A "summer drought of policy leadership" could have dire consequences for the global economy (Shutterstock photo).
A "summer drought of policy leadership" could have dire consequences for the global economy (Shutterstock photo).

Earlier in the year, I wondered if a European frost, or the uncertainty generated by the continuing crisis in the euro zone, would kill the "green shoots" of global growth. While the frost did not materialize in the spring as feared, it now looks as though a summer drought of policy leadership is wilting the crops in the field. Needless to say, this is not good news – least of all for US President Obama, who is hoping that slow steady growth will propel him into a second term.

A quick survey of recent economic developments reveals discouraging and worrying results. US employment numbers were disappointing on Friday, with very weak employment growth presaging an anemic recovery at risk of stalling out. The worry here is that strong employment growth is needed to generate the income growth that sustains consumption and the recovery. Absent strong domestic demand, US growth requires robust export growth to fuel the recovery. But look at the latest indicators from around the globe and you will be hard pressed for signs of optimism. Most notably, China is slowing rapidly and today the Financial Times reports a marked decline in inflation, leading some to worry about possible deflation. It is worth remembering that China is now the world’s second largest economy. Of course, China’s remarkable performance in recent years has, itself, been driven largely by an export-oriented growth strategy and external demand. So, how is the rest of the world doing? In a word: poorly. India and Brazilhave slowed considerably. Australia, which has been powered by strong Chinese growth and demand for natural resources, has slowed. And then there is Europe. As a result of all this, the IMF Managing Director has warned that global growth will be lower than projected only a few months ago.

All of this discouraging news has elicited policy responses from several major central banks. The ECB and the Peoples’ Bank of China cut interest rates late last week, while the Bank of England announced another round of quantitative easing. The goal is to reverse the slide to slower growth, with the attendant risk of recession.

But will these measures work?

My guess (and it is only that) is that, while certainly welcome, last week’s monetary policy announcements will only help things from deteriorating further. They will not foster the strong, sustained and balanced growth that is needed to repair the damage of the global financial and economic crisis. Lower interest rates in Europe, for example, will help banks recapitalize – not through new equity issues (who would buy it?), but through retained earnings. After all, if banks are paying zero or near-zero on their funding, any return on their asset portfolio generates an income stream that can go to build up capital. This process will take considerable time. And, in the interim, the cloud of uncertainty that hangs over global prospects continues to impart deflationary pressures. Banks need capital to support lending. But if businesses are unwilling to invest because of the uncertain outlook, additional capital will simply prevent a further deterioration in the economy.

This underscores the importance of the drama-filled EU summit heralding, after an all-night negotiating session, what some hoped was a "breakthrough" in the resolution of the euro zone crisis. Such expectations were unfounded going into the summit; unfulfilled coming out. To be sure, the decision to begin work toward a banking union was welcome. But, for the avoidance of doubt, what EU leaders agreed to in end-June is not a solution to the crisis; at best, it is a necessary and not a sufficient condition to containing the crisis. Moreover, as Wolfgang Manchu warns, by tying bank recapitalization to a full banking union and ultimately to political union, it may have been a step in the wrong direction. This seems to be the judgment of financial markets, which have once again priced Spanish bonds at levels widely believed to be unsustainable. Indeed, events of the past two weeks have mirrored the now predictable five-step pattern of the past two years.

Step 1: Situation deteriorates to a crisis level.

Step 2:Euro zone architects gather to fix the problem.

Step 3: Announcement buys some breathing space of relative calm, until markets realize that what has been announced is inadequate to quell the crisis.

Step 4: Bond yields of distressed sovereigns rise to worrying levels.

Step 5: Return to Step 1.

The difference between the latest announcement and past "fixes" is the ephemeral nature of this much anticipated breakthrough. It took less than a week for bond yields to return to unsustainable levels. Frankly, I don’t pretend to know what that signifies. However, two possibilities come to mind.

First, that the situation in European financial markets is nearing the breaking point, as the collateral crunch worsens, private lending shrinks, and confidence continues to be eroded by the corrosive effects of continuing uncertainty.

The second possibility is that the credibility of European policy makers has reached its nadir. There may have been simply too many meetings with too many announcements that have not led to a clear, credible resolution of the crisis.

Of course, there are other possible explanations for the weakened potency of "announcement effects." Regardless, the situation is not reassuring.

Leadership is needed in Europe. Unfortunately, that seems to be in short supply.

"Last week’s monetary policy announcements will only help things from deteriorating further. They will not foster the strong, sustained and balanced growth that is needed to repair the damage of the global financial and economic crisis."
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