact on prospects for growth, employment, income distribution, and the functioning of the global economy.

Japan is the latest country to say enough is enough. Having seen its currency appreciate dramatically in recent years, Prime Minister Shinzo Abe’s new government is taking steps to alter the country’s exchange-rate dynamic – and is succeeding. In just over two months, the yen has weakened by more than 10 percent against the dollar and close to 20 percent against the euro.

European leaders have already expressed reservations about Japan’s moves. The US auto industry is up in arms. And, a few days ago, Jens Weidmann, the president of the Bundesbank, publicly warned that the world risks a harmful and ultimately futile round of competitive exchange-rate depreciations – or, more bluntly, a “currency war” (a term used previously by Brazil to express similar concerns).

Of course, Japan is not the first country to go down this path. Several advanced and emerging economies preceded it, and I suspect that quite a few will follow it.

It is just over a year since Switzerland surprised many when it announced, and strictly implemented, a threshold beyond which its currency would not be allowed to appreciate against the euro. And, remember, the country’s operating model for centuries has been to provide a safe haven for foreign capital.

One need not be an economist to figure out that, while all currencies can (and do) depreciate against something else (like gold, land, and other real assets), by definition they cannot all weaken against each other. In order for some currencies to depreciate, others must appreciate. Here is where things get interesting, complex, and potentially dangerous.

[quote]In today’s world, no significant group of countries is looking for currency strength. Some resist appreciation actively and openly; others do so in a less visible manner. Only the eurozone seems to accept being on the receiving end of other countries’ actions.[/quote]

None of this is unprecedented, and there is a lot of scholarship demonstrating why such beggar-thy-neighbor approaches result in bad collective outcomes. Indeed, multilateral agreements are in place to minimize this risk, including at the International Monetary Fund and the World Trade Organization.

Yet, when push comes to shove, country after country is being dragged into abetting a potentially harmful outcome for the global economy as a whole. Worse, this process has not yet registered seriously on the multilateral policy agenda.

There are many reasons for this, ranging from the rather debilitated state of multilateral governance to the urgency of domestic issues currently commanding national policymakers’ attention. But there is also something else at work: The causes of today’s predicament are difficult to comprehend and counter effectively.

[quote]Unlike the old days, the threat of currency wars is not directly related to trade imbalances and balance-of-payments crises. Rather, an important driver is major central banks’ pursuit of experimental measures in order to compensate for policy inadequacies and political dysfunction elsewhere.[/quote]

If the world is to avoid serious harm, it is important to understand the dynamics at work. A simplified description runs as follows: Facing low growth and high unemployment, and with other policymakers stuck on the sideline, a central bank like the US Federal Reserve feels that it has no choice but to adopt a highly accommodating monetary policy. As policy interest rates are already floored at zero, it is compelled to venture ever deeper into the uncharted realm of “unconventional policies.”

The aim, as Fed Chairman Ben Bernanke said again in December, is to “push” investors to take more risk. Specifically, it is hoped that an artificial surge in asset prices will make people feel richer and more optimistic, thus triggering “wealth effects” and “animal spirits” that stimulate consumption and investment spending, bolster job creation, and, in the process, “validate” the artificial asset pricing.

In practice, the strategy has proved not to be so straightforward. Moreover, part of the liquidity that the Fed injects finds its way into other countries’ financial markets. Witness the surge in capital flows to emerging markets as investors chase higher financial returns. Complicating matters even more, these inflows have become less and less connected to the recipient countries’ economic and financial fundamentals.

Many investors also feel the need to balance increasingly speculative investments (“satellite positioning”) with much safer investments (“core positioning”). To meet the latter objective, they turn to prudently managed countries, placing upward pressure on their currencies, too – and, again, beyond what would be warranted by domestic fundamentals.

It is no wonder that more and more governments are worried about exchange-rate appreciation. In addition to short-term policy headaches, stronger currencies carry potentially significant costs in terms of hollowing out industrial and service sectors. So, after a varying mix of tolerance and “heterodox” responses, officials are pulled into loosening their own monetary policy in order to weaken their countries’ currencies or, at a minimum, limit the pace of appreciation.

This period of expanding policy inconsistencies could prove to be temporary and reversible if central banks succeed in jolting economies out of their malaise, and if countries come to recognize that greater cross-border policy coordination is urgently needed.

[quote]The risk is that the phenomenon leads to widespread disruptions, as increasingly difficult national policy challenges stoke regional tensions and the multilateral system proves unable to reconcile imbalances safely. If policymakers are not careful – and lucky – the magnitude of this risk will increase significantly in the years ahead.[/quote]

By Mohamed A. El-Erian

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Will Politics Continue To Dominate The World Economy In 2013?: Mohamed El-Erian

Mohamed A. El-Erian — Fri, 04 Jan 2013 07:38:04 +0000

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How politics and economics interact nationally and globally is one of the important questions for 2013 and beyond. There are three scenarios: good economics and effective politics provide the basis for a growing and more cooperative global economy; bad economics interact with dysfunctional politics to ruin the day; or the world muddles through, increasingly unstable, as a tug of war between economics and politics plays out, with no clear result or direction.

