The twists and turns of economic fortunes – they are enough to make you breathless. The last few days have, if such a thing is possible, seen the gap get bigger between the bulls who say all is well, and the bears who say we are doomed. The bulls say the recent spate of poor economic data is just one of those inevitable things you get on the bumpy road to recovery. The bears look towards the two-speed Eurozone, and then they look towards the US and the almost desperate tone we are seeing from Barack Obama, and, to misquote the lines from a famous song, say: “The only way is down.”

There are arguments that can be made on both sides. The last few days have seen ample airing of these diverse views. A brief summary follows.

What can be done? One school of thought says we should do nothing. Recessions are just the economy’s way of clearing itself, and governments should leave well alone. Alas, we disagree. It is time for Ben Bernanke, Mervyn King, Jean-Claude Trichet and their colleagues from central banks in China, Japan and across the world, to hit the nuclear button.

The case for optimism

During the build up to this crisis, Investment and Business News used to speculate that the Sunday Times’ economics expert, David Smith, was hoping to win the award of most optimistic economic writer of the year. He dismissed talk of an impending debt crisis, laughed off predictions of house price crashes – and when crisis finally struck, put it down to events that could not have been foreseen.

Last Sunday he once again nailed his feathers to the optimists’ mast. He argued that the recent falls in purchasing managers indices (PMIs) were just one of those glitches you get during a recovery, and that no recovery follows a smooth upward trajectory. He said: “Recoveries do not go in straight lines. There will be months when the balance of the data is weak, and months when it is strong. In every recovery there are doubts about whether it will last, and there are plenty of reasons for such doubts this time. Pockets of extreme weakness, such as the American housing market, will persist. The big picture, however, is one of recovery. That is true for the world economy, for Britain and, in the economy where the doubts are greatest, America.”

The EEF also struck a bullish note, saying: “Whilst the PMI is an interesting and often very useful leading indicator, there are two things to note: the first is that the indicator is still showing growth, and it showed record high levels of growth just a couple of months ago. The PMI balance indicates change so we can’t expect it to keep growing at record levels forever. In addition, Markit (who compile the PMI) do state that ‘the relationship [between their figures and actual growth] in manufacturing especially is never likely to be perfect, reflecting delays in the adjustment of production to demand.’

“The second point is that this is one data point we’re talking about; which refers to one month; and we are coming out of a major recession.

“The last time manufacturing came out of recession the PMI was volatile too. In fact, a similar number of months after the last manufacturing recession began the manufacturing PMI had returned to negative territory. So we’re in a better place than we were last time.” See: One ‘less positive’ PMI figure doesn’t mean it’s over for growth

And finally, returning to Mr Smith of the Sunday Times, he even managed to draw comfort from the increasing talk that interest rates might go up soon. He said: “I fully expect the Bank [of England] to leave rates on hold … for many months to come. But the fact that the discussion has begun on an exit strategy from this emergency level is a significant straw in the wind.”

The arch bear

The arch bear of economic forecasting is Nouriel Roubini, economics professor at New York University, and the man who came closer than anyone to predicting the full extent of the economic crisis. And in recent weeks the tone emitting from his lips has been getting distinctly more downbeat.

“We can try to prevent double-dip recession, but the idea we are going to have rapid recovery of growth to potential in advanced economies – US, Europe, Japan – is mission impossible,” he told Bloomberg.

Elsewhere he was quoted as saying the chances of a double-dip recession were about 40 per cent.

Speaking at a recent press conference, he said: “Three years from now we’ll [US] have another 5 million who will join the labor force. No one thinks the US is going to create as many jobs to bring the unemployment rate down.”

But what can be done? Here you can see why the professor is known as Dr Doom. He said: “I don’t think, at this point, monetary policy makes much of a difference The problems are not problems of liquidity, but problems of credit, solvency and balance sheets that are damaged that monetary policy … cannot resolve … We are running out of policy tools on the monetary side as well as on the fiscal side.” 

