The EURO countries and the U.S. could have avoided the economic and fiscal mess they are in if their political leaders had been capable of confronting reality and making tough policy decisions.  But policy leadership, not just in the EURO and the U.S., has been absent not just in recent weeks and months, but over the past decade. In fact, there has been a growing gap between credible policy advice and political decisions as ideological divisiveness has spread and strengthened to the point where political institutions, both domestic and international, seem incapable of responding to emerging challenges.

THE EURO MESS

Lets begin with the EURO meltdown and that is exactly what it s. There is a good chance that the EURO we have known for the past decade will not be here much longer.

The current situation is not simply about bailing-out Greece, Portugal and Ireland, and perhaps Italy and Spain, which is important. Rather, it is more about the very existence of the Euro and the weak foundation upon which it was originally built. This is not news to any serious financial or economic analyst in Europe. The reality is that the Euro does not meet the conditions for a common currency and this has been the case from its very beginning. It was always hoped that the conditions would eventually come into place, but they haven’t.  To-day, despite many high-level meetings and treaties, there is no free movement of labor; no free movement of capital; no common banking system; no integrated fiscal/transfer system; and, until recently, no financial market discipline.

The EU was so keen on expanding its EURO membership that it accepted Greece in 1999, when everyone knew that Greece did not meet the conditions for membership. It turned out later that Greece had “falsified” the numbers in order to be admitted, a fact well discussed among EURO countries. A realistic and responsible decision by EU leaders at the time would have been to reject Greece and Portugal as members of the EURO until they met the economic and fiscal conditions.

The second mistake was that major EURO governments and the European Central Bank (ECB) assured bond markets that no EURO country would ever be allowed to fail in meeting its debt obligations. By rejecting debt default as an option, they created the ultimate moral hazard problem. Bond markets could lend to Greece, or Portugal, or Italy at a rate pretty much the same as what they were lending to Germany. With this guarantee, there was little incentive for these countries, beyond exhortation from other EURO countries, to control their deficits and debt or to implement structural changes in labor and product markets needed to make their economies competitive. 

Not everyone was so sanguine about this moral hazard. Serious observers in the EU knew this “free rider” situation was not sustainable, despite numerous meetings of EURO finance ministers and Heads of state committing to reforms that were never fulfilled. Eventually, the gap between strong EURO countries and weak EURO counties could become so large that the strong counties would become incapable or unwilling to continue to fund the weak countries.

Over the past year, and certainly over the past several months, EURO leaders have shown a remarkable inability to introduce credible policies to deal with the crumbling fiscal and banking situations of Greece and Portugal and now Italy and possibly Spain. If more meetings and more talk could solve problems, then based on the EURO record for meetings, there should be no problem in the EURO. Meetings can be productive, however, only if the participants are willing to take a realistic view of the problem; agree to implement the tough political decisions that must be made, and effectively communicate these decisions in a transparent and credible manner.  EURO leaders, together with the ECB, and the International Monetary Fund (IMF) have failed completely in this regard.  They now want to drag the G-7 and the G-20 into their policy failures.

The open feud between the ECB and the leaders of France and Germany over how much burden private bondholders should contribute in any solution to the Greece problem can only be described as embarrassing, and this would be a huge understatement. Now the focus of the bond market has shifted to Italy, the world’s third largest issuer of debt, and a country with a debt to GDP ratio of 120%. The market also has Spain in its sights. The financing requirements for Italy alone are estimated to be around 1.4 trillion EURO and the reality is that neither the IMF and/or the European Financial Stability Fund (EFSF) currently have the resources to bail them out.  

Everyone is scrambling. The ECB has agreed to continue to buy the bonds of Greece and Portugal, Spain and Italy. EURO leaders are now talking about increasing the financial capacity and authorities of the EFSF by even more than originally planned, and/or issuing a EURO bond.  Germany is unlikely to support either alternative without greater fiscal adjustments by debtor counties; a greater contribution by creditors (read banks) to the fiscal adjustment; and, a greater say by creditor countries (read Germany) in approving the budgets of countries with serious deficit/debt problems. This would be a first step towards fiscal integration (read loss of sovereignty), which would never have been considered 12 months ago.

The fact is that over the past decade, the EURO countries have not been willing to take policy actions to ensure the stability of the EURO, because they involved issues related to sovereignty and fiscal integration: two areas where there were opposing entrenched views. The EU wanted a common currency but was incapable of agreeing on the political institutions that would ensure fiscal discipline and the structural changes needed to make a common currency work. For the EURO to continue to exist in its current form, this will have to change. The EURO countries need to be realistic in their assessment of EURO prospects and agree to greater economic and political integration if they want the EURO continue. This will take many years to happen if it happens at all.

But there is more than a fiscal and banking crisis threatening the EURO. There is also a widening gap in internal and external competiveness, which is undermining economic growth and driving a growing wedge between strong and weak countries. Ireland, Greece, Portugal, Italy and Spain need more than simply tough budget actions; they also need renewed economic growth if they are to eventually achieve a sustainable debt framework. This is not going to happen soon or without major internal adjustments. Unfortunately, their economies remain stagnant and the prospects for recovery are remote. Domestic demand is weak and these economies are facing growing trade deficits. The only way to reverse this would be through major reductions in labor costs to bring them into line with those of stronger economies.  

 Expect the next decade to be a decade of uncertainty and upheaval in the EURO.

THE U.S. MESS

Most people, not just in the U.S., but pretty much in the world, are breathing a sigh of relief now that Congress and the President have agreed to an increase in the debt ceiling on the basis of $2.4 trillion deficit reduction plan over the next ten years. We shouldn’t become complacent.

