The economy still has “major imbalances to unwind,” which will act as a drag on growth for the foreseeable future, says Craig Alexander, senior vice president and chief economist with TD Bank Group.
“In 2009, we experienced the most synchronous global recession of all time,” Alexander says. “In the middle of 2009 there were signs the tide had turned and we experienced global growth in 2010. In 2011, the possibility of a renewed downturn surfaced, but I believe it was overblown. Growth has continued in 2012, but it’s slow and has been frustrating for investors.”
The reason for such a lax recovery is what Alexander refers to as “major market imbalances,” the first of which is the cheap credit that fueled the real estate bubble. The second imbalance is the fact that, traditionally, once a bubble deflates, a period of “purging” occurs where bad bets unwind, something that didn’t happen after the technology bubble burst early in the last decade. And the last imbalance was the result of flawed thinking surrounding the concept “great moderation.”
“In the middle of the last decade, we had a sustained period of low inflation, which led to a sustained period of low interest rates,” Alexander explains. “The theory was this would lead to longer business cycles and relatively shallow downturns and the economy could be goosed with monetary policy. But it didn’t happen. Risk continued to grow and the result was 2008, in which we came very close to a depression.”
It takes time to unwind the imbalances, which is the reason for the slow recovery. Further complicating matters is the fact that imbalances created by policy responses to the crisis must now also be unwound.
“The crisis has revealed structural weaknesses in the system,” he says. “For instance the euro zone had a common monetary policy, but not a common fiscal policy, which has exacerbated the problem.”
Emerging markets, he adds, didn’t have the imbalances of the developed world, so their economies “took off” after cash injections from their central banks. China was one such emerging market, which is now headed for what Alexander refers to as a “soft landing.” If growth falls below 8%, he believes that China will slip into recession. It is currently at 8.2%, and he believes the government is taking the necessary steps to ensure growth remains above that threshold.
Japan experienced a contraction last year due to “mother nature”; the earthquake and resulting tsunami and nuclear crisis.
“Japan will have around 2% growth,” Alexander says. “This will really be a reflection of their rebuilding efforts.”
However, he believes Japan is good investment because of the amount of goods they export to China, especially high-tech products.
Moving on to Europe, Alexander says this is the “number one risk facing the global financial outlook. The risk is still real of widespread government default that could result in a domino effect worse that Lehman Brothers in 2008.
“It is absolutely critical that politicians deal with this problem,” he warns.
He adds that Greece is the “slowest moving train wreck of all time. Greece can be bailed out, but not Italy. There just isn’t enough money. That’s why everyone was so concerned with Italy a few months ago. Policies have been announced to deal with these problems, but they have yet to be implemented.”
Greece will default, he says, it’s just a question of “how much and how ugly it will be. They first announced investors will take a 21% haircut, which is a joke. Then they said 50%, which is a good starting point. Now they’ve said 75%, which is about right.”
The priority is to contain the spread of the crisis to other countries. Germany is not happy about having to bailout Greece, but they will do so, provided something like this does not happen again. Alexander sees this as a positive step, and believes it will happen through some sort of common fiscal policy.
“One other thing to consider is that Portugal is the next Greece,” he says. “If the European central bank doesn’t step up, it’s something the market could fret about.”