No one fell off the fiscal cliff. The euro didn’t collapse. Greece is still in the European Union. The stock markets are rebounding. But are we still in the Twilight Zone?
There is no one more suited at INSEAD to look into the economic crystal ball than Deputy Dean and Economics Professor Ilian Mihov – whose doctoral thesis was completed under the tutelage of (now Federal Reserve Chairman) Ben Bernanke. But when INSEAD Knowledge put the 2013 outlook question to Mihov, what we got were…more questions.
What will happen to the European debt crisis? What will happen in China? He wonders... “Right now the likely outcomes are – how should I say it? – not 'scary', but a slow recovery going into an extended recovery, which is not very satisfactory.”
Mihov pins the global growth at 2.5-2.6 percent for 2013.
He’s not surprised that the U.S. Congress avoided the fiscal cliff because “the entire package of US$600-billion dollars (in cuts and lost revenue) would be devastating for the economy: This budget adjustment is 4 percent of GDP. If spending suddenly shrinks and taxes are increased so that people don’t have disposable income, it is only a guess how far down GDP will go. The problem is not only the direct effect of fiscal contraction, but also the increase in uncertainty associated with a shrinking economy, which may create a sizable multiplier effect on the economy.”
European Debt Concerns
Mihov is more concerned about the European debt crisis. “We have 27 countries that have to agree on issues like the budget for the next six years. Working out this agreement is very difficult, and it seems that very often politicians have their own agendas which are not necessarily consistent with what the social welfare of the country requires.”
But he is hopeful for a fiscal come-back for the European Union if leaders can contain spending on such things as pensions and healthcare. That, he says requires some tough decisions and careful management of change: we live longer so we should be working longer. “Lifespan has now increased to about 90 years,” he points out. “So the issue is when do you retire? You start working at the age of 23, 24 and you retire at 60 (even earlier in some European countries). So you work 40 years to sustain a life of 90 years. That’s not possible! So retirement age has to increase. To put it simply, the age at which you start receiving social security and other benefits has to change. This can be introduced slowly, over the next 10-15-20 years. Of course, these are not popular moves and it is difficult to convince the public that the current system is not sustainable, but there is no way around it.”
Europe’s slow growth is a concern to Mihov – he thinks the continent has what it takes to do better. “Europe is still one of the leading places in the world: Europe has probably the highest concentration of skills and human capital, it has smart people, good companies – innovative and very productive companies, but then at the top you have government policies... Essentially the fundamentals are right, the microeconomics at the firm level work well, and it is sad to see that policy mistakes can derail economies ready to continue their growth.”
U.S. Recovers Slowly
On the U.S. front, Mihov finds recent job and industrial sector data encouraging and believes the country has the potential to continue and even accelerate its recovery. “But we know that the U.S. is not going to return to its potential before 2015 or maybe even later,” he claims. There’s the impact of “Super Storm Sandy” yet to be rectified. The American construction sector and housing market – whose demise led to the current recession - concern him but he believes the Fed “is doing what they should be doing by buying these mortgage-backed securities”.
That action is part of the Federal Reserve’s policy of “Quantitative Easing” (QE), which began in 2008. But will the most recent round announced in September work? “QE I was basically credit-easing in addition to being a quantitative easing move. In a speech at the Jackson Hole conference in August 2012, Bernanke mentioned that the entire QE I and QE II contributed about 3 percent to the GDP growth of the U.S. QE I was focused mainly on increasing the supply of money while opening up stalled credit channels because everything was freezing, everybody was fighting for liquidity, banks were afraid that their depositors would come to them and say ‘Where’s my money? Lehman Brothers failed... how safe are you?’ So the Fed released money into different channels, unplugging them and making them work.”
