Grasping for growth: sovereigns’ missing element

Without growth, the sovereign crisis can’t be solved. The markets are focused on debt, but what about the denominator in debt-to-GDP? Small moves in growth expectations mean large moves in long term fiscal stability. So where does it come from, and how can we get more of it? Owen Sanderson reports.

  • 13 Dec 2011
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The sovereign debt crisis has the wrong name. It should be called the sovereign growth crisis. The mountains of debt which built up in peripheral Europe limit government options in dealing with the crisis, but it was the disappearance of growth which first drew attention to the optimistic assumptions embedded in sovereign budgets across the developed world.

"It’s a multi-dimensional problem with its roots in institutions, but scepticism about the continued low growth performance plays a part," says Silvio Peruzzo, euro-area economist at Royal Bank of Scotland. "Spain, Greece and Ireland have all experienced a massive shift in growth performance since before the crisis, and unfortunately their budget exercises were all based on much faster nominal growth than they are experiencing."

But aside from requesting outside support, can governments do anything to help? Much of the politicking has focused on how to deal with the debt aspect of the crisis; precious little on growth, the denominator in the debt to GDP equation.

The IMF/EU bail-out conditions recognise the medium term growth potential of fiscal reforms (Greece is supposed to be back in the capital markets by 2013, remember?) but say little about short run effects because these options are largely closed to peripheral countries.

William De Vijlder, chief investment officer at BNP Paribas Investment Partners, says that governments can boost growth cyclically and in the long term.

"A cyclical boost just means spending more or cutting taxes, but if a government already has a high budget deficit and is already running a high debt to GDP ratio, then monetary policy is the only option," he says. "Longer term fiscal policy can change the potential rate of growth though through infrastructure investing, education and so on."

Peruzzo agrees, saying: "Monetary policy can smooth the business cycle, but longer term, the growth rate is driven by a combination of foreign and domestic demand and how they interact with the underlying supply capacity of the economy."

For some economists though, monetary policy takes centre stage, particularly in dealing with the Eurozone’s growth crisis.

Simon Ward, chief economist at Henderson Global Investors, says: "For us, monetary policy is much more powerful than fiscal policy as a driver of growth. Fiscal policy can affect the long term structure of the economy, but monetary policy is far more useful."

He argues that the Eurozone crisis has been precipitated at least in part by inappropriate monetary action. "The ECB made a huge structural error, allowing a weakening money supply late last year," he says. "It is belatedly reversing its tight money course, but it needs to ease aggressively, ideally using both QE and low rates."

Ward argues that monetary easing spread neutrally across the Eurozone would be best to restore growth, with equal apportionment by GDP or similar to deal with some of the obstacles to this course. "The constraint on this is political — buying only peripheral bonds would focus the easing, but create moral hazard and be seen as a back door bail-out," he says. "It needs to be a pure monetary policy decision. Leave the IMF and the EU to ask peripheral countries for fiscal changes, while the ECB manages monetary policy properly."

For Peruzzo, the institutional framework of the European Union is too restrictive for this to work.

"The UK and the US are different [from Europe], despite their weak growth outlook, because of the institutional framework," he says. "Having a central bank that doesn’t have a legal impediment to eventually conduct large scale asset purchases also helps. The EU institutional framework seemed to work fine when everything was going well, but today we are testing the limits of it."

Detangling the numbers

Ward’s approach has the virtue of simplicity, but is rare in the financial markets, because it requires ideological conviction rather than the sceptical agnosticism which usually prevails. It also gives money-watchers a reason for hope, even without aggressive ECB action.

Ward says Henderson’s economic forecasting is heavily based on the money supply, which is a forward looking indicator. "The rule of thumb is that it leads economic growth by around six months," he says. "It works best when you use a global money supply indicator. On that basis, things might look up. Money supply is back up since spring 2011, and this suggests improving growth from spring 2012."

But even focusing on money supply — Ward prefers to look at narrow money, M1 and related measures — has its complexities, particularly in the twilight of the world’s largest ever currency union.

"We expected, when EMU started, that individual country money supply numbers would become irrelevant," said Ward. "But since the crisis, we’ve seen very divergent numbers across Eurozone economies. These measures pick up money leaving the periphery."

De Viljder credits a broader range of indicators in forecasting for BNP Paribas Investment Partners, which adds further to problems of interpretation. "All growth is not all good — you need to look at what is driving it," he says.

He goes on to explain that inventory rebuilding is an ambiguous signal. "Inventory rebuilding following a weak patch is a good sign — it means companies are more confident — but it is a one-time only factor, so all depends on what final demand will do. Inventories also rise before a recession, so you need to be very careful with this number."

He also flags up regional imbalances, excessively concentrated growth, and excessive capital expenditure as warning signs — or questions to ask when presented with a GDP number.

Then there’s also the question about which GDP to use.

"In the majority of cases, people look at real GDP, rather than nominal," says De Vijlder. "There are a lot of inputs to untangle, deflators and so on, but economic analysis is more art than science, and involves looking at a huge range of different figures. Looking at nominal GDP makes sense if one is worried about deflation risks."

Detangling the GDP figures — reported growth — is only a small part of it. By the time we know about it, the figures are irrelevant. Growth expectations are already in the price; GDP numbers move prices only to the extent that they change expectations.

"GDP numbers themselves are not particularly important to us," says Ward at Henderson Global Investors. "They are historic, obviously, and calling the ups and down of the economic cycle — whether growth is accelerating or decelerating — is more useful."

De Vijlder adds that as a rule of thumb, equity markets will run some four to six months ahead of real growth.

But expectations are exactly what matter to the distressed sovereigns of the Eurozone. Medium term credibility on growth expectations might well restore some bondholder confidence, but instead, medium term expectations are for a collapsing currency union.

Surprisingly small improvements can play a big role in realigning expectations — Ireland’s shift back into positive growth has made it the poster child for successful austerity measures, although the economy remains well below the size it achieved in pre-crisis years.

"A pick-up in growth is perceived as positive news because it reassures the markets that debt to GDP is or will be on a sustainable path," says De Vijlder. "If the nominal interest rate on the government debt is higher than the nominal rate of growth, the debt burden gets heavier unless the government would be running considerable surpluses on its budget excluding interest charges."

Peruzzo argues that the Irish recovery, though real, is vulnerable.

"Foreign money is leading the recovery, while Ireland goes through internal deflation imposed by fiscal austerity," he says. "But it’s inconceivable that Ireland can improve if the rest of the Eurozone moves to recession. No domestic demand means an element of vulnerability in the growth story."

With a failed German auction dominating the headlines as this report went to press, Ireland’s return to positive GDP numbers may not therefore prove to be decisive in resetting expectations.

Even if the southern European sovereigns are able to muster the political will to force through austerity and restructuring measures, the backdrop of a wider economic slowdown (the Eurozone is likely to enter a second recession early next year) could mean no return to growth — and therefore no sovereign debt credibility — in the medium term. Even if the region’s leaders can sort out the mechanics of debt guarantees, macro-economic demand must ultimately come from somewhere, and that may have to be outside the Eurozone.

Europe may then be forced back on Ward’s solution — monetary reflation from the ECB, taking the path which the Federal Reserve and Bank of England took in the early stages of the crisis.

But Peruzzo cautions that ECB action is no panacea. "The Fed and Bank of England have taken exceptional monetary policy decisions in response to specific macro objectives — staving off deflation risk or producing full employment," he says. "ECB bond purchases are not addressing deflation or growth in the Eurozone as a whole. People are talking about getting the ECB to step in with explicit financing for the sovereigns, though this seems like a recipe for disaster."
  • 13 Dec 2011

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