Meltdown Part II: Return of the jitters

Is this Global Meltdown part II? Unsurprisingly, most economists say no: stop that alarmist talk, ignore fresh signs of trouble in Spain, and look at the improving data. But with many countries barely back on their feet after the deepest downturn in decades, the doomsayers see double-dip recession, contagion, market mayhem and no easy way out.

They warn that shares will plummet as investors take stock of the unprecedented scale of a swathe of sovereign debt crises. They see confidence-shattering debt defaults, a eurozone in a perpetual identity crisis and years of financial pain as households ultimately foot the bill for the bailouts ushered through in Meltdown part I.

Others are sceptical and dismiss the latest bout of market turmoil - the FTSE 100 is down 10 per cent from its April peak - as mere jitters or perhaps a correction to more realistic prices. They see the global recovery gathering pace and corporate profits rising. In Europe, they argue, the Greek problems are familiar and containable and, just in the nick of time, the various authorities have put the right solutions in place, from a £750 billion ($1.6 trillion) rescue fund to deficit reduction measures such as wage freezes for Italy's public sector.

"It's true that there are negative dynamics in terms of sovereign risks, in terms of banks, boom-and-bust risks in emerging markets and regulatory uncertainty. But when I look around the world, the fact is the economy continues to gain momentum," says Michala Marcussen, global chief economist at Societe Generale.

"The recovery is here. It doesn't mean there is no risk. But we also have to be careful about getting a situation where we say there's no solution. Even Iceland is still here."

The bears are not so sure there are solutions, at least not any obvious ones. They argue that none of the rescue remedies enacted in the first phase of this crisis - guarantees and recapitalisation for the banking system, public-sector assumptions of private-sector liabilities - can be repeated. In Crisis 2010, there is no obvious candidate to shoulder the burdens that governments took on in 2008 and 2009.

George Cooper, author of The Origin of Financial Crises, argues that Keynesian stimulus - where policymakers seek to stimulate demand to help growth and jobs - was enacted at the wrong time and is now closed off.

"We have cocked up the macroeconomic situation big time," he says.

"If this is the next leg down - and personally I think it is - the problem we have got is that both safety nets are down. You can't fiscally stimulate, and you can't cut rates any more. In the near term, we should expect more quantitative easing as a step to the inevitable endgame of outright monetisation or printing money."

This is a Japanese-style scenario, where the state buys its own government debt, the private sector deleverages, risk on the taxpayer's balance-sheet rises and growth is hampered. When authorities print money to create inflation, there is little good news for households.

"This all has to be paid for by society as a whole. It's either going to be paid for by high tax rates or it's going to be paid for by inflation [outpacing] wage growth," says Cooper.

A time of payback also means slower growth. "What this debt crisis is telling us is that growth over the past couple of decades has been artificially elevated by excess debt and we now have to start paying that excess debt back by having a couple of decades of subdued growth."

After a week in which the FTSE 100 crashed down through the psychologically important 5000 mark one day and soared back through it the next, some market commentators warn that there is more mayhem to come.

RBS strategist Bob Janjuah has issued what he calls an "uber-bear early warning alert". He thinks markets are headed for a "big puke" that could see a major sell-off in America's S&P 500 index, and the euro plunging against the dollar.

"I am deeply troubled by the world and markets," he said. "I know it's not what folks in general want to hear but hopefully you'll understand that I am trying to do my little bit to help."

Janjuah stresses that concerns over sovereign debt have moved from being a future risk to a clear and present problem. Also, he argues that global growth will "slow hard" into the year end as the impact of fiscal stimulus evaporates, and that Greece's woes will drain more money still from northern Europe.

"My fear - as seemingly supported by the political noises out of Europe over the past few days - is that when, come September/October, we all realise Greece is badly failing its budget austerity targets, the politicians in Europe again usurp the sane eco-based voices and keep pumping money/wealth into a bottomless pit," he wrote.

