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Global macro & geopolitics from a small economy perspective

Thoughts on the agenda for 2012

David Skilling
6 January 2012

2012 agenda

To kick off the year, this special, extended edition of the Observer reflects on developments during 2011 and offers some perspectives on what is likely to be on the agenda in the developed world in 2012. 2011 was an eventful year, with several major natural disasters, the Eurozone crisis and the sovereign debt challenges in the US, weak growth and turbulent financial markets, the withdrawal of US troops from Iraq, and much else. But to me the big theme from 2011 was the increased visibility of the deep structural issues in many advanced economies, due to the ongoing effects of the crisis, intense globalisation, and the rapid global re-ordering – and the growing awareness that structural changes were required across advanced economies to restore competitiveness, redefine the social contract, and respond to a changing global environment.

Across the developed world, the impact of economic and market forces on countries means that political economy is back. Debate on the state of economic and political models in advanced economies will become increasingly prominent during 2012, with consequential action likely. To make this more concrete, this note identifies five themes from 2011 that provide insight into where the debates – and government action – are likely to focus in 2012.

1. Government, markets and society
Issues of income distribution, social mobility, and unemployment assumed a much higher profile in 2011. Income inequality is at very high levels in countries like the US, median real incomes have gone sideways in many developed countries, and unemployment has increased sharply since 2008. These are not all new issues, but debates seem to resonate particularly in 2011. One example of this was the various ‘Occupy’ protest movements, an initially inchoate expression of concerns that the gains from growth have not been fairly distributed.

Increasingly tension is being observed between economic forces/market pressures and the existing terms of the social contract. Globalisation, and particularly the increased importance of emerging markets, has brought many benefits – but has also placed advanced economies under much greater competitive pressure. The economic pressures faced by households are likely to become even more pronounced in 2012 in an environment with slow growth (and where debt cannot be used to the same extent to prop up consumption). The difficulty of course is that policy answers are not straightforward; fiscal constraints make redistribution difficult, disengagement or protectionism is costly, and choices are constrained by an intensely competitive global environment. But, that said, many existing policy approaches will come under increasing pressure, and history suggests that something will have to give if these issues are not addressed. So governments in 2012 (and beyond) will need to start the hard conversations about the role of government, and develop a policy agenda to ensure their countries can compete successfully and that there is a sustainable social compact. For governments on both the left and right, new ideas are needed on how governments and societies should best respond to a revolution in the global system. To the extent that necessity is the mother of invention, we are likely to see the beginning of a period of innovation and creativity in what governments do and how they do it.

2. Can democracy deliver?
Time Magazine named ‘The Protestor’ as its Person of the Year for 2011, in recognition of events like the Arab Spring and the political protests in Russia. But this push for democracy, also seen in countries like Burma, is less in evidence in developed countries. Political decision-making institutions are under real pressure in the developed world; the US political system is widely seen as dysfunctional, the European Union’s decision-making processes (and those of many European countries) are struggling, and concerns are widely reported that hard decisions are increasingly not being taken (or that poor decisions are being made) across many developed country governments. For varying reasons, governments are struggling to respond to the challenges and opportunities they face.

In response to these concerns about the effectiveness of democratic institutions, people in many advanced economies are increasingly looking to technocrats to make the decisions and take action – examples include the newly appointed Italian and Greek governments, and the increasing reliance on the central bankers at the ECB or the Federal Reserve. And it is more common to hear praise of autocratic or managed forms of decision-making relative to liberal democracies. Unsurprising perhaps: history indicates that periods of prolonged economic strain can lead to dissatisfaction with democratic processes and undermine political institutions. These issues are likely to become more pronounced in 2012 given the challenges that developed country governments will face. Changes are needed to ensure that democracies can function effectively and command legitimacy; technocracy is not likely to be a sustainable fix. One important part of this is for governments to demonstrate that they are up to the task, both by providing political leadership – finding ways to have hard conversations about these structural issues – as well as developing and delivering a credible policy agenda to respond, which emphasises longer-term priorities as well as crisis management. Without this leadership, 2012 will be bumpy for many elected governments – and developed countries will be exposed to greater political and policy instability.

