As a result of the recent elections in France and Greece the latest mantra among European leaders is that their policies have to change from austerity to growth. There is one problem. One has to wonder what exactly do they expect to use to stimulate growth? There are two standard ways. One would be to try and stimulate their economies using fiscal policies. They could either cut taxes to encourage people to spend or the governments could increase spending on government programs. Both would stimulate the economy, but for most European countries these two options are out because they already have exceptionally high debt.
Another way to stimulate growth is to use monetary policy by cutting interest rates or more exotic programs with less proven records like quantitative easing. These might work except that all of the countries have already used these tools. Interest rates are near zero and the European Central Bank pumped a trillion euros into the European economy over the winter.
Perhaps the best way to promote growth would be to require structural reform and limit government over regulation especially of the labor market. But this has two problems. First it would take time to show results and second no self respecting European would ever continue working after the age of 62 or give up their spa leave. So it is politically impossible. So Europe's policy makers and central bankers are trapped. Without viable solutions, Europe will be subject to an inevitable slowdown. Not to worry, emerging markets will save us.
Since the beginning of the great recession in 2008 the emerging markets have been the engines of the global growth. With youthful populations, relatively low debt levels and expanding middle classes, these countries seem set to drive global growth indefinitely. But there is a problem. Despite the happy predictions of analysts and economists all over the world, no economy can escape from business cycles and some of the economies in emerging markets are showing distinct signs of stress.
While inflation is not an issue in the developed world, it is in many emerging markets. One of the worst is Vietnam.Vietnam is one of the fastest growing countries in Asia. Its GDP increased by over 8% a year from 2003 to 2007. While it has slowed recently, it is still expanding at 6%, a rate that would be the envy of most governments. Sadly the price to pay is Asia's highest inflation rate. Last year it topped 20% for the second time in three years.
Turkey and Poland are two large emerging markets on the periphery of Europe. Unlike Greece and Portugal, these two countries have been growing rapidly. Poland did not even experience a recession. Turkey declined in 2009 but bounced back to growth over 8% for 2010 and 2011. Both countries have benefited from large investments in foreign capital, but both countries have large exposures. Turkey is now running a scorching inflation rate of 10.4%. But the real problem is its current account deficit in excess of 10%. This makes Turkey vulnerable to capital flight.
Poland's inflation rate is only 4%, but the Polish Zolty just won the month of May currency depreciation contest, which will no doubt increase the inflation rate. Poland is also heavily dependent on its exports especially to Germany. So it is not only exposed to European problems but also problems in one of Germany's largest trading partner, China.
It is not just the smaller emerging markets that are experiencing problems. India's economy is slowing. The Reserve bank of India (RBI) felt secure enough in March to try and stimulate the economy with its first interest rate cut in three years. Sadly the RBI's actions were premature. Inflation increased from 6.89% in March to 7.23% in April, so any further monetary stimulation is probably not in the cards.
And then there is China. China's growth, upon which much depends, is definitely slowing, perhaps more than investors expect. What investors do expect is that if China slows, the government will step in and use its control of the economy to get it restarted. But like other countries China is also limited in it policy responses. New loans or ending real estate market restrictions would lead to more unaffordable empty houses and increase the mountains of bad debts.
While investors around the world wait breathlessly for the next stimulus from governments in developed countries and emerging markets alike, the reality is that government policy options are quite limited. They cannot undertake a fiscal or monetary policy to make things better without making other things worse. European stimulus wouldn't ignite inflation, but it would exacerbate sovereign debt problems. Most emerging markets don't have the debt problems, but they do have severe inflation, which has to be tamed. The paradox is that the one policy that politicians will not follow is the one policy that would actually work, the path of true reform. Without true reform the slowdown will be global.