Analysis: World economy wobbles as markets push policymakers

By Alan Wheatley, Global Economics Correspondent

LONDON (Reuters) - The message from this week's market rout is crystal-clear: investors have lost confidence in their politicians, who urgently need to do something dramatic to reduce risks to the global economy.

By some measures, the world economy is in better shape to withstand shocks than it was in the aftermath of the failure of investment bank Lehman Brothers nearly three years ago.

Corporate earnings are robust, banks have thicker capital cushions, big emerging markets are still expanding strongly and there has been no repeat of the global liquidity squeeze that sent the dollar soaring in late 2008.

Indeed, after this week's 8.5 percent slump in global equities, a rebound might not be far off. Wall Street initially rose on Friday after the U.S. economy created 117,000 jobs last month, more than expected, only to slide back into the red.

"People have just become spooked by a crass failure of political leadership," said George Magnus, senior economic adviser at UBS in London.

In Magnus's view, the first-half slowdown in U.S. growth -- an important contributor to the current loss of confidence -- was inevitable given how long it will take households to reduce their own debt mountain and rebuild savings.

But he said markets wanted an end to the "political dysfunction" all too evident in the protracted wrangling over the U.S. debt ceiling and the euro zone's inadequate response to the debt crisis gripping the periphery of the 17-member group.

"There are economic solutions to economic problems, but no politicians are stepping up to the plate," he said.

NO URGENCY

The Group of 20 leading economies and the Group of Seven rich nations impressed investors in late 2008 and 2009 by coordinating interest rate cuts and expanding fiscal policy to cushion the post-Lehman freefall in the global economy.

But now, deficit-spending is the perceived problem, not the solution, in both the United States and the euro zone, while interest rates are already close to zero. With little ammunition left in the armory, governments are displaying concern but not enough urgency for the likes of impatient investors.

"There is probably no consensus within the G7 on how to address this," said a source in Japan familiar with G7 negotiations. "Each country is too busy with their own problems to talk about cooperation."

Market mayhem leading to weaker growth in the rich world would naturally be negative for emerging economies.

Jun Ma, an economist with Deutsche Bank in Hong Kong, estimated that a downward revision of 1 percentage point to growth in the United States and the European Union would trim Chinese growth by 1 percentage point, too.

So what happens next?

In the United States, with budget policy now effectively off limits until after the November 2012 presidential election, some analysts believe the Federal Reserve will eventually embark on a third round of large-scale asset purchases, dubbed quantitative easing (QE), if unemployment remains too high for comfort.

The unemployment rate dipped to 9.1 percent from 9.2 in July, but that was because discouraged job-seekers gave up the hunt for work.

"With fiscal policy close to exhaustion and any remaining scope for flexibility apparently compromised by the recent bipartisan agreement on the debt ceiling, the responsibility for providing any additional support to the U.S. economy rests very much with the Fed," said Russell Jones, an economist with Westpac in Sydney.

In a note to clients, Jones said it was probably too early for the Fed to announce a full programme of QE at its policy-setting meeting next week.

But he said the central bank could reinforce its easy policy stance in the interim by taking steps to anchor long-term interest rates in order to spur investment and spending.

COMMON EURO ZONE BONDS TO COME?

As for the euro zone, heavy selling this week of Spanish and Italian bonds is raising pressure on European leaders to massively expand the bloc's emergency financial rescue fund.

Currently at 440 billion euros, it would need to be doubled or tripled to cover economies as big as Italy and Spain, whose cost of borrowing hit fresh euro lifetime highs on Friday. The two countries' 10-year bonds were yielding about 4 percentage points more than those of Germany, the euro zone benchmark.

Magnus at UBS said that, apart from expanding the fund, the issuance of common euro zone bonds was a minimum requirement if political leaders wanted to end the crisis once and for all.

European Economic and Monetary Affairs Commissioner Olli Rehn said on Friday officials would look at longer-term options, including the idea of euro zone bonds, and would present a report after the summer.

But big powers Germany and France have hitherto opposed such a radical step, arguing that it would sap fiscal discipline and raise their own borrowing costs, alienating voters.

But Philip Whyte, a senior research fellow at the Center for European Reform in London, said it was illusory to believe that Italy -- the latest target of uneasy investors -- could restore confidence by its own reform commitments alone.

"The fate of Italy - and, by extension, the euro zone - is likely to be determined as much as by decisions in Berlin and Brussels as by those in Rome. It is becoming harder to see how the polarization of yields within the euro zone can be reversed unless European leaders adopt a common Eurobond," he said in a note.

The political implications of such a development would be momentous. But it would not be the first time that muscular markets have forced policy makers to do their bidding.

"As Lenin once said, 'there are decades when nothing happens, and there are weeks when decades happen'. We fear that the current unraveling in Europe means that we might be in the latter category," GaveKal Dragonomics, a research outfit based in Hong Kong, said in a report.

(Additional reporting by Leika Kihara in Tokyo, editing by Mike Peacock)