Illustration by S. Kambayashi

AS JANUARY goes, so goes the year. That old stockmarket saying does not augur well for 2010, given that the MSCI World index fell by 4.2% in the month, the biggest decline since February 2009, and emerging markets dropped by 5.6%.

Although markets rallied a bit in early February on better-than-expected economic data, the poor start to the year reflected an inherent contradiction to the rebound of 2009. That rally seemed to be dependent both on extraordinary stimulus measures by governments and central banks, and on a vigorous economic recovery. But both cannot co-exist for long: either the recovery will not last or, if it does, the stimulus will be taken away.

In addition, governments' ability to provide that stimulus is dependent on the markets' own willingness to fund huge deficits at very low yields. But why would investors accept meagre yields if they expected a vigorous recovery? In a sense, the market seemed to be hauling itself up by its own bootstraps.

Sure enough, the bullish story has started to unravel, if only at the edges. In the developing world China has attempted to tighten monetary policy. That has caused some alarm because China was acting as the engine of global growth.

And in the developed world investors have started to question the ability of governments to keep financing their deficits. The obvious example is in Greece, where ten-year bond yields reached 7% late last month. At that level, which is well above likely Greek GDP growth, the country's indebtedness would grow very rapidly. However unpopular it may prove to be, an austerity package is needed to prevent Greece from falling into this debt trap (see article).

So even in places where governments may wish to maintain fiscal stimulus, the markets may force them into corrective action. Britain, France, Ireland, Spain, Portugal and others have all indicated their determination to keep deficits under control, with varying degrees of conviction.

But withdrawal of even small parts of the stimulus packages can send an economy back into the doldrums. As an example, American new-home sales slowed sharply after an initial end-of-November deadline for the expiry of a buyers' tax credit. Although the credit has since been extended until April, December's sales were just 342,000, compared with 329,000 in January 2009, at the height of the crisis.

The stimulus may have prevented the global economy from slipping into depression. In the medium term, however, academic studies suggest that higher government spending leads to slower economic growth. A 2008 paper by Antonio Afonso of the European Central Bank and Davide Furceri of the University of Palermo calculates that for every one-percentage-point rise in government spending as a proportion of GDP, the growth rate falls by 0.12-0.13 percentage points.

What's more, the packages have not really dealt with the problem of excessive debt, but merely transferred it from the private to the public sector. This buys time, but is akin to those debt-consolidation plans that are sold to consumers on TV. The pain is spread out over a longer period. But pain there will be, in the form of higher taxes, higher bond yields, slower growth or a combination of all three.

The authorities face a dilemma. Reduce the stimulus now and they risk plunging the economy back into recession, as happened in America in 1937 and Japan in 1997. But leave the stimulus in place for too long, and they risk damaging long-term growth prospects.

The bulls hope that the economy can escape from this trap by the simple expedient of private-sector growth. That is why they welcomed the rise in manufacturing activity signalled in this week's latest purchasing managers' indices. If the private sector rebounds of its own accord, unemployment will fall and budget deficits will decline.

But hopes for a strong private-sector recovery are undermined by the data on credit growth. In the year to December, the broad measure of money supply fell by 0.2% in the euro zone and grew by just 3.4% in America. In Britain the annual growth rate is higher (6.4% in December), but David Owen, an economist at Jefferies International, estimates that quantitative easing (QE), whereby central banks create money to buy assets, has been boosting the figure by an annualised rate of 10%. If the Bank of England stops QE entirely, the credit-growth rate could collapse. For the stockmarket rally to resume properly in 2010, economies in the developed world need to show they can stand on their own two feet.





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