NEWPORT BEACH – Watching America’s leaders scramble in the closing days of 2012 to avoid a “fiscal cliff” that would plunge the economy into recession was yet another illustration of an inconvenient truth: messy politics remains a major driver of economic developments.

In some cases during 2012, politics was a force for good: consider Prime Minister Mario Monti’s ability to pull Italy back from the brink of financial turmoil. But, in other cases, like Greece, political dysfunction aggravated economic problems.

Close and defining linkages between politics and economics are likely to persist in 2013. Having said this, we should also expect much greater segmentation in terms of impact – and that the consequences will affect both individual countries and the global system as a whole.

In some countries – for example, Italy, Japan, and the United States – politics will remain the primary driver of economic-policy approaches. But elsewhere – China, Egypt, Germany, and Greece come to mind – the reverse will be true, with economics becoming a key determinant of political outcomes.

[quote]This duality in causation speaks to a world that will become more heterogeneous in 2013 – and in at least two ways: it will lack unifying political themes, and it will be subject to multi-speed growth and financial dynamics that imply a range of possible scenarios for multilateral policy interactions.[/quote]

Politics Driving Economics

With an election looming in Italy, the country’s technocratic interim administration will return the reins of power to a democratically elected government. The question, both for Italy and Europe as a whole, is whether the new government will maintain the current economic policy stance or shift to one that is less acceptable to the country’s external partners (particularly Germany and the European Central Bank).

Monti may or may not be involved in the new government. The further removed from it he is, the greater the temptation will be to alter the policy approach in response to popular pressures. This would involve less emphasis on fiscal and structural reforms, raising concerns in Berlin, Brussels, and Frankfurt.

Japan’s incoming government has already signalled an economic-policy pivot, relying on what it directly controls (fiscal policy), together with pressure on the Bank of Japan, to relax the monetary-policy stance, in an effort to generate faster growth and higher inflation. In the process, officials are weakening the yen. They will also try to lower Japan’s dependence on exports and rethink sending production facilities to lower-wage countries.

The economic impact of politics in the US, while important, will be less dynamic: absent a more cooperative Congress, politics will mute policy responses rather than fuel greater activism. Continued congressional polarization would maintain policy uncertainty, confound debt and deficit negotiations, and impede economic growth. From stymieing medium-term fiscal reforms to delaying needed overhauls of the labour and housing markets, congressional dysfunction would keep US economic performance below its capacity; over time, it would also eat away at potential output.

Economics Driving Politics

In other countries, the causal direction will run primarily from economics to politics. In Egypt and Greece, for example, rising poverty, high unemployment, and financial turmoil could place governments under pressure. Popular frustration may not wait for the ballot box. Instead, hard times could fuel civil unrest, threatening their governments’ legitimacy, credibility, and effectiveness – and with no obvious alternatives that could ensure rapid economic recovery and rising living standards.

In China, the credibility of the incoming leadership will depend in large part on whether the economy can consolidate its soft landing. Specifically, any prolonged period of sub-7 percent growth could encourage opposition and dissent – not only in the countryside, but also in urban centres.

Then there is Germany, which holds the key to the integrity and unity of the eurozone. So far, Chancellor Angela Merkel has been largely successful in insulating the German economy from the turmoil elsewhere in Europe. Unemployment has remained remarkably low and confidence relatively high. And, while growth has moderated recently, Germany remains one of Europe’s best-performing economies – and not just its paymaster.

While some would have favoured greater policy activism, Merkel’s Germany has provided a steady anchor for a eurozone struggling to end bouts of financial instability and put an end to questions about its survival as a well-functioning monetary union (one that aspires to becoming much more). A change in German leadership would, therefore, raise questions about Europe’s policy underpinning.

The Political Economy In 2013

How politics and economics interact nationally and globally is one of the important questions for 2013 and beyond. There are three scenarios: good economics and effective politics provide the basis for a growing and more cooperative global economy; bad economics interact with dysfunctional politics to ruin the day; or the world muddles through, increasingly unstable, as a tug of war between economics and politics plays out, with no clear result or direction.

Part of the answer depends on what happens in three countries in particular – China, Germany, and the US. Their economic and political stability is essential to the well-being of a world economy that has yet to recover fully from the 2008 global financial crisis.

[quote]Current indications, albeit incomplete, suggest that the three will continue to anchor the global economy in 2013. That is the good news. The bad news is that their anchor may remain both tentative and insufficient to restore the level of growth and financial stability to which billions of people aspire.[/quote]

By Mohamed A. El-Erian

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