3. The pivot
While the developed world struggled to generate growth in 2011, growth in emerging markets continued. China overtook Japan to become the #2 economy in the world, more growth is now coming from outside the developed world than from inside, and the global population topped 7 billion driven by population growth in the developing world. The increasing heft of emerging markets, particularly in Asia, has been underway for some time of course. But 2011 was notable for the political response to this global re-ordering. Perhaps most notably, the US responded to the increasing weight of Asia, and particularly China, with the so-called pivot away from the Middle East – partly symbolised by the withdrawal of US troops from Iraq – to allow it to focus more attention and resource on Asia and the Western Pacific. There was a flurry of US activity in the region in late 2011; the expansion of the East Asia Summit to include the US, the extension of the Trans-Pacific Partnership, and the announcements by President Obama in Australia in November regarding an increased military presence. Another sign of the changing global order in 2011 were the discussions between the EU and China regarding Chinese financial support in the context of resolving the Eurozone crisis; in September, Premier Wen delivered what read like a creditor’s speech in this regard, listing a series of issues on which European concessions were wanted. And China is increasingly investing in European assets, reshaping its economic relationship.

To a much greater extent, global economics is driving international relations. This matters not just for the big players – the US, the EU, and China – but for many other developed countries that are seeking to balance their dominant economic relationships (increasingly in Asia) with their traditional political and security relationships (in the West). This tighter nexus between economic and security interests is creating strategic challenges for many, particularly in the Asian region, and will make 2012 a more complicated year – as developed countries seek to manage the ongoing pivoting of their economic and security relationships.

4. National politics in a global economy
2011 was not a great year for multilateral or collective approaches to addressing global issues. The G20 Summit in Cannes was dominated by regional, not global issues, achieving little of real substance despite the initial aspirations of the hosts. The G20 will limp on now to Mexico for its next meetings. The climate change negotiations in Durban achieved some, but not much, progress – and the stark differences in national perspectives are clear to see. The Doha Round continues to circle, with no real expectation of a meaningful conclusion. Europe, as good an example of shared sovereignty as we have, is trying to resolve the Eurozone crisis in the context of marked differences in national interests. And the many domestic challenges described above are likely to lead to a relatively inward focus rather than a focus on global issues (as well as it being election season in many countries in 2012, such as the US, China, France, and Russia). Global governance is a long way off.

Globalisation – and some global cooperation – continues, but it is a messier, more fragmented process. The global economy is becoming a much more managed domain as countries seek to advance and protect their interests. This will change the way in which countries deal with each other; the reliance on FTAs will likely continue, and we should expect more bilateral dealing on issues like food and energy security. The continuing development of regional architecture in Asia will emphasise the regional flavour of the global economy. And because the rise of major new stakeholders is complicating the task of making multilateral progress on global issues, we will see greater emphasis on bottom-up arrangements of coalitions of the willing. It seems likely, for example, that a sub-set of European countries will look to introduce a financial transactions tax soon. 2012 will likely see innovations in the nature of global engagement by countries as governments try to reconcile the reality of the global economy with another reality – that all politics is local. For small countries particularly, this will be a more challenging operating environment.

5. A less resilient world
Much was written during 2011 on the likelihood of a double dip recession, a hard landing in China, and the implosion of the Eurozone. As it was, the developed world muddled through with weak growth. My central estimate is that we will see something similar in 2012; subdued growth in Europe but management of the Eurozone situation, very slow recovery in the US, supported by positive contributions from emerging markets. The financial crisis will continue in slow motion. This is not great, but in itself it is not a disaster. The problem is that there is a wide distribution of possible outcomes (as one example, consider the differing views on China’s economic outlook), that shocks are very possible, and that most developed countries have much reduced resilience. And of course this estimate is contingent on making some progress on the issues discussed in this note; failure to do will create greater downside risk.

The world remains highly inter-connected: the effects of a marked slow-down in growth in China, problems in a major banking sector, political turbulence, or a pandemic, would radiate quickly through the global system. The advanced economies are not well positioned to absorb further shocks, given the stretched state of government balance sheets, loose monetary policy settings, and the likelihood of sluggish domestic growth. This suggests that an increasingly important policy debate in 2012 will be how to balance the priorities of managing the current stresses (e.g. through fiscal stimulus) and building resilience against future shocks (e.g. by strengthening the fiscal position). Debates about the pace of fiscal consolidation will likely become more pronounced in this regard, as they already tend to be in smaller, advanced economies. Again, the challenge is balancing the shorter-term demands of crisis management and the longer-term structural priorities. This reduced resilience also means that governments are increasingly likely to seek to manage other economic risk exposures (e.g. energy and food security, capital flows) through a range of deliberate actions (as Switzerland and Japan did with respect to exchange rate intervention in 2011).

Overall, I am neither hugely pessimistic nor optimistic about the outlook for developed countries in 2012. Rather, my sense is that 2012 will be a highly challenging year across the developed world, and responding to the emerging environment will require much hard work and thinking by governments and others. But advanced economies have responded to structural changes previously, and I see no reason why they can’t this time as well. It is true that current course and speed is not that encouraging, but that can be changed. Time to get to work.