Not unexpectedly, S&P downgraded the U.S. government from AAA to AA –plus: the first downgrade in U.S. history.  The downgrade was based partly on the view that the agreement between Congress and the President fell far short of the $4.0 trillion needed to stabilize the debt-to-GDP ratio within ten years, and partly on the view that the President and Congress were, and will be, unable to come to any sensible policy plan to support job creation in the short term and control debt accumulation in the longer term.   The downgrade was justified as the subsequent political acrimony and posturing illustrated.

No one actually believed that the U.S. would not pay its debt (the Constitution requires that the debt be paid) and bond yields actually fell after the S&P downgrade. What concerns everyone, including debt raters, is the failure of political leaders in the U.S. to show leadership and to take the tough policy decisions that are essential to getting the economy growing in the short term, while ensuring debt control in the longer term. People are concerned that no one in Washington is in control of the country, and this won’t help build confidence.

The U.S. could very well being entering a dark decade of lost growth. The data now show that there has been little recovery from the “great recession”. In the last six months, the U.S. economy has grown at an annualized rate of only 0.8%. There is little, if any, domestic demand growth and certainly no net export growth. Unemployment remains stubbornly high, homeowners are still under water, income disparities are growing, investment in infrastructure is being postponed, and educational institutions are being starved of funds.

People are looking for leadership and hope but neither has been forthcoming. The U.S. has a short-term problem of too little demand and a long-term problem of too much debt.  The U.S. economy is basically stagnant and the recent agreement on the deficit will make it worse in the short term and possibly even in the longer term.

In 2001, the Congressional Budget Office (CBO) was forecasting continuous surpluses for the following decade.  This ended with the election of George Bush who immediately introduced major tax cuts for high-income Americans and also set the U. S. on the long road of two wars and rising military spending. Forecasts of surpluses soon became forecasts of deficits as far as the eye could see.

Economists and financial experts warned that the government’s fiscal situation was out of control and that without major fiscal action the deficit would continue to rise, as would debt and the debt burden.

No one in the Bush administration seemed to believe that rising deficits and debt were a problem. They believed that economic growth would result in lower deficits. After all, the economy hade been growing steadily for almost a decade and unemployment was falling.  Even worse, no one (including the Federal Reserve Board) understood that the expansion was based on unsustainable trade imbalances, non-credit worthy mortgage lending, non-transparent financial instruments, and unlimited and uncollateralized leverage.  The economy was based on a financial house of cards, which came tumbling down in 2007.

The U.S economy has never recovered from the meltdown of the financial sector and now the average American is being asked to shoulder the burden of adjustment, through budget cuts, unemployment, and lost opportunity.

Unfortunately, politics and political institutions in the U.S. have become so paralyzed with divisiveness and acrimony that they are incapable of dealing with the country’s economic and financial problems.

Expect the next decade to be a decade of uncertainty and weak growth in the U.S.

HOW SHOULD CANADA RESPOND?

The government could do nothing. The government could tell Canadians they are better off than other G-7 countries. It could tell Canadians not to worry and stop focusing on short-term stock market fluctuations.  It could tell Canadians that Canada is not an Island in the economic world but growth will continue; and finally it could tell Canadians that that the government is doing the right thing and so they should go back to their barbecues.

This is OK as far as it goes but this strategy is not sustainable in the context of what is happening in the EU and in the U.S.  

There is a better than 50% probability that the U.S. economic growth will remain stagnant for the foreseeable future. This means that economic growth in Canada will also slow from expectations only two months ago. In Canada, the government will become a drag on economic growth as the temporary stimulus in the Economic Action Plan is withdrawn. Consumption will remain low as households rebuild their balance sheets.  Employment income remains weak. Investment will be lackluster as companies protect their liquidity and postpone decisions given uncertainty. In other words, don’t expect much support from domestic demand. Exports will also be a drag on growth.

Could the Canadian government do more to support growth and build confidence? How should the Canadian government respond to these international developments?

These are our recommendations to the Prime Minister and the Minister of Finance.

Tthe government must be pro-active, not reactive. When Parliament convenes in September, the Prime Minister should announce that the government will introduce a new Economic Action Plan to support economic growth and job creation as soon as possible. The Minister of Finance could do this in a fall policy statement.

The New Economic Growth and Job Creation Plan would include the following:

1)     A realistic assessment of the international economic environment and what it means for Canadians;

2)     A commitment to a medium-term fiscal anchor that ensures a declining debt burden for future generations;

3)     A commitment to continue to find the expenditure savings announced in both the 2010 and June 2011 budgets;

4)     A commitment to reallocate these savings from the program expenditure reviews to new initiatives to support research, investment, innovation and infrastructure in a federal-provincial partnership.. It doesn’t matter if the deficit is eliminated in 2014 or 2015 as long as it is eliminated;

5)     A commitment to begin the difficult but necessary process of tax simplification and reform to support efficiency, economic growth and job creation. The government would commit to use the savings (which would be substantial) to lower both personal and corporate income taxes, thereby supporting economic growth and job creation; and finally,

6)     A commitment to quickly reach an agreement with the provinces on the economic and fiscal consequences of the ageing of the population and how the current transfer agreements (which are to expire at the end of 2013-14) will be restructured to meet these challenges.

This Economic Growth and Job Creation Action Plan would remove uncertainty, and strengthen productivity growth and job creation. The government is right to say Canada is better off than other advanced countries, but this does not mean that a credible Action Plan to support economic growth is not needed. This is an opportunity for the government to show real leadership when other countries are failing.