Five Economic Trends to Watch in 2012

Authors: Gary Burtless, Senior Fellow, Economic Studies, Brookings

Institution, Brookings Institution
A. Michael Spence, Distinguished Visiting Fellow
Yukon Huang, Senior Associate, Asia Program, Carnegie Endowment for
International Peace
Thomas Philippon, Associate Professor of Finance, New York University Stern
School of Business; Ashley Lester, Executive Director, Head of Market Risk
Analytics, Morgan Stanley
Jacob Kirkegaard, Research Fellow, Peterson Institute for International
Economics
Interviewer(s): Christopher Alessi, Associate Staff Writer

December 27, 2011

Amid an uncertain global economic climate, six economics experts identify the
most important trends to watch in 2012, with uncertainty being a recurrent
theme.
The Brookings Institution's Gary Burtless identifies U.S. political polarization
and the subsequent lack of a strong and coherent policy response to the current
economic slump. CFR'sMichael Spence pinpoints global volatility, with the center
of risk in Europe. The Carnegie Endowment's Yukon Huang says China's growth
trajectory would be lower in 2012, and its economic policies tested when a new
generation of leaders takes power.
NYU's Thomas Philippon and Morgan Stanley's Ashley Lester say 2012 will be
defined by investors searching for safe assets, and their choices will have
consequences for global economic growth. While the Peterson Institute's Jacob
Kirkegaard believes that greed will, in fact, trump fear--at least in the eurozone.

Gary Burtless, Senior Fellow, Economic Studies, Brookings Institution,

Brookings Institution

Political Polarization and the U.S. Economy

The president, the entire House, and one-third of the Senate face reelection next
year. The choice of a governing party, if one party gains control of both the White
House and Congress, could have enormous consequences for the economy. The
increasing partisan and ideological division between the two parties constitutes
the single most important influence on future economic policymaking.
In dealing with business cycles, Republicans and Democrats once called plays
from the same playbook. Richard Nixon famously remarked, "I am now a
Keynesian in economics"--a position that had long been embraced by Democrats.
If we believe current Republican leaders, it seems plain they have moved a long
way from Keynesian prescriptions for the economy. An increasing majority of
Republican leaders rejects once-standard remedies for a slump. Their preferred
remedies for stagnation now include hard and low ceilings on public spending
and another round of deregulation, strategies firmly rejected by Democrats. The
deep divide between the two parties has made it hard to select and implement a
consistent policy response to the slump.

We face the possibility that a political impasse will leave the government
without a budget for essential federal functions and without the borrowing
capacity to fund normal operations.

Congress and the president may be able to settle on a budget and to staff most of
the crucial positions in government. However, the budget may not fund the
implementation of laws enacted by previous Congresses (such as the health
reform law), and the Senate may leave critical [federal] positions unfilled. We
face the possibility that a political impasse will leave the government without a
budget for essential federal functions and without the borrowing capacity to fund
normal operations. The nation has entered an era of policy uncertainty, which
will continue unless one party or the other gains unquestioned electoral
ascendancy.

A. Michael Spence, Distinguished Visiting Fellow

Global Volatility

The main trend in 2012 is volatility, with the preponderance of extreme

macroeconomic risk on the downside. It is a two scenarios environment with
roughly equal weight, with the center of global risk located in Europe.
In one scenario, core Europe succeeds in stabilizing the sovereign debt markets
through reform programs in key countries like Italy, supported by direct
intervention by the European Central Bank in sovereign debt markets to prevent
a yield run-up from turning a manageable fiscal and growth challenge into a
solvency problem. In the other scenario, the EU argues about fiscal
centralization, while the yields run up, undermining bank capitalization, reform
momentum, and, ultimately, the stability of the eurozone.
In the first scenario, the United States experiences slow growth and high
unemployment, without much policy action until after the presidential election,
leaving the fiscal stabilization, growth, and employment largely unattended, and
structural adjustment in the hands of the private sector without much public
sector investment or support. Emerging economies settle down to near pre-crisis
growth patterns and remain the incomplete growth engine of the global economy.

Virtually all of the risk stems from uncertainty about bold policy action and
coordination within and among advanced countries.
In the second scenario, the core eurozone begins to come apart leading to sharply
negative growth, then transmitted to the United States' fragile recovery and to the
emerging economies in terms of headwinds and reduced growth, because of a
sharp fall-off in external demand.
Virtually all of the risk stems from uncertainty about bold policy action and
coordination within and among advanced countries. As the probabilities attached
to political gridlock shift, expectations about market and economic trajectories
will move with them.

