Thursday, November 15, 2012

US, EU and China: Prospects for growth.

            November, 2012 has been very important for the United States and China, because both had very important government shifts or not as was the case of the US, where after spending $6 billion on campaigning, they produced the exact same government they had before the election.  So now we have a good idea what direction we can expect the world’s two largest economies to go in more or less for the rest of this decade.  There were no major elections in the EU member countries, but we have to include this entity in our discussion as well, because as of 2011, together with the US and China they accounted for 57% of the world’s nominal GDP according to IMF stats for that year.  Given the large share of the world’s economy that these three entities command, it is fair to say that the direction these three economies are headed is where the whole world is headed.  It is therefore wise in my view to look at each one individually in today’s global context, because we need to get away from US election rhetoric and promises, which dominated the media for the past few months and get back to reality.

The European Union:

            It is no longer a secret that the EU is likely to see a continuation of the current slump for the rest of the decade.  There are few reasons to believe things will improve any time soon.  The unending rounds of government budget deficit reduction through spending cuts and tax hikes in many individual member countries are having a larger negative effect on economic growth than most believed would be the case.  In short, it seems most European economists under-estimated the multiplier value of government spending.  As the economy continues to drag, new corrective measures are needed to adjust year after year, so in effect, Europe is caught in a vicious cycle, which they better find a way to break out of, before the union itself breaks up if and when the masses will lose their patience.  They need to find growth even as they continue to tighten the budgets.  It is not an easy task, nor are the European elites up to the task.  This year’s move to tax foreign airlines for their greenhouse gas emissions is the perfect example of just how out of touch European leaders are with the realities they face.  That move caused billions of dollars worth of economic losses, and tens of thousands of jobs, due to retaliatory measures, such as China’s move to cancel Airbus purchase agreements.

            It is sad to admit to the fact that there are currently more risks to the downside for Europe’s economy than there are upsides.  Given the large debt load of some of the members, it is a real possibility that we can see a few sovereign defaults, especially in the Euro area, where devaluation is not a viable alternative to actual default by individual members, because it is hard to devalue as long as the union contains global exports powerhouse Germany and a few other members which have a sound economy and a fiscal house in good order.  Greece’s debt/GDP ratio is expected to go to 190% next year, up from 175% this year, and that is despite many fiscal tightening measures already implemented.  When the crisis first hit them in 2008, their debt to GDP ratio was about 120%  Some optimistic projections assume that Greece’s ratio will decline to 120% of GDP by 2020, which is still very high and overly optimistic in my view.  Greece can only solve this through outright default.  It cannot cut its way out, because every cut leads to further recessionary pressures, and a shrinking economy with a still rising debt  They most certainly cannot grow out of it, because there are currently no engines of growth available to them.  For four years now, we keep getting the same forecast for Greece.  A return to growth is always two years away.  This year they project that it will happen in 2014, and in 2014, no doubt they will claim it is just two years away again.

Italy’s debt to GDP ratio is about 120%, and its economy is stagnated, so they cannot grow out of it.  Spain will have to take a bailout soon, in order to deal with the broken banks.  France may become the victim of excessive deficit procedures over their many years of running deficits higher than 3%.  As a result, they could lose EU budget funds, deepening the hole they are in even further  These are just a few of the potential imminent default candidates.  These problems can actually lead to a much bigger problem, which is a breakup of the union.  Such an event would cause a global recession of unparalleled magnitude in depth and duration.  It is a very real danger, and it is likely to happen this decade, if it is to happen at all.

As long as growth is absent from the region, the likelihood of a breakup happening will rise as people will become more bitter.  It may only take one member to start the avalanche of exits.  Currently, we should watch non-Euro zone members of the union such as Britain, which may decide to jump ship early on.  The Euro skeptic Czechs may also surprise by possibly being the first.  There is even a small chance that a country like Hungary may head for the exits if some factions of the EU power and decision-making apparatus cannot help themselves but continue to attack them, for either political reasons to avenge the defeat and demise of Hungary’s socialists, or by those looking to punish Hungary for the way it dealt with the current crisis, by forcing multinational banks to share in the pain.  It is much harder for Euro currency members to jump ship, but not impossible either, so it is of paramount importance that EU politicians get their act together.

