A big hairball of risk
Jun 4th 2012, 3:09 by G.I. | WASHINGTON
PERHAPS the most disconcerting aspect of the world’s current flight to safety is the lack of a single overriding threat to justify it. China is slowing, but hardly in recession. Europe is in crisis—but when has it not been in the last three years? And America—well, there’s that fiscal cliff later this year but it’s hard to find any investor thinking that far ahead.
The puzzle was underlined by May’s weak jobless report in America. What fundamental factors could explain it? Consider the usual suspects:
1. Petrol prices rose much less this year than a year ago, and peaked in the first half of April. Retail sales, the most obvious place where petrol prices would be felt, didn’t signal distress.
2. The current episode of European stress can be traced to Spain’s announcement in early March that it would miss its deficit targets, but equity markets in America didn’t take notice until the Greek elections in the first week of May. That’s too late to explain a slowdown that began in April.
3. Emerging markets are slowing sharply. But even after extraordinary growth, exports to China, Brazil, India and Russia only equal 1.3% of American GDP. And a slowdown in emerging markets would be ambiguous for America by both hurting exports and pulling down oil prices.
It’s tempting to chalk it up to technicalities. Consider the following contrast. GDP grew 2.2% annualised in the first quarter and Macroeconomic Advisers thinks it’s growing 2.4% in the current quarter. But employment growth shows a completely different picture: it plummeted from 225,000 per month in the first quarter to 73,000 so far in the second. Perhaps in reality employment grew 165,000 every month from January to May but warm winter and off-kilter seasonal adjustment telescoped most of it into the first three months at the expense of the next two. However, I have learned over the years that blaming bad data on seasonalities or technicalities usually reflects wishful thinking. Better to take it at face value.
What I think preys on the minds of financial and business-world risk takers is not a single threat but a multitude of them, regurgitated in one big hairball of risk. And all are about policy.
1. The easiest to understand is China. The fall in credit, property prices and industrial activity are the result of a deliberate government effort to corral inflation and rebalance from investment towards consumption. The downsides of China’s tiáo kòng (”macro control”) are well known: state-directed allocation of credit and investment is wasteful and distortionary. But the upside is that when the taps are opened, the effect is almost immediate. For example, businesses routinely pay their bills with bank drafts. When the authorities increase bank reserve ratios, those drafts immediately become harder to come by. Investors have learned to put enormous faith in tiáo kòng: as quickly as the authorities put the brakes on, they can release them. “Weak data to prompt effective support,” is how Barclays headlined a typical report Friday.
There are two problems with this optimistic take. The first is about will: authorities may be more willing to tolerate a slowdown and less enthusiastic about stimulus of the kind used in 2008 since it would delay rebalancing away from investment. The second is about ability. China’s record of managing growth is not to be taken lightly but the policy that guarantees 8% growth with no booms or busts has yet to be invented. If China suffers a hard landing this year, it will only prove its leaders are human. Odds of a good outcome: 80%.
2. The most insoluble is Europe. It has faithfully followed Robert Feldman’s CRIC cycle: crisis, response, improvement, complacency. The European Central Bank bought the euro zone valuable time with its long-term loans to banks earlier this year; that time has been wasted. This is hardly a novel observation, but Greece isn’t about Greece; the euro zone can survive without it (the reverse is not necessarily true). Whether it can survive a sudden and disorderly departure that precipitates runs on banks throughout the periphery is another matter. To fireproof the euro zone, most everyone outside Germany thinks euro members should share responsibility for each other’s banks (via common deposit insurance) and sovereign debt (via Eurobonds). Germany has refused to countenance this, and presumably won’t until Greece is in the process of leaving the euro. The optimists are convinced that Germany will bend if that’s the price of saving the euro. What they may not appreciate is that there is no single “Germany” to nod his head when some line is crossed; the country is a mosaic of competing power bases who may not coalesce around a solution in time to save the region. Odds of a good outcome: 60%.
3. The most perplexing is America. The fiscal cliff at the end of the year is a problem in itself, and symptom of a larger problem. If all the tax increases and spending cuts programmed to take effect at year-end do so, GDP will suffer a 5% hit. Neither party wants this to happen. The larger problem this symptomises is the parties’ inability to agree on any sort of stable fiscal policy that would take the place of the cliff. If they could, there wouldn’t be a cliff in the first place. Optimists love to quote Winston Churchill’s line about Americans always doing the right thing after exhausting all other possibilities. Yet Congress and the administration have precious little time and incentive to do the right thing. Countless things could happen: Republicans who thought their leaders gave away too much before could force the government to shut down or default on the debt; a lame duck Barack Obama could refuse to override the fiscal cliff and bail out president-elect Mitt Romney; and who knows what the campaign may bring. Odds of a good outcome: 70%.
The key takeaway is that while a good outcome is the likeliest scenario for each, the combined probability of all three turning out well is only one-third. And by the way, that’s without throwing in all sorts of other risks such as: Israeli attack on Iran; civil war in Syria; a victory by the populist Lopez Obrador in Mexico; and so on. Is it any wonder that the marginal investor or business would prefer to hold Treasury bonds or sit on cash? And that sort of disengagement can make economic pessimism self-fulfilling.
The original post is linked here.