Your Global Economic Mess Is Now Being Served

If there were an official anthem for the European debt crisis, it would be Lady Gaga’s “Bad Romance,” and not just because the pop star croons a few lines in French and chants the name of a continental capital. The once slow, now increasingly fast-moving economic disaster unfolding across the Atlantic is best understood as a really, really dysfunctional relationship.

As Harvard economist Ken Rogoff puts it, “Europe is like a couple that wasn’t sure they wanted to get married, so instead they decided to just open a joint checking account and see how things went.” They went badly. Germany, the thrifty partner, is wringing its hands about how to handle the fact that its Mediterranean lover has drained the account and doesn’t want to go on a budget. The southern European attitude is pretty well summed up in Gaga’s lyric “I want your everything as long as it’s free.”

This bad romance will reach a turning point this summer as Europe finally decides whether it wants to break up or get married. But in the meantime, friends and family haven’t been immune to the turmoil. The most recent, abysmal U.S. employment figures–about half as many jobs were created as was expected–were explained in part by the fact that big American companies have been hit by weakening growth in the euro zone, since sales there make up a significant chunk of their revenue. And in the U.S., Congress failed to come up with a growth plan after the stimulus money ran out. There’s also uncertainty about whether Europe’s banking crisis will migrate to American shores. At the same time, the fast-growing emerging markets of China, India and Brazil that have buoyed the global economy over the past couple of years have started slowing down too, which has affected U.S. exports.

These three regions–the U.S., Europe and the emerging markets led by China–make up the legs of the stool that is the global economy. Since the financial crisis of 2008, we’ve dealt with two broken legs at once (the U.S. and Europe)–but not all three. That has economists very worried, so much so that some are saying there’s a serious chance, perhaps as much as 40%, of a double-dip recession in the U.S. by year’s end if things don’t change. “Left to its own devices, the U.S. economy would continue to exhibit rather anemic growth and low job creation,” says Mohamed El-Erian, head of Pimco, the world’s largest bond trader. “But the stronger the ill winds [from abroad], the higher the risk of another recession.”

Certainly, markets are roiled; the Dow Jones industrial average regurgitated nearly 300 points, and European and Asian indexes plummeted. But within that turmoil, an important fact has gone largely undiscussed: this global slowdown is synchronized in more ways than one. Not only are the fortunes of the world’s major markets and economies still very much tied together, but the root cause of their problems is the same: dysfunctional politics.

There are economic solutions available that could calm markets and help countries avoid the risk of a double dip; what’s lacking is the political will to implement them. Europe, for example, needs a real fiscal union, true political ties that bind and an effort by its strongest nation, Germany, to lead that process of deeper integration. So far that hasn’t happened, and both Europe’s politics and its financial system are balkanizing. “There hasn’t been a Lehman moment,” notes Mike Mayo, a banking analyst from CLSA, who famously called the last meltdown. The prospect of immediate catastrophe is often edifying. But without that, the response has been incremental and ineffectual. Greece totters. Spain withers. Italy dithers.

And growth in Asia is no longer a given to offset weakness in the rest of the world. China is trying to stick a finger in the dike with a new stimulus program to sustain growth till the end of the year, when new leadership will take charge of the Communist Party Politburo in Beijing. But like the U.S. stimulus since 2009, it’s a quick fix; what’s really needed in China is an entirely new growth model, one predicated on consumer, rather than government, spending. But the Chinese leadership, whose vulnerabilities have been exposed by the Bo Xilai scandal, is reluctant to rock the boat of vested economic interests. (Many of China’s wealthiest families are tightly connected to the Communist Party, which is loath to derail the real estate boom that has made them rich communists.)

The U.S., for its part, has decent economic fundamentals–consumer debt is down, spending is up, the housing market is bottoming out, and a homegrown gas boom is creating jobs and will eventually make energy a lot cheaper. But then there is the partisan politics. Economists are already fretting over a fiscal cliff-hanger at the end of the year, when Bush-era tax cuts and payroll-tax cuts will expire at the same time Congress has to bicker about another raise to the debt ceiling. As Bank of America’s Ethan Harris noted in a recent report, history will likely repeat itself with a policy-induced soft patch for a third year in a row, creating an economic drag that could shave an entire percentage point off GDP growth. It’s still a 2% economy.

Omnishambles

In Europe, where recession is now baked in for 2012, 2% growth would elicit cheers. Chaos there is such that there’s a new word, omnishambles, in the British lexicon to describe a situation in which an apparently carefully crafted policy stance unravels in a bewildering number of directions, leaving all affected parties in a state of shock and despair. During one particularly spirited parliamentary debate, British opposition leader Ed Miliband used the word to describe Prime Minister David Cameron’s latest budget.

But it’s perhaps better used to describe European efforts over the past two years to save the euro. The European crisis, said hedge-fund titan George Soros in a recent speech, is “not a financial but a political one.” The crisis is growing not because of underlying, unsolvable economic issues but “because of a failure to understand the dynamics of social change” in Europe–namely, that the half-measures of unity that worked when the euro was created in the boom days of 1999 became woefully inadequate once global growth ground to a halt nearly four years ago. Now it’s every nation for itself, a scenario complicated by a shared currency.

