Is optimism the same as realism?

Wolfgang Munchau, columnist for the Financial Times, wrote in a recent article that one should wake against some complacency that the financial and economic crisis will give way to a speedy recovery process, which financial markets may have started to discount in recent months.

Last week, the green shoots shrivelled. In South Korea, China and Germany, exports were declining once again. In the US, the Federal Reserve’s Beige Book said “economic conditions remained weak or deteriorated further during the period from mid-April through May”.

The March signs of revival turned out to be little more than a technical inventory correction, with no change in the underlying trend. The world economy is still contracting, though perhaps not quite as fast as at the start of the year.

Global industrial output is still on the same trajectory as it was during 1930. The only question is whether we can avoid 1931 and 1932. The answer is yes, but on conditions that seem increasingly implausible if we extrapolate current policies. We can avoid calamity if monetary and fiscal policies remain supportive throughout the duration of this crisis, if we fix the banking system and if we impose regulations to constrain a resurgent financial sector. We also have to be lucky to avoid another round of market turbulence in the near future.

In other words ... the answer may well be no. Central banks and governments therefore risk moving too swiftly out of a recession-mode strategy. When the president of the Bundesbank, Axel Weber, publicly talks at this time about how to communicate a rise in interest rates, it tells me that the danger of a premature exit, at least in Europe, is clear and present.

Nobody is solving the toxic asset and recapitalisation problems of the banks. Financial regulation does not seem to be extending much beyond populist pseudo-measures on tax havens. Plus there is still financial meltdown potential in the system. Latvia, for example, is a ticking time bomb.

So at this point, I see the chances as roughly even between a global slump and a return to quasi-stagnation. What is so galling about this scenario is that it is avoidable. The central banks took the right decisions. But the political reaction has been near-catastrophic almost everywhere.

Instead of solving the problems to generate a recovery, the political strategies have consisted of waiting for a recovery to solve the problem. The Europeans are relying on the Americans to generate growth. The Americans are relying on the Chinese, who in turn are waiting for the rest of the world.

Even if the US were to generate some growth, as is likely after this summer, it would not benefit global exporters; China may be one of the fastest growing economies in the world, but it is only about half as large as the eurozone in dollar terms. While Chinese investments are up by more than 30 per cent from last year alone, imports are down 25 per cent. All this hype about decoupling and China pulling the world out of recession is baloney. The data tell us that China’s exports and imports are both falling, and that imports are falling faster.

As everybody expects the others to move first, nobody ends up moving. In the meantime, the problems grow worse. US house prices, which are down by a little over 30 per cent from their peak, still have some way to fall. Until the US housing market hits rock bottom, perhaps sometime in 2010, there is no chance of a recovery in the securitisation market, without which there may not be sufficient credit growth.

As the recession continues, the number of personal and corporate insolvencies will rise, which in turn will aggravate the problems of the banking sector. I am not surprised that the Bundesbank’s Mr Weber resists the publication of stress tests for the banking system. It would show that the German banking system was insolvent – and that bad and potentially bad assets were equivalent to about one-third of gross domestic product.

This is why last week’s news about the withering green shoots is so important. It tells us that the non-strategy of waiting until things get better is not working. The March signs of life reinforced complacency. Optimism will get us out of this crisis only if it is founded in reality.