While he has no doubt that QE I was a major success, he is not quite as enthusiastic about QE II, which focuses on keeping the money supply beefed up by buying only Treasury securities. “I’m much more convinced QE I was a big help for the economy,” opines Mihov. “QE II is much more difficult to evaluate. Overall it worked, but we’ve reached the limit. At this point, the ball is in the hands of fiscal authorities and governments and companies.” Work done by academics and Fed staffers that indicate QE I and II combined lowered bond yields by an un-trivial 120 to 155-basis points. The combined actions also increased considerably the Fed’s balance sheet, from about US$900 billion to over US$2.6 trillion.
Latin America Stars, China Slows
Latin America had a difficult 2012, Mihov believes, but will improve a bit in 2013. Mexico seems to have become Latin America’s star performer. “Exports from Mexico are increasing at a very fast pace,” claims Mihov. “Everybody is saying how Mexico is stealing jobs now from China, replacing China as the exporter of certain goods to the U.S. Chile is certainly a bright spot in Latin America. The potential of these countries is great as long as the policies of the governments support the creation of new businesses, the creation of new businesses and their evolution.”
In Asia, the slow-down in China (granted, to a still-impressive 7.5-8 percent per year) doesn’t worry Mihov because it was an expected deceleration. He says it’s not an entirely cyclical slump but an evolutionary one. “China is converging closer to the frontier, to the rich countries. They have been growing very fast by imitating what advanced economies have been doing for decades, but every additional replication they do is more difficult than the previous one. Therefore growth rates cannot be 10 or 11 percent as before. This kind of decelerations have happened before in other countries – in Germany and Japan and all those other countries that have converged to the frontier.” Mihov is also optimistic about the outlook for Indonesia and the Philippines despite their lacklustre track records.
Calls for Reform
Mihov has a few “fixes” to suggest for Europe and the U.S. In Europe, he’s keen to see interest rates on government debt under control in countries that are doing well but nonetheless turn to bond markets for financing. Paying these higher yields – rather than profligate government spending – is a big culprit in the sovereign debt crisis. Take Italy, for example. “Italy has a primary surplus,” Mihov points out. “They have more revenue than spending but because the interest rate at which they issue new bonds is much higher than the growth rate of the economy, their debt-to-GDP ratio continues to increase. If you don’t stop this then the dynamics become uncontrollable.”
Then there’s the competitiveness issue: what goods and services can a country actually produce and how can the business environment be improved to support this output? You cannot have economic growth without business. “There is no other way to create growth than to have people organising themselves or being organised in a process of production - which is basically to have businesses. The alternative is to have a primitive society: each of us has a couple of cows and chickens and a garden, and each one of us raise them and eat whatever we have back there.”
In the U.S., Mihov would fix the tax code – doing away with the system of tax expenditures, itemised deductions, exemptions, etc. – overturn the system and then lower the tax rate. Not the often-touted “alternative minimum tax” just more clarity. “In Singapore the tax rate schedule is very simple: from zero to 20 percent, with no deductions. I would suggest something very similar in the U.S. - no (or very few easy) deductions but the benefit is that there will be no tax rates as high as 39 or 40 percent either. From this point on you start discussing how progressive such a tax code could be. With a convoluted tax code, it is difficult to see the progressivity of the tax schedule.”
These changes don’t address the spending side of the equation – what those tax receipts are used for by governments. Mihov is an austerity advocate, but believes it is within governments’ charge to kick-start the economy when things get tough. He is convinced that in the long-run there is no alternative to balancing the budget. Persistent deficits like the ones we have had in the past will have to disappear.
A key impediment to the speed of the recovery in Europe and in the U.S. is the current climate of uncertainty. “If uncertainties are removed, then companies will start investing,” Mihov says. “”Looking to the next two, three, five, ten, twenty years, the uncertainty only builds up; it doesn’t go away because the fiscal situation in the U.S. and many other countries only deteriorates in the medium and long run. Whether governments will be able to resolve this uncertainty is a big question: to make an adjustment over the next several years. If we can have that plan then we can convince companies and the public that actually the economy is safe and sound.”