March 29, 2010 Patrick Oliver-Kelley


And the Stress goes on and on and on.

It appears that Europe has hammered out a salvation plan for Greece. But it is still too little, too late and it’s only temporary. China’s government began to rein in lending. India raised reserve requirements and Brazil’s stimulus is being phased out. Central banks in the Rich World are beginning to unwind emergency liquidity facilities.

All this has knocked asset prices for a loop. Questions abound: the strength of the recovery is fragile. Favorite restaurants are busy, but few other businesses are seeing any traffic. New home sales have fallen to the lowest level, ever, in many countries. Second is the scale of the sovereign-debt problems. Finally, is the question of how well central bankers are at designing and coordinating the withdrawal of the stimulus packages.

The fight over Deficit Reduction has begun. Deficits are so large, and the bond market is getting impatient. Who gets the bill: Taxpayers, public sector workers, entitlement recipients, foreign investors, and future generations?

First, we must be honest about the size of the problem. Speculators did not invent the deficits.

Second, we must focus on economic growth. That will reassure markets. Increase tax revenues and reduce spending on unemployment, on entitlements and other welfare benefits. Avoid protectionist taxes, create more flexible labor markets, raise the pension age.

The crunch, especially in Europe, is between taxpayers and public sector workers. Spending cuts do better than tax rises, though some countries may be tempted to diminish their debts through higher inflation. Today that is not possible. We are heading into an era of austerity; the social cohesion of many nations will be put to the test.

Emerging economies are doing the best. India and Brazil are in good shape. China’s economy is vulnerable, but there are few signs that it will tighten too much, too fast. Key is their ability to re-orientate their economies towards domestic spending, thus pushing up the cost of capital.

In the Rich World there are reasons for gloom. There are few signs of private demand growth. Output is only restocking. un-employment , though seemingly stabilized, does not show any sign of reversing. Their singular problems of aging population and soaring health and pension costs are ingrained. Housing is wobbly; household debt is shrinking but from stratospheric heights. Consumer spending is subdued.

Europe and Japan, the outlook is less good. Japan has slipped back into deflation. In the Euro-zone, recovery, long before the Greek crisis hit, is faltering. Euro speculators focused their attention on Spain.

Emerging economies should unwind their stimulus and raise interest rates before inflation takes off. It’s too early to tighten in the Rich World, though aspects of increased inflation remains remote. Governments need to do more to control their deficits and boost economic growth, the sooner ,the better. Any rise in interest rates might itself spawn a higher risk premium on sovereign debt.

As for the US, this suggests that a bigger rise in yields than expected, and a worsening of its debt position. President Obama must craft a credible medium-term plan to cut deficits. The new Health Bill only adds to the deficit.

The market is likely to demonstrate a spiritless uplift. The economy and political vulnerability of the Fed virtually rules out any significant short or long term interest rate rises in 2010.

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