Following the recent spate of upbeat data, today’s consensus outlook (which I largely share) is that this year the economy may again grow about 2% and then speed up modestly in 2014. Unemployment is expected to remain high and total business profits to slide a bit. Federal Reserve forecasts, which have been chronically over-optimistic, do not foresee full employment for years to come. A year ago, similar projections tended to be dismissed as unacceptably dour. Today, because our representatives managed, literally at the last moment, to avoid plunging us over the fiscal cliff, we are relieved and pleased just because slow growth is continuing.
Although unlikely to happen for years, any anticipated or actual tightening of monetary policy would mean higher interest rates. How much higher? If would-be borrowers are undeterred by the rise in rates, then rates will have to go up a lot until borrowers back away. On the other hand, if the market regards the rate increase as preemptive, indicative of the Fed’s determination to contain inflation before it gathers momentum, short rates may not need to rise much, while long rates might even decline as inflationary fears are quieted.
“You might wonder why anyone cares about a tiny nation with an economy not much bigger than that of metropolitan Scranton, Pa.,” writes Paul Krugman, who assesses the debt crisis afflicting the Mediterranean country’s unusually large banking system, which functions as a tax haven for wealthy foreigners. Since Cyprus belongs to the Euro zone, Krugman argues, “events there could still trigger contagion (for example, bank runs) in larger nations.” Ultimately, the country let its banks grow too consolidated and too big, even after the global financial turmoil of 2008. “Everyone has seen the damage that runaway bankers can inflict, yet much of the world’s financial business is still routed through jurisdictions that let bankers sidestep even the mild regulations we’ve put in place.”
While Cyprus is special, it’s not that special. Germans don’t want to bailout Russian depositors, but they also don’t want to bail out anyone. The Spain model isn’t working and the expectation that it will means disappointment. A euro zone mired in recession is not going to be able to out-grow its debt problem with a weak financial system. Those banks needs to be recapitalized, and to avoid the problem of a fractured currency, it needs a banking union, something the Eurogroup has already begun work on. Recognizing reality may make markets nervous, but to solve the crisis, creditors, private or public, will eventually have to pay up.