1. To the Point
Discussion on the economy, by the Chief Economist March 30, 2012
Cecilia Hermansson
Group Chief Economist
Economic Research Department
+46-8-5859 7720
cecilia.hermansson@swedbank.se
It’s the politics, stupid!
 Man-made political and economic institutions underlie a nation’s economic
success. After the financial crisis and recession, many of these institutions need
to be rebuilt in the US and Europe, and it is important this be done in a truly
democratic environment.
 Financial markets have pressured Europeans to speed up budget consolidation,
and the US cannot rule out the same treatment in a few years time. Politicians
need to set the deleveraging agenda before the financial markets do, with
potentially high costs to the US and the global economy and societies.
The US and Europe should rebuild institutions democratically
The title of this month’s version of To the Point is a “snowclone”: of Bill Clinton’s
“It’s the economy, stupid,” often heard during his campaign against George Bush in
1992. Even if Bush was seen as the experienced candidate in terms of foreign policy,
he had not talked sufficiently about the economy, and the recent recession.
Two decades later, it is only natural that the state of the economy will decide who
wins this fall’s election. If unemployment continues to fall, President Obama has a
good chance, but if it rises again, as more people re-enter the labour force and growth
slows, the Republican candidate, most likely Mitt Romney, has a better chance.
Even so, the way politics is carried out and institutions are built up is the most
important factor determining why nations fail or succeed. This is the message, taking
both the short term and the very long, of the recently published book “Why Nations
Fail”, by Daron Acemuglu and James Robinson, two distinguished economists, who
cover more than 400 years of global history. Their conclusion: it is not culture, nor
the weather or geography. It is not even ignorance of what the right policies are. It is
man-made political and economic institutions that underlie economic success.
The message is, of course, important to developing countries, where living standards
have stagnated or risen slower than in the more developed world. However, political
leaders in the US and Europe can also learn from this book. Two key institutions are
at stake in these two parts of the world: the health care system in the US, and the
Economic and Monetary Union (EMU) in Europe. How they are developed will
matter to the success of these economies and their well-being. Also, regulations of
business and banking, tax reforms, education reforms, etc., etc., are at a cross roads
without a clear agreement on how to proceed forward.
Many people feel more removed from decision making than ever before. This is
particularly true in Europe, where top meeting after top meeting is called and where
decisions are made in a less transparent way than in national parliaments. In the US,
the political agenda is shorter than normal because it is an election year, and all major
decisions have to wait until after the election. This means that the world’s largest
economy slows every fourth year, whilst the rest of the world continues to move
forward. Also, the current political gridlock could very well continue next year.
It is important to continue on the democracy road that Europe and the US have
travelled for hundreds of years, and not turn to the authoritarian methods China and
Russia use. Even if authoritarian growth seems high now, it will not lead to sustained
growth, supported by truly inclusive economic institutions and creative destruction.
The financial crisis and the global recession have made politics more difficult to
pursue, but the institutions that are at stake will best be developed in a democratic
system.
No. 3
2012 03 30

2. To the Point (continued)
March 30, 2012
2
Chart 1: 10 year government bond rates
Source: Ecowin.
Chart 2: Inflation rates in major economies
Surce: Ecowin
Economic Research Department
SE-105 34 Stockholm, Sweden
Telephone +46-8-5859 1000
ek.sekr@swedbank.com
www.swedbank.com
Legally responsible publishers
Cecilia Hermansson
+46-8-5859 7720
Financial markets – a cure or a curse for politicians?
German Chancellor Angela Merkel and Italian Prime Minister Mario Monti live
under the threat of financial markets’ mood, while governments in the US and
the UK seem to have more degrees of freedom.
It is evident that when creditors no longer wanted to finance Greek or Italian
debt without a high risk premium, the budget consolidation and reform process
intensified. Compared to the US, European countries have speeded up to get
their houses in order. Deleveraging in the public sector has started, while the US
administration is still on a path where the federal debt is rising to towards
infinity.
UK, with experiences from market punishment in the early 1990’s has chosen
the European road as well, something that made the Nobel Laureate Peter
Diamond at the policy conference arranged by National Association of Business
Economics (Nabe) the other day to declare: “Britain is a mistake!”
The question is where mistakes are made: in Europe or in the US? Of course, it
would have been better to back-load than front-load measures in the UK to not
risk the recovery given that we know market confidence is being upheld. The
cost, however, to the society of much higher interest rates at a time when debt
burdens are around 100 % of GDP is high. Also for the US, the point where
more action is needed is approaching.
We know that financial markets are not always rational. Behavorial finance
teaches us that herding, anchoring, heuristics are just some examples of why
markets make systemic errors. In the process of understanding the sovereign
debt crisis in the euro zone, there have been market misunderstandings and
exaggerations on the way, but the main message is that the combination of the
current set up of the EMU and increasing public debt no longer works. Since
politicians, including the German and French, made major mistakes diluting the
Stability and Growth Pact around 2005, the return to discipline had to come
from outside pressure. In a democratic society that pressure could have come
from the opposition, the media, the justice system, etc., but their incentives to
help to correct these mistakes were small. Instead, the investors, who had put
their money at stake, delivered the verdict, signalling the importance of the
linkages between financial markets and politicians in a market economy.
So what about the US? Financial markets are starting to ask the pertinent
questions: Will the US be able to grow itself out of the debt burden? Will
budget consolidation start in time to calm markets? Will the Federal Reserve
allow more inflation so that the debt burden shrinks in real terms? Or will
market confidence get lost on the way, raising interest rates 400-500 basis
points, thus contributing to a new economic crisis and a possible global
meltdown?
Most policy makers in the US would say that the public debt deleveraging will
have to start soon, and that growth rather than inflation will do the trick. It may
be possible, but if the political gridlock remains and even worsens after the
election, at the same time as other important decisions are hard to take, e.g. the
health reform, banking and housing regulations, etc., then market confidence
can disappear sooner than expected. And that is the problem, as a nation you
have the financial markets’ confidence until you no longer have it, and the time
span between these two stages can be short, very short indeed.
Cecilia Hermansson
To the Point is published as a service to our customers. We believe that we have used reliable
sources and methods in the preparation of the analyses reported in this publication. However, we
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the Point.
Source:ReutersEcoWin
jan
08
maj sep jan
09
maj sep jan
10
maj sep jan
11
maj sep jan
12
Percent
0
1
2
3
4
5
6
7
8
UK
USA
Japan
Germany
Italy
Source:ReutersEcoWin
08 09 10 11
Percent
-2,5
0,0
2,5
5,0
7,5
10,0
12,5
15,0
17,5
India
Brazil
US
Japan
Germany
UK
China