Some of the things they could do in order to promote a return to growth include a relaxation of environmental standards, including their unilateral war on greenhouse gas emissions, which is also a war on growth and jobs.  Easing of worker protection rights is not a bad idea either, because joining the race to the bottom is the only way to remain competitive.  Identifying the millions of workers who work under the table across the EU might be a better way to raise revenues than raising taxes, with less resulting drag on the economy.  There are probably many other things they could do, which I overlooked.  I fear however that they will fail to do much at all.  It seems all our elected politicians are stuck in the same old ideological debates over spending and taxation.  The result of inaction will most likely lead to EU economic growth in the 0-1% per year rate for the 2010-2020 period.  The data released today on Q3 GDP, shows that the Eurozone is now in a double-dip.  I will dedicate my December 1’st article to the subject of what a prolonged period of such a slow pace of growth will mean for western society.

The United States:

            With the elections over and done with, it is important to leave the electoral rhetoric behind and admit that neither side could have delivered 12 million net jobs in the next four years, even though both sides would have sworn that it would be a piece of cake as long as their recipe of ideology-chip cookies would be followed.  There are a few factors that give the US a chance at the very least to fare better than the EU.  None of these factors have anything to do with government policy however.  Cutting taxes, and other gimmicks sold to the electorate would have no impact whatsoever on the current economic trend.

            Energy is probably the top factor that is likely to positively affect the US economy.  Many people worried that Obama will prevent private companies from realizing the full economic potential of the new trends in hydrocarbon exploitation, but there is no actual reason to worry about it, because it is a little bit like the worries expressed four years ago that Obama was coming to take people's guns away.

            The shale oil and gas developments are more than a tool to improve US energy independence.  It is more than improving the economy through helping cut US reliance on oil and gas imports.  Hydraulic fracturing requires a high rate of drilling activity to keep production growing, or even to keep it flat.  Well decline rates are very high.  A natural gas well can decline from the initial flow rate by as much as 60% in the first year.  This means that six new wells are required the following year just to replace production losses from ten such high decline rate wells drilled the previous year.  The need to keep this high rate of drilling may be bad news for the long-term viability of the industry, and for the country’s domestic energy production prospects, but it is good news for those looking for work and willing to move to find it.  It is also good news for suppliers of equipment to the exploitation companies and those looking for a job in manufacturing those products.

            It is also good news that the government is able to continue to sell its debt at a very low interest rate.  Ten year bonds currently pay about 1.65% interest per year.  Inflation rates are higher than that, so the interest on debt is not becoming a high burden for the government just yet.  It will once interest rates go up, and the bonds sold in the last few years will mature and the government will have to roll over the debt at a higher rate.  For now however, they can continue to support growth through government spending.  If the US federal government will continue to accumulate debt at current rates till 2020, its total debt will be about $25 trillion.  At a rate of 2% interest, that will be manageable at around $500 billion.  If for any reason, we will see signs that rates are on a sustained rising path, such a high debt load will be dangerous.  To put it into perspective, at a 5% interest rate, the government will have to pay $1.25 trillion per year in interest.  The federal government’s total budget for this year is about $3.8 trillion, and revenues are about $2.6 trillion.  Even if revenues were to double by then, to $5 trillion, interest on debt will eat up a quarter of those revenues.

            Given these considerations it is wise to assume that the US government will cut its deficits substantially by then.  They will probably start addressing this problem at the end of this year already as they deal with the potential “fiscal cliff”.  Cuts in spending and increases in tax intake will slow the economy however, as we already saw with the EU.  For reasons I already articulated in other articles as well as in my book, it is unlikely that maximum potential growth rates in a country like the US will be more than 2% per year on average.  That average will be further reduced by measures meant to reduce the deficit.  That in turn will guarantee that the government’s revenue intake will not double as I assumed earlier.  Adding up the assumed rate of inflation at 2% and growth at 1.5% on average for the 2010-2020 period, revenues will grow to $3.5 trillion.  Remember that assuming the interest rate will grow to 5% by 2020 would mean that interest on debt will be $1.25 trillion, or a third of revenues collected.  Cutting the debt load by a trillion dollars, or even two or three trillions, will not have much of an impact.  There are just no easy answers, to this problem, except for two possibilities.  Do whatever it takes to keep interest rates low.  Alternatively inflation can be ramped up, changing the nominal revenue growth trajectory.  Increasing annual inflation rates from the 2% target to about 8-9%, and assuming economic growth will average 1-2% per year, would lead to government revenues doubling every seven years.

