Hope or Continued Uncertainty Darden Experts Track the Global Economy

06 April 2012

The news reports seem positive. Jobs are coming back to the U.S. economy. Yet some economists are scratching their heads over why.

The gross domestic product usually outpaces job growth after a recession, and that’s not happening. Some say this is a warning sign; others say there is room for optimism. Across the Atlantic, the 17 countries belonging to the euro zone approved a second bailout for Greece and, perhaps more importantly, the European Central Bank (ECB) began to act as a lender of last resort by instituting operations that allowed euro zone banks to shift problem debt to the central bank. Some believe this will help the euro zone get on a more sustainable track, while others say the union will dissolve because, were it to remain intact, Greece and other periphery countries would be doomed to a life of austerity. University of Virginia Darden School of Business Professors Alan Beckenstein and Frank Warnock share their national and global perspectives, asserting the U.S. economy is getting what it needs to recover while cautioning that the euro zone could derail progress.

For the euro zone, Warnock looks to the theory of optimal currency unions that advances three causes for the success or failure of currencies. They include:

  • Whether countries holding the same currency are linked by trade
  • Whether they have natural ways to limit size and frequency of member-specific shocks
  • Whether those countries can alleviate shocks when they occur

“On the first point, the euro zone passes the optimal currency union test. But in the other areas, the euro zone doesn’t measure up,” says Warnock. “While countries in the euro zone are linked by trade, their structures aren’t similar enough to limit member-specific shocks. They also, unlike the U.S., lack a mechanism to alleviate shocks when they do occur.”

According to Warnock, if the damage is limited to Greece, many of the problems from a troubled euro will stay within the euro zone. However, if more European countries become affected, the crisis would have a much broader reach and spell trouble for the U.S.

“What’s troubling is that we can’t know for sure if the consequences for the U.S. will be mild or catastrophic,” Warnock says.

Warnock also examined China’s growth and the state of the U.S. dollar. Most emerging market economies (EME) saw a rise in capital inflows (or foreign funds for investment) during the bubble years. When the bubble burst, the inflows stopped. According to Warnock, the surge in capital flows resumed this past year, forcing upward pressure on many EME currencies.

“EMEs responded by resuming their buildup of foreign reserves, which caused an increase in inflation in many countries,” says Warnock. “China tightened monetary policy to slow its economy and tame inflation. A big question is whether China’s landing will be a soft one.”

For the U.S. dollar, it is so far down that things might be looking up, according to Warnock. Against the euro, the dollar has strengthened and can further strengthen with a strong inflow of foreign direct investment.

While America is now on the mend, the picture is only slightly better.

According to Beckenstein, the structural remedies that prevented the current recession from being worse have had secondary effects that work against establishing a new growth plan.

“Let’s call them legacy effects,” says Beckenstein. “We need to examine whether the government’s rescue efforts will affect future spending behavior and create more bubbles.”

In addition, Beckenstein cites that GDP growth is steady, although slow, and while there is real job growth behind the unemployment numbers, those who have been out of work for a year or longer exist in alarmingly high numbers. Their skills are quickly eroding.

Beckenstein predicts that by the end of this year, the GDP will grow by 2.1%; core inflation will grow by 2%; unemployment will decline to a yearly average of 8.1% (but 7.7% by the election); and the Dow Jones Industrial Average will close at 12,900, with volatility of over 1,750 points during the year.

“For true progress, there needs to be a new consensus around economic growth — one that focuses on investment and productivity, wealth creation not based on speculation, and balancing the budget,” says Beckenstein.

Warnock and Beckenstein discussed their predictions for the American and global economies earlier this year during presentations held at the Darden School of Business and other locations in Virginia. As jobs numbers and the recent events of the euro zone unfold, their cautious expectations create room for hope amidst uncertainty.

About the University of Virginia Darden School of Business

The University of Virginia Darden School of Business delivers the world’s best business education experience to prepare entrepreneurial, global and responsible leaders through its MBA, Ph.D., MSBA and Executive Education programs. Darden’s top-ranked faculty is renowned for teaching excellence and advances practical business knowledge through research. Darden was established in 1955 at the University of Virginia, a top public university founded by Thomas Jefferson in 1819 in Charlottesville, Virginia.

 

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