Echoes of 1930s Heard in the West's Current Political Crisis

(Reuters) -- Dysfunctional politics threatens to deliver a protracted period of slow global growth, possibly lasting well beyond 2012, which will only deepen the political and economic problems for the West.

The global financial crisis that began four years ago has morphed into a political crisis for the United States and Europe. Leaders incapable of wrestling their debt loads to manageable levels or reviving strong economic growth are stoking turmoil in markets and populist unrest among the citizenry.

The political malaise is also hastening the shift of world economic power toward developing countries led by China. At worst, it could cause a second global recession, bringing with it political upheaval on a scale not seen since the 1930s.

These unpalatable scenarios are being sketched by a growing number of leading political strategists, academics, and economists after an extraordinary year when the once-unthinkable came to pass: The United States had its credit rating downgraded while the developing world enjoyed upgrades; Europe went cap in hand to China for a financial bailout; and Brazil overtook Britain within the Group of 7 club of major economies.

The shifting international economic order toward developing countries is nothing new. But it has been happening at a faster pace than expected, accelerated by what these analysts have begun describing as Western democracy in crisis.

They see a government credibility problem in the United States and across the European Union, stemming from a perception that the political elite is too closely tied to the financial elite in the West, and their collusion caused the financial chaos of 2007 and 2008, as well as its messy aftermath, leaving the average citizen burdened with higher public debt, higher taxes, more unemployment and ever-deeper austerity cutbacks.

Left to pay for what voters see as the elite's mistakes, public confidence in government has been undermined, and political paralysis has set in as Western leaders struggle to pull governmental levers that are not working effectively.

In contrast, developing nations have been modernizing their institutions and markets, delivering growth rates in the past decade triple those of the West. By 2020, the Center for Economics and Business Research in London estimates that India and Russia will have joined China and Brazil in the G-7 ranks as the biggest economies in the world based on total gross domestic product, ousting Britain and France. Only the United States, Japan, and Germany will be left from the old G-7 that had dominated the international order since World War II.

Niall Ferguson, a prominent economic historian now at Harvard University, calls this an historic power shift.

For the better part of 500 years, it was Westerners on both sides of the Atlantic who could say that they had the best economic system, that they developed the best political system, and so forth. And those claims have sounded increasingly hollow in our time, Ferguson said in an interview.

The breakdown in public confidence caused by the financial crisis has revealed a deeper problem. What we're seeing in government is part of a wider crisis of Western institutions, he said.

The Tea Party movement in the United States, the Occupy Wall Street movement, and riots in Europe all are populist expressions of this breakdown of trust. Institutionally, it is reflected in a U.S. Congress deadlocked over taxes and spending with lawmakers so polarized by different narratives on the causes and fixes for the financial crisis that it is nearly impossible to reach decisions, even though both sides recognize that if left unchanged, their policies will bankrupt the nation, he said.

In Europe, leaders lurch from summit to summit, making partial decisions on fixing a debt crisis and trying to save the 17-member monetary union. But in the process the political elite in Brussels and the capitals are losing touch with their democratic base, which is uncertain it wants to pay the price required for monetary union through deep cutbacks.

Heather Conley, a former U.S. undersecretary of state for European Affairs and now a senior fellow at the Center for Strategic and International Studies, said this near political paralysis seen in the United States and Europe is common when governments are at an inflection point.

Without decisive direction and leadership, we march in place or attempt to muddle through, uncertain of which path to take. The West is at such a moment, she said.

Only an external shock, I fear, will force us to take the uncertain [new] path. Or we will become so frustrated that the West will choose leaders who will take us in a radically new direction. I'm not sure our frustration level has reached that level, yet. But Europe may be arriving there soon.

Governments in Greece, Italy, Ireland and Spain have collapsed or been voted out of power in the past year, and 2012 brings presidential elections in the United States, France, and Russia.

Asia Not Immune

The fallout from Europe's debt crisis is being felt far and wide.

Japan already has endured nearly two decades of lost economic growth and weak political leadership after its financial bubble collapsed in the early 1990s.

George Friedman, geopolitical strategist and CEO of Stratfor Global Intelligence, sees a distinct risk that China too will join the club of countries in political stalemate, subdued or stalled growth, and popular unrest -- with potentially serious consequences.