China:

            One might not know this by following the mainstream media, but there is a shift of leadership underway in China.  This shift did not cause $6 billion to be spent on campaigning, nor did the big issues get debated, with varying views being pitted against each other.  One might argue that there is little need for debate even though China is about to enter an era of slower growth decelerating from about 10% per year to about 6.5% according to most mainstream economic forecasts coming from the IMF, World Bank and other entities.  I have taken a different approach to forecasting long-term growth for the world as well as for different countries and regions ( read here ), which I have to say that since I did publish them seem to be better aligned with reality thus far than what the mainstream has been pushing.  I think for instance that China will have to fight hard to achieve 5% average yearly growth in the next two decades, which is significantly less than the assumed and expected 6.5% average.

            China has to fight many factors indeed, because the model they used to get here is no longer viable.  Take for instance their per capita GDP.  They are now closing in on the EU’s poorest members Romania and Bulgaria, which means that their wages are not as competitive anymore.  Even with my assumption that they will only get 5% yearly growth on average, they will overtake even the relatively stronger countries such as Poland and Hungary in per capita GDP by around 2020.  That is good news on one hand for the average Chinese citizen, because this will surely translate in an elevated living standard for many, but it will also result in a loss of wage competitiveness.  Eastern and Central Europe should be expected to start pushing aside Chinese exports from Europe gradually.  The European Union is currently China’s largest export partner, and it is now in danger of losing that market, even though it seems most including many investors do not realize this just yet.

            The example of China’s future in Europe’s consumer market is what generally becomes the dilemma of fast-growing economies, which were at some point overly reliant on their wage competitiveness as a way to gain the right to manufacture.  As growth leads to a lessening of the wage advantage gap, the economy hits a wall, and in the absence of competent leadership ready to manage the hard task of continuing to compete in the absence of the wage advantage, the impact can be fatal.  In the case of the Chinese, they have much work to do in order to find improvements in efficiency meant to counterbalance the loss of the wage advantage.  They have rampant corruption they need to deal with, which is not an easy task.  They need to find a way to increase domestic consumer spending, including through the all important measure of providing a basic social safety net that is currently lacking.  They need to start paying attention to the damage they are inflicting on their environment, because at some point it will lead to a decline in their population’s collective health, and it will be costly for both the individuals and the government.  These are all things they have to deal with in the current decade if they want to have a chance to avoid complete disaster.  The main key to solving most of these problems is what will make it problematic to do so.  They will have to break the current relationship they have with the US.  They have to start spending the proceeds of their exports on the people, which means they will no longer be able to support the American consumer through lending the US money.  The effect of such a policy will be larger than the actual size of the sum of money that China has been lending.  Remember the calculation we made of US interest on federal debt, and the effect that raising interest rates to about 5% from the current rate which is less than 2% will have on government finances.  Once again it is becoming more and more evident that there are no easy answers left.

Conclusion:

            As we continue to rely on classical moves meant to resolve our problems, it is becoming more and more obvious with every year that passes that we are failing to resolve these issues and with every failure we are getting closer and closer to the point of no return.  Solutions such as the one I proposed in my book in the form of a standardized global trade tariff meant to rebalance the world’s economy, can only work for as long as there is still a world economy left to save.  In the absence of bold new ideas, and bold leadership, we have nothing left to hope for.  The only thing left for us to do as individuals is prepare for hard and unforgiving times, because even though it might not yet be obvious to most, the hard times are comming and there will be many victims.

             

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