Why the West is in disarray

Europe's divisions and US' political dysfunction mean that they are the two biggest threats to the world economy, writes Claude Smadja

For almost three years now, the scenario has been the same: a much-vaunted European summit announces some decisions that are supposed to provide a silver bullet to solve the crisis; the media salutes it as significant progress or even as a 'turning point', while the markets breathe a sigh of relief and go quiet for while; then the backtracking starts, and we are back to where we were before.

The last European summit, in June, was supposed to have decided that the European Stability Mechanism would use its euro 500 billion to help directly recapitalise banks in distress, once a euro-zone banking supervisor authority was established.

The agreement for such a banking supervisory authority was supposed to happen by the end of the year. Guess what?

Since June it has become clear – Germany's dictates – that the funds of the European Stability Mechanism will not be used for retroactive recapitalisation, and that the Mechanism will be used with strict conditionality, only for new banking loans turning sour.

This means that it will be almost useless in addressing the current acute problems of the Spanish banking system.

Then Chancellor Angela Merkel let it be known that there was no possibility whatsoever that an agreement on the Banking Supervisory Authority would happen by the end of the year.

The only solace in this all-too-familiar scenario is that the European Central Bank has, in September, declared itself ready to purchase an almost unlimited number of government bonds -- with strict conditions attached -- thus bringing down interest rates and allowing the governments of embattled euro-zone countries to get new loans at affordable terms.

The beauty of Mario Draghi's decision -- taken against the adamant opposition of the governor of the German central bank -- is that it has so far calmed the markets and kept down interest rates without the ECB having actually to buy bonds.

If one can appreciate this welcome respite, this does not however get us any closer at the moment to a genuine solution of the European political, economic and financial crisis.

The differences in approach between France, Italy, and Spain on the one hand and Germany, Finland, and Holland on the other are starker than ever.

Any pretence that the Paris-Berlin axis -- until now the basis and driver for European integration -- still exists has now disappeared, and the gap between Germany's and France's economic weight and political priorities continues to grow. In the meanwhile, the economic situation continues to deteriorate throughout the continent, with levels of indebtedness relative to GDP increasing instead of decreasing.

France is due to reach 10 per cent unemployment by the end of the year, and Italy, Spain, Portugal -- not even mentioning Greece, which is in a free fall -- are sinking ever deeper into recession and joblessness.

France joining the recession club in 2013 now looks unavoidable, and Germany -- for all the vaunted robustness of its economy -- will be lucky to achieve zero growth.

In fact, whatever the forecast about additional shrinking or stagnation of economic growth in the coming period, another question is looming larger and larger: and that is, how long will Southern Europe's political structures be able to withstand the increasing social and political dislocations created by ever-rising unemployment – especially among the youth -- and ever deteriorating living conditions?

Even the International Monetary Fund has now recognised that the blind pursuit of deficit and debt reduction targets was creating more harm than good, and that it was, in fact, aggravating the situation and lessening the chances of recovery.

This, and the absence of any significant results from the harsh austerity medicine inflicted at tremendous cost to the economic and social fabric of the countries involved, is seemingly not enough to deter Berlin from its "redemption through pain" recipe.

In fact, there is a semblance of a rationale behind this apparent blindness -- and that is from the fact that, for Chancellor Merkel, the imperative to solve the European crisis has taken second seat to the dual priorities of winning the next elections in the fall of 2013 and sealing the Berlin consensus in Europe -- in other words.

"German Europe".

You may put these dual priorities in whatever order you choose, as they are complementary in the eyes of Ms Merkel.

The problem is that no significant country, let alone no economic bloc, can today commit economic suicide without endangering the international economy.

So, Europe's situation is now the number one risk for the global economy in 2013. As if this were not enough, the situation in the US now constitutes the second most important risk for the economic outlook next year.

If no political compromise is achieved in the US Congress by the end of this year or in the early days of 2013, the US economy will be buffeted by two compounded shocks: the ending of two categories of tax reductions -- and thus tax increases -- and the automatic, across-the-board budget reductions of more than $100 billion a year.

If it were to come into effect because of political paralysis, this "fiscal cliff" would presumably bring the US economy back into recession or at least to zero growth next year, with easy-to-fathom consequences and ripple effects for the global economy.

Of course, reason dictates that a compromise will occur; however, the present dysfunctionality in the American political system means that we are in for some nail-biting moments at the end of this year. General Electric, for instance, announced this week that it is refinancing in advance $5 billion of bonds to protect itself against the possible turmoil of a fiscal cliff.

It is a sad but telling irony that the two economic regions that were in the past not shy of patronising and giving lessons on economic governance to the rest of the world are today the ones whose irresponsible behaviour is putting at risk the global economy.

Once the shocks and aftershocks, and all the lessons, from the 2008 crisis are absorbed, and once, hopefully, much-needed changes in economic and financial structures will have taken place, what history may retain from the 2008 crisis and its aftermath is how it has put an end to whatever claims of legitimacy the Western powers -- Europe and the US -- may have made in the past to telling other countries how they should be managed, or run their economies.

The writer is president of Smadja & Smadja, a strategic advisory firm