Postcards from Old Europe – Reality Check

I’ve found that it does one good to take a step back from the onslaught of data releases and to focus on what one could call the “big picture”. While decomposing the latest payroll data has its merits one should not forget that every figment of data is but a little thread in a broad tapestry of current events.

I’d like to use this post to share my view of the big picture with you. The major elements that make up my medium term view of the economic situation (and capital markets) are US interest rates, the trajectory China finds itself on, the price behavior of commodities and geopolitics.

Interest Rates

Classical methods of determining the “neutral” Fed Funds rate such as the Taylor rule come to the conclusion that the Fed should remove policy accommodation briskly. The only problem is that the Fed isn’t really buying coventional wisdom at this point in time. I think they are correct. The current US economy is not on a normal recovery path.

Massive doses of fiscal and monetary pump priming have served to resuscitate the economy at the cost of inflating bubbles in asset markets. The current weakness shown by leading indicators are portents of an economic slowdown in the second half. Having said that, I believe that the Fed will not hike by as much – or as fast – as the consensus seems to think.


China watchers fall into two camps at the moment. There are those who believe that the Chinese government will engineer a measured slowdown of economic growth while the other group is looking for the slowdown to turn into a hard landing. The Chinese economy is still for all intents and purposes a beast which is firmly ruled by the hand of the government. Policymakers have flexed their muscles and have engineered a visible slowdown in growth already.

This was mostly achieved by exerting direct controls on capital markets such as credit restrictions on certain industries. The problem is that this doesn’t do much to alleviate China’s real problem: the massive influx of foreign direct investment. So while the US is grappling with unsustainable deficits, China is fighting against unsustainable surpluses. The line between slowdown and crash is rather fine and depends as much on policymaker’s choices as it does on the behavior of foreign investors.


Right now this means “oil”. Simple story here: high oil prices constitute a drag on economic performance. Prices of most other commodities have moderated – a process which was helped along by the slowdown in China and of course by a reduction in speculative long positions (our friend, the carry trade).


The most talked about political event is the US presidential election in November. I’m not all that sure that it is the most important with regard to its economic implications. The next administration will probably not engage in fiscal austerity measures – regardless of the party affiliation. The other thing to keep in mind is that control of the White House does not equate to control of Congress. Even if Kerry should manage to win the election he would still face an uphill battle if he attempts to repeal the Bush tax cuts.

Europe is a different story. Elections in major European countries are still pretty distant and governments have settled firmly into survival mode. The ECB is becoming ever more frustrated by the slow pace of structural reforms while governments seem ever less likely to pursue deregulation or – perish the thought – moderation with regard to spending.

Political Japan has turned somewhat shaky over the past couple of weeks as the ruling LDP has weakened in polls ahead of Sunday’s upper house elections. Markets expect Prime Minister Koizumi to resign if the LDP does very badly and this is taken to mean a slowdown or even stop of reform.

The way ahead

I’m pretty sure that the aspects mentioned above will exert their influence on economic events ahead. The caveat is of course that everyone knows that we could be in for any number of positive or negative surprises from other factors that are not even on the radar screens yet. What do you think the future will bring? I invite you to use the comments to your heart’s content.

See you next week. Remember to visit CurryBlog for regular postings on capital market related issues.