Incident

Two largely unrelated but simultaneous incidents–a renewal of the eurozone debt crisis and a precipitous fall in the valuations on the Chinese stock market–have reawakened fears of global financial instability and reminded that world economy is not out of the woods of the crisis that shook its foundations in 2007-08.

Significance

These two developments on opposite sides of the world, mainly unconnected with the recent failure of the G20 summit in Seoul, threaten international confidence in the continuing global economic recovery.

Background

It took Europe’s central bankers a few too many months earlier this year to admit that the Greek budget crisis was not a one-off event but rather a symptom of problems inherent in the eurozone system, especially affecting countries mainly in the “periphery”. (Thus was born the infelicitous acronym PIIGS to stand for Portugal, Ireland, Italy, Greece, and Spain.) The EU finally set up a fund to help resolve possible state insolvencies, but experts question whether it is big enough to cope with a generalized systemic crisis in Europe if more than a few countries need help all at once. Ireland’s admission that it will have to seek resolution assistance for its banks, coupled with recent news that the financial situation in Athens is still worse than yet believed, has rattled the euro zone once again.

Due to European and North American economic stagnation, “hot money” has flowed to Asia since the economies there began to lead the world economy out of the recent global recession. One of the most remarkable examples is the main index of the Indonesian stock exchange, which today is at 3.3 times its level from two years ago. The more widely followed Shanghai Stock Exchange Composite (SSEC), bellwether of the principal Chinese equities market, more than doubled from early November 2008 to early August 2009 before taking a breather and falling back. Because of Beijing’s influence on global demand for raw materials, every move in Chinese fiscal and economic policy and every statistical announcement from Beijing is followed by financial markets as closely as Washington’s.

Bottom Line

European stagnation is unlikely to change despite recent German economic statistics. The housing bubble in Ireland has collapsed, imperiling the balance sheets of the country’s banks, which the government has partly nationalized in response. It is preparing a budget of still greater austerity even as unemployment has risen and wages fallen. But Ireland is hardly the only EU member to do so; indeed, it is only following Greece’s lead from earlier this year. British banks (formally outside the euro zone) are the most at risk from Irish travails. As Irish state debt is under a question mark, a bailout is increasingly called for in an atmosphere of fear of “contagion” spreading to the other PIIGS. The euro itself is seen as ultimately under threat; and Germany, seeking to increase its own exports to buy domestic social peace through higher employment rates, is unwilling and unable to save Europe.

Beijing economic decision makers will continue to put Chinese domestic priorities ahead of international considerations. The SSEC closed Wednesday down nearly 10% in just five trading days after rising just over 20% in the previous six weeks. This decline followed the announcement last week of higher than expected inflation figures in China. Those numbers sowed fears of a fiscal tightening that would put a damper of domestic, and consequently also international, growth. While Chinese leaders will take care to observe the international effects of their domestic economic and financial policies, they will look after their own economic house first of all. The political leadership is concerned to stave off social instability that could result from a dampening of economic growth and concomitant rise in unemployment. Concerns for domestic Chinese equilibrium will take precedence over concerns over the fall-out of Chinese policies on other countries’ economies, even at the risk of a global slowdown that would restrain foreign demand for Chinese-produced goods.

The US economy cannot escape these global financial forces. The interconnectedness of global markets means that the US stock exchanges have been hit by the international jitters; however, domestic instabilities are not absent either. The mortgage crisis remains papered over. The recent rise in commodity prices (across the board through agriculture, industrial metals, precious metals, and beyond) is a nascent bubble driven, among other things, by the effective devaluation of the US dollar, which has fallen roughly 15% relative to other currencies this year and, despite occasional strength, may fall as much as another 20% over the course of 2011. This will continue to drive “hot money” to more prosperous Asian economies and stock markets. It will also guarantee inflation in the US economy while job creation proceeds, but not at a rate sufficient to diminish the number of unemployed plus less than full-time employed plus “discouraged workers,” which continues to grow.