The crisis in the Eurozone

Many assume that the problems in Greece, Spain, Portugal, Ireland and Italy have subsided. Don’t you believe it.

Greek GDP was revised this week, and it was revised downwards. In Q2 the economy contracted by 1.8 per cent. Household spending fell 6.2 per cent. Capital Economics said: “In all, then, the outlook for Greece remains pretty dire … the Government may eventually have little choice but to restructure its debts.”

But the problems in Greece are just a small part of the story. The truth is, a Eurozone crisis in awaiting lurks above the European horizon like an Acropolis, albeit one that is temporarily obscured by mist.

Wolfgang Münchau, writing in the FT this week, referred to some research painting a sorry tale indeed on Ireland. He put it this way: “In Ireland, the main problem is the banking sector. The economists Peter Boone and Simon Johnson have done some of the maths and found that the total amount of debt likely to end up with the Irish government amounts to about one-third of GDP. They concluded that with 10-year market rates at current levels – close to 6 per cent – Ireland is effectively insolvent. To correct this Ireland would need to generate spectacular rates of future growth. But do we really believe that the Celtic Tiger trick can be replicated?”

As for Italy, initial estimates of growth suggested the economy expanded by 0.4 per cent in Q2. But Capital Economics said: “With firms’ stocks now likely to be fairly close to their desired level and the global trade recovery losing momentum, the support that these two expenditure components are currently providing may wane soon, prompting the economy to stagnate or even fall back into recession.”

As for what the markets think, the spread between yields on German government bonds and bonds from the region’s more indebted countries has risen sharply and is now approaching the kind of extreme seen back in the spring and early summer, before the IMF and EU bailout package was agreed.

But the Eurozone’s woes are not restricted to those countries that the press have rather unpleasantly nicknamed the PIIGS. Belgium could be sitting on a major crisis in waiting. Right now the country is riven by political uncertainty, making the stalemate suffered in the UK for a few days just after the election seem like child’s play. With fears over the solvency of Belgian banks, watch out for news from this country that could spark another crisis. Even France is not immune. The fact is, unless the French retirement age shoots up, France will be struck by one almighty crisis in a few years’ time. Upping the retirement age to 62 is just one tiny step along a very long road. And yet even this move elicits strikes across the length and breadth of the land.

US woes

As for the US, the problem there is one of political checks and balances creating a new crisis. The US needs one thing or another. It either needs massive Keynesian stimuli, such as Barack Obama is calling for, or it needs a period of letting the markets do their work. Instead, political clashes between Democrats and Republicans are leaving the US with neither.

The latest row is over tax breaks for the rich. George Dubya tried to stimulate the economy with temporary tax breaks, and now the time is approaching for these breaks to either be removed or renewed. Mr Obama wants to remove the breaks for the rich, and maintain them just for those earning less than $200,000 or $250,000 per couple. Republicans are up in arms.

Mr Obama wants to see massive spending on infrastructure projects such as roads and bridges; Republicans are saying, No.

China provides hope; Germany digs its heels in; Japan suffers

But at least China is providing a ray of hope. There seems to be a growing realisation on the other side of the Great Wall that China cannot rely on exports for its growth for much longer. For example, Cheng Siwei, who is the chairman of China’s highly influential International Finance Forum, not to mention a former vice chairman of the Standing Committee of the National People’s Congress of China, recently told the FT: “A very high growth rate and huge trade surplus cannot be sustainable because they have a negative impact.” He added: “So what we are doing is to change our development patterns from investment driven to domestic consumption driven.” He said China wants “to make trade more balanced by increasing imports and diversifying foreign trade and also encourage our companies to go out to balance FDI to China and FDI from China.”

Alas, we are seeing little sign of similar changes in Germany. Germany is celebrating its new-found economic strength – with quarter on quarter growth in Q2 at 2.2 per cent.

But Professor Roubini dismissed this recently, saying Germany suffered a sharper slowdown than the US during the recession, so you would expect her bounce back to be more significant. But he sees Germany’s recovery as temporary.

