The world economy’s shifting challenges

As 2014 begins, efforts to revive growth in the world’s most influential economies – with the exception of the eurozone – are having a beneficial effect worldwide. All of the looming problems for the global economy are political in character.After 25 years of stagnation, Japan is attempting to reinvigorate its economy by engaging in quantitative easing on an unprecedented scale. It is a risky experiment: faster growth could drive up interest rates, making debt-servicing costs unsustainable. But Prime Minister Shinzo Abe would rather take that risk than condemn Japan to a slow death. And, judging from the public’s enthusiastic support, so would ordinary Japanese.By contrast, the European Union is heading toward the type of long-lasting stagnation from which Japan is desperate to escape. The stakes are high: Nation-states can survive a lost decade or more; but the EU, an incomplete association of nation-states, could easily be destroyed by it.The euro’s design – which was modeled on the Deutsche Mark – has a fatal flaw. Creating a common central bank without a common treasury means that government debts are denominated in a currency that no single member country controls, making them subject to the risk of default. As a consequence of the crash of 2008, several member countries became over indebted, and risk premia made the eurozone’s division into creditor and debtor countries permanent.This defect could have been corrected by replacing individual countries’ bonds with Eurobonds. Unfortunately, German Chancellor Angela Merkel, reflecting the radical change that Germans’ attitudes toward European integration have undergone, ruled that out. Prior to reunification, Germany was the main motor of integration; now, weighed down by reunification’s costs, German taxpayers are determined to avoid becoming European debtors’ deep pocket.After the crash of 2008, Merkel insisted that each country should look after its own financial institutions and government debts should be paid in full. Without realizing it, Germany is repeating the tragic error of the French after World War I. The current arrangements governing the euro are here to stay, because Germany will always do the bare minimum to preserve the common currency – and because the markets and the European authorities would punish any other country that challenged these arrangements. Nonetheless, the acute phase of the financial crisis is now over. The European financial authorities have tacitly recognized that austerity is counterproductive and have stopped imposing additional fiscal constraints. This has given the debtor countries some breathing room, and, even in the absence of any growth prospects, financial markets have stabilized.Future crises will be political in origin. Indeed, this is already apparent, because the EU has become so inward-looking that it cannot adequately respond to external threats, be they in Syria or Ukraine. But the outlook is far from hopeless; the revival of a threat from Russia may reverse the prevailing trend toward European disintegration.As a result, the crisis has transformed the EU from the “fantastic object” that inspired enthusiasm into something radically different. What was meant to be a voluntary association of equal states that sacrificed part of their sovereignty for the common good – the embodiment of the principles of an open society – has now been transformed by the euro crisis into a relationship between creditor and debtor countries that is neither voluntary nor equal. Indeed, the euro could destroy the EU altogether.In contrast to Europe, the United States is emerging as the developed world’s strongest economy. Shale energy has given the US an important competitive advantage in manufacturing in general and in petrochemicals in particular. The banking and household sectors have made some progress in deleveraging. Quantitative easing has boosted asset values. And the housing market has improved, with construction lowering unemployment. The fiscal drag exerted by sequestration is also about to expire.More surprising, the polarization of American politics shows signs of reversing. The two-party system worked reasonably well for two centuries, because both parties had to compete for the middle ground in general elections. Then the Republican Party was captured by a coalition of religious and market fundamentalists, later reinforced by neo-conservatives, that moved it to a far-right extreme. The Democrats tried to catch up in order to capture the middle ground, and both parties colluded in gerrymandering Congressional districts. As a consequence, activist-dominated party primaries took precedence over general elections.That completed the polarization of American politics. Eventually, the Republican Party’s Tea Party wing overplayed its hand. After the recent debacle of the government shutdown, what remains of the Republican establishment has begun fighting back, and this should lead to a revival of the two-party system.The major uncertainty facing the world today is not the euro but the future direction of China. The growth model responsible for its rapid rise has run out of steam.That model depended on financial repression of the household sector, in order to drive the growth of exports and investments. As a result, the household sector has now shrunk to 35% of GDP, and its forced savings are no longer sufficient to finance the current growth model. This has led to an exponential rise in the use of various forms of debt financing.George Soros is Chairman of Soros Fund Management and Chairman of the Open Society Foundations.Copyright project-syndicate