A NEW self-assurance has spread through financial markets. The MSCI index of global stocks is up by more than 7% since the start of the year and by almost 20% since early October. Bond yields in Spain and Italy, the two biggest of Europe’s embattled peripheral economies, have fallen to their lowest levels in three months. Greece’s fraught negotiations with its creditors have dulled the rally this week—but only a bit. Given that a huge sovereign default could occur in scarcely more than a month, there is strangely little nervousness.
Why the exuberance? In part it reflects genuinely good economic news, especially in America, where January’s far stronger-than-expected employment figures, along with upbeat statistics from manufacturing and services, suggest that recovery in the world’s biggest economy really is gaining momentum. The cheerier mood is also based on a belief that the European Central Bank (ECB) has vanquished the worst dangers for the single currency with its massive provision of three-year liquidity to the region’s banks. Calamities that seemed all too plausible a couple of months ago, such as the collapse of a big European bank or a series of failed bond auctions leading to the imminent fracturing of the single currency itself, now seem highly unlikely.
In addition, the market rally is a natural reaction to the fact that central bankers have doubled down on their commitment to cheap money. The Federal Reserve recently made clear that it does not expect to raise interest rates until the end of 2014, much later than expected. The Bank of England, which was due to meet on February 9th after The Economist went to press, is likely to launch another round of bond-buying. The ECB, which meets the same day, may cut rates again soon.
Will the good news last? Recent history suggests caution. A year ago America’s economy was widely expected to accelerate, boosted by the Fed’s second round of bond-buying. Instead growth slumped, pulled down by a combination of outside shocks (higher oil prices as a result of the Arab spring, disrupted supply chains after the Japanese earthquake) and policy errors at home and abroad (wrangling over America’s debt ceiling and the ever-deepening euro mess).
Too soon to celebrate
America’s economy is in better shape this time, not least because households have reduced their debt further and the housing market is closer to a bottom. But the euro zone’s debts are bigger than ever; many of its economies are in recession. And the list of potential spoilers is uncomfortably similar to that of a year ago. Tensions with Iran could spawn a 2012 oil shock. Meanwhile, the risk of policy mistakes remains worryingly high on both sides of the Atlantic: central bankers may have saved the day, but politicians could still mess things up.
In America that could happen because good economic news, oddly enough, reinforces partisan gridlock. With unemployment falling and optimism rising, both Republicans and Democrats in Congress have less incentive to set aside election-year posturing. The most imminent decision is whether to extend the payroll-tax cut and unemployment insurance, both of which are set to expire at the end of February. Failure to extend them might not kill the recovery, but would surely weaken it. Far more dangerous is the budget debacle looming later in the year. Under current law the Bush tax cuts expire on December 31st and a slew of automatic spending cuts kick in. Together they would amount to a fiscal tightening of almost 4% of GDP, more than enough to drag the economy down again. At the same time America needs a credible plan to fix its medium-term finances, a plan that would include tax reform and measures to rein in spending on health care and pensions. The political calendar makes all this hard enough. A stronger economy will tempt politicians to even more partisan rigidity.
The dynamic is not dissimilar in Europe, where the ECB’s bold provision of liquidity has calmed nerves and limited the severity of the bond crisis and the recession. The trouble is that the ECB’s success has reinforced Germany’s conviction that its preferred solution to solving the single currency’s underlying problems—namely, a hefty dose of austerity for all—is the right one. A lasting solution for the euro will require a more balanced approach, one which includes a greater focus on growth. Unfortunately, today’s calm makes it less likely that German politicians will countenance such a shift, with the result that the euro zone’s troubles will fester.
It may sound churlish to dwell on the potential for politicians to spoil the party when, at last, the news is better than expected on both sides of the Atlantic. Sadly, based on the recent past, it’s plain prudent. This newspaper will be ready to celebrate only when politicians, and not just central bankers, start making the right choices.
http://www.economist.com/node/21547242
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