What is clear, however, is that the German model is not sustainable. Her economic growth is coming on the back of the cheap euro, but other Eurozone economies rely on exporting to Germany. While Germany expands on the back of a falling currency, her Eurozone partners are not seeing a corresponding improvement in the terms of trade that relate to them.

Meanwhile, Japan suffers as the yen hits its highest level against the dollar since the mid 1990s. To an extent, German exports are occurring at the expense of struggling Japanese exports. But the Eurozone’s weakness has nothing to do with Germany; the currency is cheap because of the woes of the other members. If Germany still had the Deutschmark, her currency would be sky high right now. Her exports would be lower, Japan’s exports higher, and exports to Germany from the rest of the block we call the Eurozone would be much higher.

The great money supply contraction

But the challenges above are as nothing compared to the great threat still to come. The real worry is the danger of a massively contracting global broad-money supply.

Bear in mind, broad-money supply is partially determined by credit. The more lending there is, the higher this version of the money supply,

The threat comes from four quarters.

Quarter 1:  Banks are still trying to rebuild their balance sheets. They remain reluctant to lend. This is putting downward pressure on broad-money supply

Quarter 2: Regulators. Well-meaning regulators may make things worse. Under the Basel II Accord, banks are required to keep their Tier 1 and 2 capital ratios at 8 per cent. Rumour has it that Basel III will require this ratio to be upped to 16 per cent.

Roubini Global Economics said: “According to reports, the German banking industry’s lobby said that the new numbers would require Germany’s top 10 banks to raise US$135 billion in new capital, which ‘would stymie the banks’ ability to function, curtail lending and undermine Europe’s biggest economy’.”

But that is just the beginning. Applied globally, the Accord would mean banks would have to curtail lending by much more.

Quarter 3: Second housing crash. Evidence that housing markets in the US and the UK could suffer a second wave of strong falls – this will have two implications. Bank balance sheets will as a result look more vulnerable, making them even less keen to lend. Secondly, consumer confidence will fall and spending will drop, meaning the demand for credit will fall. Central banks failed to grasp the extent of the link between house prices and consumer spending during the boom. This failure was little short of scandalous. Central bankers and many economists alike are still underestimating the significance of this.

Cheap houses are essentially a good thing. When they rise too high it is inevitable they will fall. But falling house prices can be catastrophic. This happened in Japan, and as a result, or at least partially as a result, Japan suffered 20 years of economic anaemia, falling consumer prices and contracting money supply.

Quarter 4: Demographics. As the population ages, saving will inevitably rise, and demand for credit will fall. Again, there are strong parallels with Japan from 20 years ago.

The solution

Quantitative easing (QE) is not working. It matters not how much money central banks create; banks are not lending, and broad-money growth stalls.

What is required is Quantitative Easing Mark II. Mervyn King has said the Bank of England will absolutely not buy anything other than government bonds. He said that how the money the bank creates is spent, is down to the government. The Fed, on the other hand, has dropped hints about extending QE.

While this column is broadly a fan of Dr King, in this sense we think he is wrong.

It is no good the Bank of England buying government bonds, when the government is trying to reduce debt. All that this policy is achieving is making bonds expensive. The bank is hoping that as a result, other asset prices will rise.

But trying to promote recovery by pushing up asset prices, when the whole crisis was caused because asset prices were too high in the first place, is not sustainable.

Instead, central banks in the UK and the US need to directly promote lending to business by funding bonds drawn on venture capital firms, and maybe new banks with a more business-friendly agenda.

The central bank in China probably needs to encourage more consumer borrowing.

But in the Eurozone the problem is almost impossible to solve. There, the central banks need to encourage businesses in Greece, Spain, Ireland and the rest to invest more, and German consumers to borrow more.

Above, we said the Eurozone problem is almost impossible to solve. However, ‘almost impossible’ implies that a solution is possible. And so it is. There is a solution.

The solution there, quite simply, is the end of the euro.