DAVOS // The World Economic Forum's annual meeting opened here yesterday with participants voicing concern about whether efforts to tighten regulations to prevent future crises might be undermining efforts to recover from the latest one. The debate about the health of the global economy so far still seems to pivot around two central concerns. First, that continued weakness in the US and Europe might be pulling western economies into a Japan-style deflationary quagmire; and second, that efforts to revive growth with government outlays and low interest rates have merely reinflated the bubble of global credit, creating an unsustainable rally in stocks, emerging markets and commodities.
"I see deflationary pressures in advanced economies," said Nouriel Roubini, an economist from New York University's Stern School of Business and the chairman of Roubini Global Economics. Mr Roubini predicted continued recovery in the first half of this year, but faltering growth in the second six months. "Monetisation of fiscal deficits will lead to rising long-term interest and a crowding out of the private-sector recovery."
Mr Roubini and others painted a picture of two global economies, both at risk: one an anaemic economy still struggling to emerge from recession, characterised by high unemployment and rising public debts; and the other a global economy that in many ways resembles the one before the crisis, turbocharged by massive amounts of credit, moving at reckless speed and on the brink of disaster. Governments have created the latter economy in trying to cure the former, participants said. In fact, one economist noted, aggregate global debt has not declined since the crisis erupted. On the contrary, to alleviate the impact of the private slowly reducing its debts, governments have been going deeper and deeper into deficit.
"We've never seen such a large-scale fiscal expansion in our economic history," warned Heizo Takenaka, a former Japanese economics minister who is now the director of the Global Security Research Institute at Japan's Keio University. Participants were generally optimistic about the outlook for developing economies, particularly China's, which appears to have successfully used a combination of fiscal spending and easy lending to maintain economic growth near 10 per cent, despite a sharp fall in export demand.
But with waves of hot money flowing out of the US, where interest rates are nearly at zero, to China and other emerging markets, signs of a dangerous bubble are emerging. Now authorities in China are limiting credit growth and economists warn that developing economies face a quandary - if they fail to follow China's path and curb expansion, they risk creating an inflationary spiral that devastates real incomes. If they start to tighten money supply and reduce spending, on the other hand, they risk crimping economic growth before demand for their exports has recovered.
"We've had a situation of excessive demand being created by industrial countries. Now the hot potato of excessive demand is being shifted to emerging markets," said Raghuram Rajan, a finance professor at the University of Chicago's Booth School of Business. "They've never managed that well. This time, will they do it better?" Many economies are already grappling with the new inflows of hot money. Under normal macroeconomic policy, a central bank would respond to rising asset prices, easier credit and signs of an overheating economy by raising interest rates. But in smaller economies, the deluge of money from abroad would only speed up in response to higher rates.
To keep their currencies from rising as cheap dollars flow in, therefore, many central banks end up buying up the dollars and selling their own currency, amassing ever larger reserves that they tend to plough back into US government debt, exacerbating the destabilising imbalances many economists say set the stage for the crisis. This conundrum led one European regulator speaking in an off-the-record session on how to handle financial bubbles to suggest that developing economies might need to impose capital controls to prevent their economies from overheating.
The danger, though, is that policymakers in developing economies tend to take their cue from their counterparts in the West, said Arif Naqvi, the group chief executive at Dubai's Abraaj Capital. "So when western governments talk about regulation and re-regulation, our governments take notice," he said. "The problem with that is we've just come out of regulation and protectionism." With early coverage of the meeting dominated by the debate over plans in the US to tax banks for receiving bailout money and prevent them from speculating on their own account, the issue of how to better regulate financial markets and financial institutions appeared already to be overshadowing the debate over macroeconomic policy.
With the first day of meetings still under way, a consensus appeared to be emerging that markets needed better regulation and that the "free-market fundamentalism" that guided central bankers and economists for the past 20 years had been overturned by the crisis. The question ahead, then, is to what extent regulations need to be imposed, and when and how they can be harmonised across borders to prevent bankers and investors from skirting them by shifting locations.
"The old system has broken down," said George Soros, the chairman of Soros Fund Management. "Globalisation has been pursued on the false premise that markets don't have to be regulated." @Email:email@example.com