Is the sharp correction in global equity markets forecasting a double-dip recession in the advanced economies? The case for a double dip is a simple one. The argument is that the global recovery was based on unprecedented fiscal and monetary stimulus. Governments and central banks have intervened massively to prevent their economies from imploding.
In the process, private debt, which had clearly risen to an unsustainable level, was converted into public debt. The hope was that since private demand for credit was low, the massive government borrowing would not push up interest rates. For some countries, that hope proved to be short-lived. In Greece and a few other European countries, investors are now demanding much higher interest rates to buy their bonds, because they see that the debts run up by these governments are unsustainable. Harsh austerity measures are, therefore, being forced on such states. The upshot is that growth will falter. It is this worry that is driving down prices in asset markets, as fears of deflation loom large once again.
There are other concerns. Recent economic data out of the US has not been very robust and several leading indicators are past their peaks. Weakness in the housing market persists. In China, the government has been trying to cool down the overheated property market and curbing bank lending. And behind all this looms the threat of financial market regulation, which will add to the cost of credit. In short, financial markets are grappling with a very high degree of uncertainty and this is reflected not just in the equity markets, but also in commodity and credit markets. Inter-bank lending rates have been rising.
So will the second half of 2010 be like the first half of 2009? So far, the markets do not reflect that apocalyptic scenario and the stress indicators are well below the levels reached during the Lehman bust. The core European countries have not been affected. Governments and central banks have also learnt lessons from the Lehman crisis. And the Chinese government may take its foot off the brake if growth slows drastically. But it’s a telling comment on the fragility of the global economy that even a $1 trillion bailout package cobbled together by the European Union and the International Monetary Fund to stem the Greek contagion has not restored confidence. Investors are realizing that while pumping in large amounts of money may address the liquidity problem, it doesn’t do anything for solvency. And the recognition is slowly dawning that in an age of global open markets, Keynes may not have all the answers.
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