A real threat of stagnation

In Europe, or in the US more particularly, we are seeing investors are losing confidence in the ability of various economies, various governments to service their debts. In Italy’s case, in Spain’s case investors think or believe that the Spanish and Italian economies will not grow sufficiently quickly for them to be able to service the debts that they owe now. So, this is a question really of solvency.Why is this happening at the moment and why Italy and Spain rather than other countries? In Italy’s case it is a combination of three things; one is a very high level of public debt, about 120 percent of GDP, the Italian economy has performed very poorly economically for the last ten years, so its economy is actually no bigger now than it was ten years ago, it did grow a little bit before the financial crisis and then it suffered a huge recession in the financial crisis, and it is basically stagnated since. So, this is a combination of very high debts, very poor growth performance and political instability, or at least a political system that no longer seems to be able to throw up leaders who prop the countries rather than particular private interests. And I think it is very damaging for Italy that the prime minister seems to devote more time to insure his own commercial interests or advance than to address the country’s economic problems. But that alone does not explain why Italy is in such trouble. The other is because it is the member of a currency union it does not have any control over its own currency. Effectively, Italy is borrowing in the foreign currency. So, for example, if we compare Britain and Italy, Britain’s public finances are also in a very bad shape, but Britain can currently borrow about three percent, so it borrows at the same level of interest as Germany and the US; that is because investors think that the British economy has better growth prospects than Italy; that is also down to the fact that Britain borrows in its own currency, so they think the risk of default in Britain’s case is remote, because when it came to it Britain Central Bank, the Bank of England, could just print money. So, the reason why Italy and Spain are in such trouble is their poor growth prospects, high levels of overhauling deficiency; and in Spain’s case a lot of the debt is private sector dept in their own currency and they have no control over their own currency.

Many analysts blame the rating agencies for the situation, how justified is the blame?

I think they have it both ways on the rating agencies. In the one up to the crisis they were accused of being too sanguine about ignoring risk; now they have been accused of being too risk-averse. I think to an extent I can understand frustration with the rating agencies, but I think it is a bit of the red herring, I think investors should not be putting too much store by rating agencies anyway; any bank or any other financial situation that makes lending decision on the bases what the rating agencies are saying. The rating agencies do have an influence, but I think overall their focus on the rating agencies is misplaced; it is a sort of a question of shooting the messenger. What the rating agencies are currently saying about this sustainability of public finances in many European economies is really difficult to question, is pretty uncontroversial, they are not saying anything that most investors do not already know. If one looks at the debt positions of Italy, or Ireland, or Greece, or Spain, and their status as members of the currency union it is quite obvious that they are concern over solvency and I think that is why the rating agencies are drawing attention to that. It is also worth baring in mind that rating downgrades do not always have that much of impact. For example, Japan has been successfully downgraded and the Japanese government can continue to borrow 1.5 percent. The reason why ratings decisions in Europe at the moment are causing such consternation and why they are seen as such a problem is that the situation as the whole is serious and that is adding to the sense of instability, but it is not a cause of that instability. I certainly think that within Europe governments joined the signal currency without understanding what they were doing. A country joining a single currency affectively seeds much of its sovereignty; it is also affectively signs up to a very liberal economic agenda. For single currency to work all the members of that single currency have to be very highly integrated with one another, so there cannot be any barriers in any form, people must be free to move from one country to another, good trade, good services kept to, everything must be free to circulate freely, also you need not only a central bank but you need a central treasury, there needs to be a land of last resort. Affectively, if you join a single currency, you are agreeing to become a part of a broader economy. Now, lots of governments did not understand that, they joined a single currency for political reasons; they saw it as an opportunity to have a seat at the top table, they saw it in many respects as a shield against the rest of the world, but it is not, it is more like a corset, it requires discipline and it requires a sharing of sovereignty. Now, they can save the euro, but they have to accept that it is going to require much closer political integration, much closer market integration and it will require solidarity between the various members of the currency union. Much as money flows from wealthy parts of Germany to poor parts of Germany, or from wealthier parts of Britain to poor parts of Britain, or from wealthier parts of the US to poor parts of the US, much as that happens money has to flow from wealthier, fiscally stronger parts of the Eurozone to poor, fiscally weaker parts. That is what happens within a single currency, within a single country and that is what is going to happen within the Eurozone. Of course, that raises all kinds of concerns because there is not so much solidarity between the members of the Eurozone, there is solidarity within member states, people grumble about the amount of tax that is paid to support poor areas of particular countries, whether people in Germany or the US, but it still happens, there is no serious opposition to that because doing the sense of solidarity between people of individuals countries. The problem within the Eurozone now that they need to become much more integrated, but there is no political support for that, at least in the countries that are stronger. What they have been doing so far is just piling more debts on top of the old ones, extending their own debt largely. So they did in Ireland, Portugal, Greece for a long time. The debt deal they did in Greece a couple of weeks ago does not actually reduce Greece’s level of debt. Now, they need to restructure the debt, so Greece, Portugal, Ireland meaningfully reduce their debt about half, they then need to support Spain and Italy, so the European Central Bank needs to buy Spanish and Greek debt in order to get the yield, in order to get their growing cost down.

