Fiddling while Europe burns

Economic models and projections are incapable of capturing the scale of the threat to Europe’s and the world’s economy.

Economic forecasts are sophisticated, computer- generated mathematical constructs. They are only as good as the data and assumptions that are fed into them: rubbish in results in rubbish out.

For more than a decade the most widely used forecasts have more or less ignored the financial sector, the activities of investment banks and stock markets, and foreign exchange, bond and derivatives trading, at a time when these financial-sector businesses have come to dominate day-to-day economic activities.

This simple fact helps to explain not only why the transatlantic economies are in such dire straits, but also why the numbers in the economic forecasts that the European Commission will publish for the European Union today (15 September), that the Organisation for Economic Co-operation and Development (OECD), the rich countries’ think-tank, issued last week, and that the International Monetary Fund (IMF) will release next week, are of so little value.

They did not predict, and cannot capture or explain, this summer’s traumatic collapse in consumer and business confidence, and the crushing of the “animal spirits” that the British economist John Maynard Keynes identified as one of the great forces driving economic activity.

The Commission and IMF forecasts will suggest, as the OECD’s figures did, that the stuttering transatlantic economic expansion of the past two years has shuddered to a halt. Today, there is much talk about whether or not Europe and the US are on the brink of a ‘double-dip recession’, a second part of the so-called ‘great recession’ that began in 2007, and whether they are facing what Stephen King, chief economist at HSBC, has called “an economic permafrost”.

This, believe it or not, is an optimistic version of events. Senior eurozone officials are already using the word “recession” to describe what lies ahead for Europe. Privately, they and the financial markets worry that Europe’s sovereign-debt crisis could unleash something much worse.

If the eurozone sovereign-debt crisis leads to a disorderly disintegration of the euro, they fear that the next downward leg in the performance of the transatlantic economies will not be a dip but rather a plunge that will lead the historians of the future to describe our era, in a phrase redolent of the 1930s, as the ‘second great depression’.

So, at a European Central Bank press conference last week (8 September), an emotional Jean-Claude Trichet, the ECB’s president, passionately defended his institution’s record and signalled that it was back in full-on crisis-management mode.

The next day came an eruption that confirmed just how deep are the divisions in the eurozone over the sovereign-debt strategy, and how close the single currency is to imploding. After a week of ill-tempered debate within the ECB, which helped to explain Trichet’s outburst, Jürgen Stark, the ECB’s chief economist, announced his resignation.

In London, just before the Stark bombshell, Christine Lagarde, the head of the IMF, on her way to a crisis meeting of Group of Seven finance ministers and central bankers in Marseille, issued a call for co-operative action. “Countries must act now…to steer their economies through this dangerous new phase of the recovery. The world…is collectively suffering from a crisis of confidence in the face of a deteriorating economic outlook and rising concerns about the health of sovereign [borrowers] and banks,” she said.

Chillingly, she warned that “the scope for policy action is considerably narrower than when the crisis first erupted” in 2007-08.

American anger

Just when a show of G7 unity was needed, Tim Geithner, the US Treasury secretary, decided to use the Marseille meeting to let long-simmering US frustration boil over in public, blaming Europe for the crisis of confidence.

He has a point. As Rome and Athens have fiddled in their negotiations for a eurozone bail-out, Europe has been burning: oblivious Finland has been nit-picking over the bail-out terms, and eurozone governments have been mulling over the details of the yet-to-be-approved 21 July plan to strengthen the debt strategy.

No wonder that Julian Callow, the chief European economist of Barclays Capital, and one of the most measured commentators on the single currency, declared: “September is likely to be the defining month for the euro’s destiny.”

The divisions within the ECB and the eurozone are understandable, for the economic policy challenge is truly perplexing.

If Congress agrees, the US, thanks to President Barack Obama’s new budget proposals, will have opted for more fiscal stimulus. But is this the way forward for Europe with its stronger social safety net? Britain seems to be heading for more unconventional monetary stimulus, anathema to hard-money advocates at the ECB, not least because they doubt its efficacy. Most analysts, including Trichet, seem to have concluded that the eurozone needs much tougher instruments to enforce fiscal discipline on miscreant members. But time is running out and political procedures in the EU and the eurozone are proving too time-consuming.

The search is on for an initiative to reduce the crisis-management burden on the ECB. One option being closely examined is to turn the official bail-out fund, the European Financial Stability Facility, into a bank. Officials who have looked at the details believe that this could be done without legislation in the 17 eurozone states.

Perhaps it is not surprising that economists at the Swiss bank UBS chose this moment to put together some figures estimating what might be the cost of a eurozone break-up. For a weak country leaving the single currency, they put the burden in the first year at a massive 40%-50% of GDP. For a strong country, such as Germany, the figure was 20%-25% of GDP.

Their methodology has been attacked and their results dismissed as too pessimistic. But these estimates are too low, so closely entwined are the transatlantic economies and especially their banking systems, so fragile are the world’s financial markets, and so vulnerable are the Asian economies.

The disorderly disintegration of the single currency would be another body blow, not only to the transatlantic region’s economic performance, but also to the already tarnished image of the West’s model of capitalism and to the global political influence and prestige of the US and Europe. Economic models cannot capture these effects either.

Stewart Fleming is a freelance journalist based in London.