The financial meltdown has left many wondering whether governments did too much, or not enough. It also leaves the essential question, what's next?
By Stuart Green, HSBC Bank Plc.

The more excitable may talk of economic Armageddon having been averted, but a prolonged spell in the financial wilderness certainly threatened the major economies last year.

Due to the nature of the current crisis, conditions across both the financial markets and the real economy were always likely to prove more intertwined than usual, and both areas have seen substantial improvements in recent months. Although still subdued, risk appetite has made a welcome return, credit conditions have staged a cautious recovery and measures of both business and consumer confidence have bounced off exceptionally low levels. At the very least, the so-called "negative feedback loop" (where deteriorating financial conditions and economic weakness threatened to feed upon each other with growing ferocity) now appears to have been stemmed. Considering the gravity of the situation confronting policymakers in the dark days of last autumn, such positive developments should not be downplayed.

But given the extent to which activity collapsed around the turn of the year, it could also be argued that the progress seen to date across the various economic data releases could yet prove to be the "easiest" part of the recovery, with the hard part of any broader return to health yet to begin. Having fallen by 30 percent over the year through May, Japanese industrial production has a long way to go before a number of significant monthly gains would look anything like a healthy level of output.

An uneasy truce
As a result, an improving cyclical picture and underlying structural concerns could easily coexist during the summer and autumn months. During the short term, concerns will naturally focus on the ability to sustain the rise in activity once the impetus provided by a stabilization of the inventory cycle fades. But on a more medium to longer-term perspective, one of the more pressing tasks for both policymakers and investors appears to be determining what may constitute the new "normal" in post-bubble conditions and, more fundamentally, how such assumptions will influence perceptions of trend growth within the major economies.

The aggressive approach adopted by policymakers last autumn has presented investors with issues that will beguile for many years to come, while the worst excesses accumulated during the "boom" years may be difficult to work off during the "bust." The need for possibly painful structural adjustment, both within and outside of the financial sectors of the major economies, and the threat of more onerous regulation, now loom large. What lies in wait over the economic horizon, therefore, remains a source of major anxiety.

Reshaping the future, and the past
Financial crises have a nasty habit of not only lowering expectations of the scope for future growth, but also re-shaping the assessment of earlier growth and the factors that drove this. From a historical standpoint, estimates of trend or potential growth rates are typically extremely vulnerable during the current stage of the economic cycle, as each of the drivers of the earlier upturn (and their likely longevity) are subjected to ever greater scrutiny. What appeared to be a modest and sustainable expansion at the time may eventually be deemed a credit-fuelled, asset-price-inflated boom, which was always doomed to failure. Comparisons between the present day and 1990s Japan perhaps are now slightly commonplace, and the messages that they provide are at risk of being overlooked as a result. But one of the more salutary points must be the manner in which estimates of the productive potential of the economy were successively downgraded as the expected recovery failed to emerge.

Clearly, the prospect for a further rise in household sector indebtedness within the major economies (and the stimulus this provided to consumer spending) now appears wholly dubious. This is due not only to the apparent willingness of individuals to pay down debt levels, but also because of the impaired ability of the financial system to facilitate further increases as securitization markets remain subdued. The degree of adjustment seen in the U.S. household sector to date has actually been fairly quick, reflecting among other factors the extraordinary decline in policy interest rates of the past year, and the equally dramatic fall in oil prices. But the lesson from earlier financial crises, which may yet be replicated elsewhere, is that once underway, this process of adjustment can be prolonged, painful and extremely disruptive to the establishment of a broader economic recovery.

Assuming the burden
Undoubtedly the key concern around the medium-term outlook is that large parts of the developed world will be weighed down by private and, increasingly, public sector debts, leaving economies delivering sub-par growth until the level of indebtedness has been lowered to more sustainable rates. It is of course important to remember that the often large-scale government intervention in financial sectors over the past year may not automatically lead to increased fiscal burdens. But the very volatile conditions across government bond markets have recently served as a powerful reminder of the fiscal challenges that now await many economies. Estimates of future government debt levels have, to put it bluntly, experienced something of a rout over the past 18 months, with the International Monetary Fund (IMF) now forecasting the 2014 debt-to-gross domestic product (GDP) ratio of the major economies to be some 36 percentage points higher than that registered in 2007 (See chart, right).

Both the discretionary fiscal packages and the fiscal implications of economic downturn have proved hugely costly. But the ultimate bill facing taxpayers around the world will remain unknown for years to come due to the government guarantees that have been extended to the various corners of financial markets. Given the looming demographic challenges, the current financial crisis and the "lost" output (and therefore tax revenues) it implies have proved exceptionally poorly timed. Indeed, persistently higher government borrowing and a skyward trajectory of debt-to-GDP ratios could yet prove the most visible consequences of the credit bust and economic collapse of the past 18 months. As long as government bond yields remain below nominal GDP growth rates over the longer term - something that still appears more likely than not – this increased indebtedness is not clearly or technically unsustainable. But the dynamics around government finances will remain extremely troubling over the medium term.

Difficult decisions will need to be made with regard to expenditure and taxation, while new sources of demand for government paper will need to be cultivated. Governments may be presented with a very different set of incentives with regard to matters such as inflation and exchange rate stability than markets have become accustomed in recent decades, while what appear to be unconventional policy measures today could become all too familiar as the fiscal challenges mount. Indeed, should the perception of public finances deteriorate sufficiently, fiscal policy itself may lose some of its current efficacy, requiring ever greater government interventions to produce the desired objective and, presumably, result in ever larger economic distortions.

Despite all the developments of the past year, therefore, it is still possible that the most formidable challenges may lie ahead, and that the more demanding questions are yet to be answered. It now seems likely that the worst outcomes that threatened last autumn have been averted, but it is far from certain that a solid, durable recovery will emerge over the coming year or, when abstracting from the cycle entirely, just what economic underpinnings remain. Following the extraordinary journey of the past 12 months, financial markets could yet discover that it is often better to travel than arrive.

Stuart Green is senior global economist in global banking and markets, at HSBC Bank plc.

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