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Global macro & geopolitics from a small economy perspective

The gathering storm

David Skilling
27 April 2012

Over the next few years, many advanced economy governments will confront growing pressures to return to fiscal sustainability, to strengthen competitiveness, and to redefine the social compact. This will be economically and politically demanding, and creates the potential for a more volatile, less open global environment. This stormy global weather is likely to be particularly challenging for small countries. So this week’s Observer reflects on the potential global impact of these hard choices as well as the implications for small countries.

Kicking the can down the road
The challenges facing governments are well-documented: deleveraging, including substantial fiscal consolidation; structural reform of the economy; addressing unemployment and inequality; and so on. But despite the noise over the past few years, the reality is that outcomes are not much improved. At best, only modest deleveraging has occurred in the large developed countries; household debt has reduced in only a few countries (such as the US, where it is easier to walk away from mortgage debt). And in many cases reduced private sector debt has been offset by increased sovereign debt. The structural fiscal consolidation is still to take place; the IMF estimates an average improvement in the fiscal balance of 8% of GDP is required across the advanced economies. Even the UK’s aggressive fiscal plans have not yet halted the increase in public debt. In addition, significant structural reforms to strengthen competitiveness have not yet been made. And income distributions have worsened over the past few years, as unemployment has increased.

The absence of progress on structural issues is perhaps unsurprising, with the primary focus on managing the immediate pressures of the crisis. And relative to some expectations, this effort has been reasonably successful; although the crisis is far from solved, the Eurozone is intact and there has been no generalised slump. ‘Kicking the can down the road’ is often used as a term of criticism, but the complexity of the challenge – and the options open to decision-makers – means that this was a reasonable approach. And national deleveraging is a long, difficult process in the context of sluggish growth and widespread deleveraging across many advanced economies. But many developed countries are now in an increasingly difficult situation: many structural issues are as yet unaddressed; some of the short-term measures – such as quantitative easing and stimulatory fiscal policy – cannot be continued for much longer; and governments are encountering political problems even before making the more substantial adjustments. The uneasy calm will not last, and hard(er) choices will need to be made.

The politics (and economics) of austerity fatigue
The emerging political discontent in Europe, the US, and beyond, that is associated with sustained austerity, high unemployment, and so on, makes it hard to see that the scale of change required is feasible (witness the French Presidential race, the US primary season, the fall of the Dutch government). Governments will struggle to deliver the changes that economists and markets say are necessary. My sense is that it will be increasingly difficult for governments to maintain the current trajectory because of a combination of political forces, economic realities, and financial market pressures. Governments are likely to find it more difficult to deal with the chronic medium-term issues than the acute phase of the crisis.

Given that imposing losses on their populations is not an attractive option, those governments that are able will seek to allocate losses elsewhere. There are a few, related options in this regard. First, acting to lower the value of the exchange rate in order to improve competitiveness. There are already examples of deliberate exchange rate intervention, the US and China are both criticised for their monetary and exchange rate policy settings, and the Brazilians talk about ‘currency wars’. Second, increased push-back to globalisation as countries seek to boost domestic growth and employment; perhaps some trade protectionism, but also foreign investment restrictions and attempts to create national champions. And third, ‘financial repression’, in which the burden is transferred from debtors to creditors by reducing the real value of the debt (e.g. negative real interest rates, requirements to hold government stock). The weakening multilateral system means that these behaviours are less likely to be constrained by international rules, creating potential for volatility and a less open system.

Safety in numbers
Many small countries have done well in achieving fiscal consolidation and structural adjustment (with some well-known exceptions like Greece). Small countries tended to have lower debt and stronger competitiveness, but even those small countries that did get into problems (e.g. Iceland, Estonia) were able to undertake relatively rapid internal adjustment. But small countries are heavily exposed to the behaviour of other countries. And the emerging challenges described above create substantial risks for small countries. The potential for both misalignment and increased volatility of exchange rates, increased friction in the relatively open global system (that has benefited small countries disproportionately), and financial market turbulence, pose substantial challenges for small countries.

Small countries will need to continue to run prudent policies (e.g. current account surplus, low public debt) to reduce exposure, and also act to strengthen their competitiveness. But they will need to do more than just run a tight ship. Being a small, independent country may be increasingly uncomfortable. Increasingly, small countries may need to look to regional and other groupings in order to ‘bulk up’ on dimensions ranging from market access to capital flows, and exchange rate arrangements. It is instructive that there are only a few small countries that have free-floating, independent currencies. It is easy to regard the Eurozone as a failed currency experiment, but several small European countries remain on the waiting list for the euro (in order to manage their currency exposure). These trends may reinforce the regionalisation of the global economy, and lead to new groupings emerging as well as pressures on existing groups. A creative, flexible approach to external strategy will be increasingly important for small countries in this more challenging global context – finding ways to combine the benefits of small national size with the benefits of larger economic groupings.