Andrew Milligan, head of global strategy at Standard Life, firmly disagrees. "Yes, it's difficult, but on balance the authorities look to be doing the right things to put it on a manageable basis - with the proviso this is going to take time," he says.

"We do need to step back from some of the day-to-day concern and the large amount of inflammatory statements that have been bandied around by market participants and politicians, some of whom have a position they are trying to talk up or down.

"Nobody doubts there is a fiscal headwind that has already started, and is starting to pick up, and that's why we expect rates to be low for a while. But there is still a difference between slow growth and double-dip recession."

He sees various ways of dealing with the debts that have built up, including sharp rises in exchange rates, austerity measures, inflation and debt restructuring - though this need not be as extreme as some in the market fear.

"There are no magic wands and it is a matter of dealing with the debts case by case," he says. "The question of who foots the bill can only be answered when we decide how we will pay [it]."

However containable Greece's problems may be at the moment, the latest red flag raised in markets has worried even the optimists. Spain, with an economy four times the size of Greece's, is widely recognised as the domino that must not be allowed to fall.

But there are worrying signs, not the least of which was the downgrading of its AAA credit rating by Fitch on Friday, following up a similar move by Standard & Poor's four weeks ago. The country has been hit by a property slump, and with it the breakdown of a sector that once accounted for almost a quarter of the economy. Real estate companies owe about US$300 billion ($444 billion) to Spanish financial institutions.

Spain's commercial banks have so far been among the most resilient in the West thanks to investments in South America and diversified portfolios.

The real strain is in the other half of the financial system, made up of 43 community banks known as cajas, which enjoy tax breaks in return for reinvesting profits locally. They are usually controlled by appointees of local politicians more interested in gaining votes through spending than on keeping the books in check. The Bank of Spain has already seized control of two of them - CajaSur and Caja de Ahorros de Castilla La Mancha.

"This week's failure by the small Spanish savings bank CajaSur has drawn attention to the fact that the Spanish property crash may yet bring bigger casualties," says Jane Foley, research director at Forex.com.

With unemployment above 20 per cent, and draconian budget cuts - including a 5 per cent salary cut for thousands of public sector workers - few believe that Spain will generate enough growth over the next few years to service its debt.

More turmoil may be ahead if the socialist Government of Prime Minister Jose Luis Rodriguez Zapatero cannot reach an agreement on labour reform with the unions, who have threatened to call a general strike. The Government's €15 billion package of cuts squeezed through Parliament by just one vote last week.

The Government has reiterated its solvency and its commitment to pay its debts, but investors want results, not promises. Spain is already being forced into paying higher interest rates to find buyers for government bonds. And the International Monetary Fund, fresh from approving a Greek rescue loan, is urging Spain to liberalise its rigid labour market and reform the regulation of cajas.

Some economists, however, believe Spain is taking steps in the right direction. "Let's stop the drama about cajas: CajaSur was insignificant to the Spanish banking sector [0.6 per cent of banking sector assets] and it was in the offing for a long time," say analysts at BNP Paribas. They argue that taking the bank into administration was "a wake-up call for other cajas to step up their merger plans".

Credit rating agency Moody's has also said that government bank deposits and guarantees to support reform and restructuring in the industry "appear sufficient". There are also some signs that budget cuts are already delivering an improvement in public finances.

If the market manages to move on from Madrid, politicians had better hope it does not turn its attention to the United States, the looming, silent presence in the crisis debate. Economists point out that the US, whose Treasury Secretary Timothy Geithner has just toured Europe to talk about debt, has yet to lay out its own fiscal consolidation timetable.

Tim Drayson at Legal & General Investment Management is worried that a lack of political will to tackle the US deficit will prompt a damaging spike in American bond yields.

"Just the sheer size of the US would have global repercussions," he says. "The focus right now is on Europe. If it moved to the US, it would make what we have seen in recent weeks look mild."

- Observer