At first sight, there is little to connect the ugliness in China and Greece. The former reflects the unwinding of a market bubble; and the latter is driven by weak and deteriorating economic and financial fundamentals. Yet both share a common element, and they are not the only ones: They have benefited from the ultra-loose experimental policies that have been pursued by major central banks around the world.
Global equity markets have not been doing well lately, and understandably so. With the Chinese stock markets crashing and Greece risking a disorderly exit from the eurozone, a growing number of investors have decided to take some chips off the table -- and this despite frantic efforts by government, both in China and in Europe, to stabilize things. Some investors are even worried that this may be the moment in which asset prices, having been inflated by experimental central bank policy, revert back to the lower levels warranted by the more sluggish fundamentals (such as economic growth rate, inflation rate and unemployment rate).
Facing a frustratingly sluggish economic recovery after the 2008 global financial crisis and possessing considerable political autonomy, western central banks took on massive macro-economic policy responsibilities, and not because they wanted to but rather because they felt they had to -- other policymaking entities, with much better policy tools, were essentially sidelined by political dysfunction.
The only way these central banks could pursue higher economic growth was by artificially bolstering the prices of financial assets. They did so on the hope that buoyant stocks markets would make people feel richer and therefore entice them to spend more (what economists call the "wealth effect"); and that this would trigger companies' "animal spirits," leading to higher corporate spending on plant, equipment and people.
The more western central banks invested in this policy approach, the greater the pressure on other central banks to also adopt more simulative policies. The collective policy response succeeded in bolstering asset prices worldwide; but it was a lot less effective in engineering an economic lift off -- thus inserting a notable wedge between financial asset prices (high) and fundamentals (sluggish).
Such a wedge could eventually close in two ways: in a good way, in which fundamentals improve and validate prices; and a less good way, whereby prices revert down to levels warranted by the weaker fundamentals. And those of us analyzing this great decoupling worried about the potential of a shock taking place before fundamentals had time to improve -- one caused by a policy mistake and/or a market accident.
Now, the Greek situation risks delivering the former, and China risks providing the latter.
Greece and its creditors have been locked in protracted and acrimonious negotiations. There has been no shortage of European leaders' summits, Eurogroup gatherings of Finance Ministers and technical meetings between Greek officials and the "institutions" consisting of the European Commission and the International Monetary Fund. Yet all have failed in delivering on the four necessary outcomes: comprehensive structural reforms, less and more intelligent austerity, debt forgiveness and sufficient external financing. Meanwhile, the situation on the ground has gone from bad to worse.
With banks closed for more than a week now, the Greek economy is imploding in a disturbingly accelerated fashion. Economic activity is grinding to a halt and tourism is falling fast. Shortages of goods are emerging, including fuel and other imports. Capital controls are in place seeking to counter the flights of euros still in the country. ATMs are running out of cash. A growing number of small businesses is nearing bankruptcy. All of this fuels an already-alarming unemployment crisis, with about 50 percent of the youth currently unemployed.
Meanwhile in China, the authorities have felt virtually powerless as an eye-popping stock market boom, which had sucked in more and more citizens (including those using leverage to buy stocks), has turned into a crash. And the more stocks fall, the greater the investor rush to the exit -- despite big efforts by the government to put a floor under the market.
How about the future?
The global system has the ability to manage through each of these shocks, though not without some stress. It could even handle them both together, provided nothing else goes wrong. Yet success is not guaranteed. It requires much better coordinated and more comprehensive policy responses. And should such responses continue to struggle, asset prices will converge down towards the lower levels warranted by fundamentals, thus ending the great decoupling between the prospects of advanced and emerging economies.
