May 2010

 

In our first quarter Economic and Business Outlook, we discussed the prospects for further economic recovery and identified key risks to sustained economic expansion.  The economy is fragile and its course is vulnerable to adverse geopolitical events, global financial market dislocations, the withdrawal of monetary policy support, and government policy misadventures.  We have seen evidence of each of these factors at play over the last few weeks.

 

Sovereign debt concerns in Europe and military tensions on the Korean peninsula have dominated the headlines and airwaves.  Markets have reacted to these uncertainties in a predictable fashion as investors have retreated from risk and sought safety in US Treasury debt.  After building historically significant returns over the last several months, markets were too frothy and these concerns provided the catalyst for correction.

 

Behind the headlines, complex cross-currents are shaping the intermediate and long term course of the global economy.  European debt problems are the result of unaffordable social entitlement programs and stifling regulatory and tax regimes plaguing developed countries in Western Europe as well as Japan and the United States.  These burdens will inhibit economic initiative, risk-taking, and growth for years to come.

 

Here at home, the US Congress is posed to enact financial services reform that is among the most far-reaching pieces of economic legislation in the post WWII era.  These laws may weaken an already fragile banking sector and impede economic progress.

 

The European Central Bank, the Federal Reserve, and the Bank of Japan will maintain accommodative monetary policies, including historically low interest rates, for the next several months as the recovery struggles for equilibrium and as governments attempt to sort out the disarray in fiscal policies.  Markets here and abroad will remain volatile as investors adjust to these realities.

 

It is paradoxical that the former centrally planned economies of Eastern Europe and Asia are the engines of global economic growth today.  Favorable demographic trends and the adaptation of free market based economic policies are driving spectacular growth in these countries.  While this rapid pace of growth poses its own risks, living standards are markedly improving for billions of people.

 

Capitalism is the most effective and efficient economic system the world has ever known and capital will always flow to the best opportunities. The continued drift toward heavy government intervention in the developed economies will restrain returns and result in subdued growth.  In contrast, countries with market friendly economic policies will continue to enjoy superior returns and more rapid economic development.