The mar­ket’s trou­bling mes­sage

The Pak Banker - - OPINION - Ashoka Mody

AMID one of the worst mar­ket routs on record, a cho­rus of re­as­sur­ing eco­nomic com­men­ta­tors in­sists that global fun­da­men­tals are sound and in­vestors are overreacting, be­hav­ing like a pan­icked herd. Don't be so sure. Con­sider how wrong econ­o­mists have been about the ef­fects of the 2008 fi­nan­cial de­ba­cle. In April 2010, the In­ter­na­tional Mon­e­tary Fund de­clared the cri­sis over and pro­jected an­nu­al­ized global growth of 4.6 per­cent by 2015. By April 2015, the fore­cast had de­clined to 3.4 per­cent. When the weak last quar­ter's re­sults are re­leased, the re­al­ity will prob­a­bly be 3 per­cent or less. Econ­o­mists are used to lin­ear mod­els, in which changes fol­low a rel­a­tively grad­ual and pre­dictable path. But thanks in part to the political and eco­nomic shocks of re­cent years, we live in a highly non-lin­ear world. The late Dan­ish physi­cist Per Bak ex­plained that af­ter long ab­sences, earth­quakes come in quick suc­ces­sion. A breached fault line sends shock waves that weaken other fault lines, spread­ing the vul­ner­a­bil­i­ties.

The sub­prime cri­sis of 2007 breached the ini­tial fault line. It dam­aged U.S. and Euro­pean banks that had in­dulged in its ex­cesses. The Amer­i­cans re­sponded and con­trolled the dam­age. Eu­roarea au­thor­i­ties did not, mak­ing them even more sus­cep­ti­ble to the Greek earth­quake that hit in late-2009. Euro­peans kept build­ing tem­po­rary shel­ters as the bank­ing and sov­er­eign debt cri­sis gath­ered force, never con­struct­ing any­thing that would hold as new fault lines opened. En­ter China, which briefly held the world econ­omy to­gether amidst the worst of the cri­sis. Just in 2009, the Chi­nese pumped in credit equal to 30 per­cent of gross do­mes­tic prod­uct, boost­ing de­mand for global com­modi­ties and equip­ment. Ger­mans ben­e­fited in par­tic­u­lar from the de­mand for cars, ma­chine tools, and high-speed rails. This ac­ti­vated sup­ply chains through­out Europe.

But China is be­com­ing more a source of risk than re­silience. The num­ber to look at is not Chi­nese GDP, which is al­most cer­tainly a political state­ment. The coun­try's im­ports have col­lapsed. This is trou­bling be­cause it is the epi­cen­ter of global trade. Shock­waves from China can test all the global fault lines, mak­ing it a po­tent source of fi­nan­cial tur­bu­lence. Only China can undo its ex­cesses. Its vast in­dus­trial over­ca­pac­ity and ghost real es­tate de­vel­op­ments must be wound down. As that hap­pens, large parts of the fi­nan­cial sys­tem will be knocked down. The re­sult­ing losses will need to be dis­trib­uted through a fierce political process. Even if the coun­try's gov­er­nance struc­ture can adapt, the re­quired deep-rooted change could cause China's slow­down to per­sist for years. Be­yond China, Europe re­mains the most se­ri­ous fault line. Ital­ian banks are sad­dled with bad loans. As in much of the euro area, au­thor­i­ties had hoped the bank­ing prob­lems would go away. Now, though, the govern­ment will need to bear some of the losses, weak­en­ing Italy's al­ready frag­ile pub­lic fi­nances. At 134 per­cent of GDP, the coun­try's sov­er­eign debt is barely sus­tain­able. Worse, the econ­omy is stag­nant: Per capita GDP is lower to­day than in 1999, when Italy adopted the euro. A coun­try that does not grow can­not re­pay its debts.

Briefly out of sight, Greece and its cred­i­tors are en­gaged in an end­less war of at­tri­tion. The cred­i­tors -- Ger­many in par­tic­u­lar -- re­main mind­lessly com­mit­ted to fis­cal aus­ter­ity, which the bat­tered Greek econ­omy will no longer bear. If Greece ul­ti­mately leaves the euro area, the en­tire cur­rency union could un­ravel. As in China, Europe's fun­da­men­tal prob­lem is an ob­so­lete political and gov­er­nance struc­ture. Man­ag­ing so many na­tions in a semi-hi­er­ar­chi­cal sys­tem un­der Ger­man hege­mony can no longer work. The con­tin­u­ing tragedy of the refugee cri­sis may be the unan­tic­i­pated but fi­nal blow. One rea­son the tremors have per­sisted so long, and are in­flict­ing so much dam­age, is that the pri­mary driver of bet­ter liv­ing stan­dards -- pro­duc­tiv­ity growth -- has been ex­ceed­ingly weak. In turn, per­sis­tent eco­nomic dis­tress is weigh­ing heav­ily on vul­ner­a­ble pop­u­la­tions, fo­ment­ing anger and forc­ing some­times dis­rup­tive political change. Fi­nan­cial mar­kets of­ten do get things wrong. But they are bet­ter than econ­o­mists in sens­ing non-lin­ear­i­ties, the crit­i­cal junc­tures where fun­da­men­tal shifts oc­cur. Pol­i­tics, eco­nom­ics, and fi­nance are threat­en­ing to move the tec­tonic plates. This is a bad mo­ment to look the other way.

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