Yukon Huang, Senior Associate, Asia Program, Carnegie Endowment for

International Peace

China's Rise Under Stress

History will note that 2012 marked China's shift to a slower growth trajectory and
the anointment of its "fifth generation" of leaders. This comes at a time when the
country faces formidable internal and external challenges.
Slower growth of around 8 percent will reduce policy options, but could be better
for China and the world. More sustainable outcomes will placate popular
concerns [in China] about increasing disparities, corruption, and environmental
degradation. And, if [China is] more consumption oriented, [it] will ameliorate
global trade tensions.
Many, however, foresee an economic collapse from a prolonged eurozone crisis,
while others believe that Beijing can avoid a sharp downturn. But with weak
financial institutions and its infrastructure-led growth model under attack, it may
not have all the tools to achieve its goals.

With weak financial institutions and its infrastructure-led growth model under
attack, [China] may not have all the tools to achieve its goals.

Domestically, an increasingly active middle class is generating pressure for more

accountable governance. But, motivated by the Arab Spring, the system has
moved aggressively to contain any social discontent that might spark more
politically sensitive movements.
Externally, China's rise is seen as having stimulated nationalism. Beijing's
belligerent responses to overlapping maritime claims have elevated tensions and
driven its neighbors to support a stronger U.S. presence. The potential for
conflict will force China and the United States to redefine their respective roles.
Asian countries can delineate the boundaries of influence for these two powers
but given their varied interests, alliances will shift with circumstances.
China must walk a very narrow line at a time when its outgoing leadership is
reluctant to take any far-sighted decisions.
Thomas Philippon, Associate Professor of Finance, New York University Stern
School of Business; Ashley Lester, Executive Director, Head of Market Risk
Analytics, Morgan Stanley

Shortage of AAA Assets

Blaming speculators and irresponsible creditors for the successive financial crises
since 2007 is edifying and partly true, but the recent booms and busts might have
more to do with the search for safe assets than with the search for risk.

Two-thousand-and-twelve will witness a widening gap between the preferences

of savers and the needs of borrowers.

Unlike the Internet bubble, the household and sovereign credit boom was fueled
less by dreams of fabulous growth than by the promise of safety. Financial
engineering was supposed to turn risky mortgages into safe-as-houses, AAA-
rated bonds;similarly, the euro was supposed to turn previously irresponsible
countries into paragons of German fiscal discipline.
With those illusions shattered, 2012 will witness a widening gap between the
preferences of savers and the needs of borrowers. Savers will look ever harder for
safe assets as risks in the world economy loom larger. Alas, the safety they buy
will likely be as illusory as the safety of AAA subprime debt.
The reason for this is the paradox of safety. Borrowers repay debt more easily
when they have more income, that is, when the economy grows. But economic
growth comes from people taking risks. If savings do not go to risk takers, growth
will stall, and even the safest borrowers will turn out to be risky. In economics,
just like in cycling, static safety is an illusion. The only way for the world economy
to remain safe is to keep pedaling, and take some risks.

Jacob Kirkegaard, Research Fellow, Peterson Institute for International

Economics

A New Appetite for Risk

Accelerating financial market panic has, since late 2009, gradually pushed the
euro towards the point where today an increasing number of observers openly
question the survival of the common currency. During the crisis, it has been
evident how the European political response has been reactive, timid, and first
and foremost too slow, to successfully restore confidence.
The new trend to look for in the euro area in 2012 will manifest itself in
financial markets rather than in the political realm.
Considering the ongoing political divisions among European countries and the
constant demands for cumbersome democratic validation in (at least) seventeen
member states of any decisions taken, it seems unlikely that elected leaders will
be able to fundamentally change this dynamic.
The new trend to look for in the euro area in 2012 will manifest itself in financial
markets rather than in the political realm. At some point, the economic
fundamentals of the euro area--as well as the messy [policy responses of] its
governments --will have ensured that market fears surrounding, for instance,
[high-yielding, but risky] Italian government debt will be surpassed by the greed
of yield-hungry investors.
Investors will begin dumping safe haven, but extremely low return (indeed
substantially negative and wealth destroying when accounting for inflation)
German bonds, and instead purchase higher yielding, but no longer that risky,
Italian bonds. At that point, Italy will begin seeing its interest rates decline,
reducing the need for new austerity and potentially swinging its and the entire
euro area economy from the current "bad equilibrium" to a better one.

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