By the way, when you said that they are piling new debt on top of the older ones, it actually reminds me of the solution which is now at least promoted in the United States: they are raising their debt ceiling which means that the debt is just going to accumulate.

I think the situation in Europe is more serious than in the US. There is no doubt that the US has a fiscal problem but the US has much better growth prospects than Europe: it has much younger population than Europe, and it borrows in its own currency, so it is a fundamentally different position. For example, the US can carry more debt that it is carrying at the moment – it is not ideal and they do need to sort out to the underlined reasons for the build-up of debt, some of the reasons why debt is raising issues that growth is so weak, but other reasons are entitlement programs, healthcare entitlement programs which they need to address going forward, but the US position, despite the media coverage in the last couple of weeks, is not as serious as the problem we are facing in Europe. What we need to see in the US is some responsibility being exercised by the Republicans in particular. I think people are overanxious about the US, it is a problem, but is not near as problematic as what we are seeing in Europe.

And finally your forecast for Europe and the rest of the world?

I think there is no doubt that global growth is slowing, that we are seeing a real threat of stagnation, of a new recession in the industrialized West and I think there is a doubt over the ability of the emerging economies to drive growth in the global economy. I think that people have been too optimist about China; China has got some problems too. So, I think the economic outlook looks quietly uncertain, very worrisome. I think there is a significant risk of the Eurozone crisis going out of control. I think fears about the US are overblown, but there is no doubt that the world is going to have to get used to a lack of the US leadership. So, the US will be a more uncertain place, to be honest, but there are very few alternatives to the US leadership in the world and the idea that we are going to get some stable multilateral leadership comprising China is likely farfetched. China is a very inward-looking country, still a very poor country, trying to focus on basic needs of its large population – it is no in a position to supply the US. I think we are looking at a huge uncertainty, massive uncertainty about the outlook for the global economy. We just have to look all the major players and the outlook in Europe is grim; China has an enormous number of challenges, it is still growing rapidly, but they have this growth model which is basically large amounts of cheap labor, large amounts of investment capital, as one of its course; they now need to become more productive, they now need to use resources more efficiently and they cannot rely on exports anymore, because the principal export markets are stagnant, so they have to reform their domestic economy. India is growing rapidly, but again there is a question mark over its ability to sustain that, because they are not investing in infrastructure, whatever. I think that Latin America looks pretty good, but I think one of the main reasons why Latin America is looking good is that its commodity prices are very strong. So, Russia looks at the moment very good because of its commodity price issue. If we see a prolong stagnation in Europe and the US, slowing of growth in India and China, then commodity prices will follow and then the countries that are currently benefiting from strong commodity prices will see their economic prospects deteriorate. I think we are at a crossroads: things look tricky, there are a lot of unresolved problems and there is a lack of leadership, the combination of that lack of leadership and all these unresolved problems is tricky.