Germany, the strongest European Union economy, has been pilloried for its reluctance to back Eurobonds whose risk would be shared by euro-zone members. The Germans are also taking heat for insisting that debtor nations like Greece submit to backbreaking austerity budgets. But you can understand the German point of view–why give a blank check to spendthrift nations like Greece when you have no political control over how they spend it?

Yet the bottom line is that the half-measures have failed to settle markets and turned a debt snowball into an avalanche. Soon, Greece may vote to reject the next round of austerity, which would begin the dreaded “Grexit” from the euro zone. While that wouldn’t be such a big deal, since Greece accounts for just 3% of the euro zone’s GDP, Greece wouldn’t go alone. Spain, which is 13%, is teetering too, as are Portugal and Italy. More important, investors have begun to understand that even a euro zone without its weakest members can’t survive without real political integration. “Without that, the euro is just fundamentally unstable,” says Rogoff.

The China Challenge

The really unnerving feature of the global economy is that the emerging markets are slowing too. Even China, which has become a second global growth engine after the U.S. since the financial crisis, seems shaky. For the past two decades, investors have pretended that there was no political risk in the Middle Kingdom, but recent events have made it clear how wrong that assumption was. The fall of Bo–the former party head in the sprawling western Chinese city of Chongqing who has been accused of torture and whose wife is accused of murder–has set off a major political scandal in China and underscored how flawed the country’s growth model is.

The Chongqing model, which is the national norm, stresses hyperdevelopment of real estate and greater power for state-owned enterprises. It’s fraught with vested interests, environmental degradation and growth that has been called “unsustainable” by the country’s own Premier, Wen Jiabao, who has also warned that China is in for another Cultural Revolution if it doesn’t embrace both economic and political reform.

That means not only raising Chinese salaries and encouraging consumers to spend but also giving a more entitled and educated middle class greater civil liberties. An odd turn of the market in early June highlighted the links between those two issues when the Shanghai stock index fell 64.89 points, a number recalling the date of the Tiananmen Square crackdown, June 4, 1989. The event was picked up and used as a rallying point by democracy protesters online; government censors quickly swung into action and barred searching the topic.

But just as it’s impossible to implement any real reform in an election year in the U.S., so it is in China. Worried about an abrupt slowdown that might create higher unemployment and social unrest before the new Politburo takes power, the Communist Party has introduced a new stimulus plan, one predicated mainly on the same old kind of growth. While there are a few steps to boost private consumption–like a one-year scheme to subsidize the purchase of energy-efficient appliances–it’s mostly business as usual, with a lot of big infrastructure projects that are helping fuel a real estate bubble that makes Florida and Arizona look tame. “Prospects that the Chinese economy will soon be put on a more sustainable, consumer-led footing look remote,” says Capital Economics’ chief Asia economist, Mark Williams.

From Bad to Where?

The most rational actors in all of this may be the Americans, who have done a respectable job of getting their personal debt loads down since the financial crisis and have slowly begun spending again, which is one reason the U.S. economy is in better shape than Europe’s. But that consumer recovery is still delicate, to say the least. And job growth is anemic, which restrains wage growth, so incomes are flat. According to the Economic Cycle Research Institute, income growth over the past three months has been lower than it was at the start of the past 10 recessions. That’s what this “recovery” looks like. The result is that the U.S. economy is “as sensitive to external shocks as I can remember it ever being,” says Jim O’Neill, Goldman Sachs’ chief economist.

There will likely be plenty more shocks in the long, hot summer ahead. The next three months will bring a resolution, one way or another, to the euro-zone crisis. Soon, the Greeks will either vote to continue with austerity measures or else break from Europe, reissue the drachma and begin the first chapter of a new, volatile post-euro era. If that happens, the value of the euro and any new currency would surely plummet, and social unrest would soar.

European leaders are frantically working to come up with a last-minute solution to avoid a Greek exit, a Spanish banking meltdown and a broader euro breakdown, like allowing some bad European debt to spill over into a giant communal pool that might be paid at a later date. But markets aren’t buying it. It’s clear that they want a guarantee that Germany and the Bundesbank (via the European Central Bank) will write a very large check to cover whatever the bad debt of Europe turns out to be.

The Germans, in turn, want assurances that they’ll have some control over how their neighbors spend in the future–assurances that have become trickier since Franois Hollande won the French presidential election and made it clear that France isn’t keen to give up its fiscal independence. Most economists, spooked about another Lehman event, are holding out hope that European leaders will come to some sort of epiphany and get their act together to save the euro.

As Lady Gaga might sing in her best French, Faites vos jeux. Place your bets. The 2% economy is looking like the best-case scenario for the U.S. this year. If Europe fails to step up to its crisis, the consequences will be much, much worse. “If the euro falls apart, the U.S. would go into a double dip, and it wouldn’t be a small one,” warns Rogoff, sharing the consensus view. As everyone knows, the only thing worse than a bad romance is a nasty divorce.