When the United States, Europe, and China go into a crisis of this sort, it can reasonably be said that the center of gravity of the world's economy and most of its military power is in crisis. It is not a trivial moment, Friedman wrote in Dominoes of Doom on the Web site EconomyWatch.com.

China's economy, heavily dependent on exports, is slowing fast. Officials described the global economic outlook as extremely grim last month after its annual work conference, signaling deep concern as China enters a year of leadership change.

The Chinese government responded to the global recession spawned by the 2007-2008 financial meltdown with a massive credit expansion that has stoked inflation and fed a property boom. It also increased controls on the economy through state-owned companies, further concentrating state power, which Friedman sees as politically destabilizing as growth slows down.

Witness in the past month villagers in southern China in a 10-day standoff with public officials over land expropriation, thousands marching in Haimen city to protest a power plant, and a worker sit-in in Dongguan city demanding back pay after their paper plant closed.

Ending Paralysis

The best that can be hoped for in 2012 is a muddling through, with economic growth in the United States averaging about 2 percent compared with zero in the Eurozone, analysts said. World growth, buoyed by emerging markets, looks set to average about 3 percent.

Martin Sass, founder of the New York-based hedge fund M.D. Sass with $7.5 billion under management, is among those pinning his hopes on the elections breaking the stalemate. I never expected the level of dysfunction in the U.S. and European lawmaking ... and I never saw fundamentals count for so little in the stock market. Politics and contagion were the drivers of this underperforming market, not balance sheets and earnings.

It is going to take a new election in November [in the United States] to get any legislation through to deal with our problems, Sass said.

If the political system starts functioning effectively again, Mohamed El-Erian, CEO at PIMCO, the world's largest bond fund family, said it's not too late for policy makers to catch up and avert a serious economic downturn.

But elections alone may not prove to be the answer. To break the paralysis, political leaders need to offer a new vision, one that rebalances the cozy linkage between finance and politics: Otherwise, the credibility of the political system will remain compromised, said Scheherazade Rehman, professor of international affairs and finance at George Washington University.

There has to be a shifting of our institutions. The banking system is at the heart of our economic system and with it extraordinary ties to the political system. We have to rethink the close relationship that caused the breakage, she said.

The political crisis shot to the foreground this year as voters lost confidence in how governments responded to the 2007-2008 financial crisis, global recession, and the resulting explosion in sovereign-debt levels. Two narratives have emerged of what went wrong. The left casts the banker as the prime villain, unpunished by the political elite who allowed CEOs to violate all the principles of fiduciary and moral responsibility in pursuit of personal gain, which fuels the perception of a political system in collusion with a criminal financial elite it is unwilling to punish.

The right-wing narrative casts big government as the villain for exploiting the crisis to expand its regulatory powers that intrude on free markets, and to spend money on huge bailouts and social-welfare programs that have only exploded the budget deficit.

In both narratives, the victim is the average citizen who is left paying a gigantic bill -- through high unemployment, higher taxes, and lost economic opportunity. Either way, the compact between political governance and economic life has broken.

The political reaction, whether big government is seen at fault or big business, the reaction is that the system is tainted and there is too much crony capitalism at work, said Raghuram Rajan, finance professor at the University of Chicago and former chief economist at the International Monetary Fund.

There is a distinct possibility that political dysfunction will continue well after the 2012 elections -- held in May for France and in November for the United States, while China completes its leadership handover by the spring of 2013.

In the United States, voters could return a divided and polarized Congress again, continuing the legislative standoff. One-party rule may prove little better, if the path chosen toward budgetary discipline is excessive taxation or ultrasteep budget cuts. In France, the election winner's relationship with Germany and fellow EU leaders will prove critical.

Although Western democracy has demonstrated the flexibility to reform when facing severe challenges, the shadow of the 1930s looms large. This uncertainty over whether strong political leadership can emerge in 2012 is haunting markets.

John Browne, senior economic consultant to Euro Pacific Capital, is among the pessimists. He told clients in his year end note that American and European Union politicians have shown utter unwillingness to take tough decisions they know should be enacted to avoid looming global economic disaster.

With an estimated $6 trillion-plus solvency shortfall of the Eurozone banks, and $16 trillion in U.S. public debt, it will take leadership of far greater caliber to avert a disaster. Such leadership is nowhere in sight, he said.

(Reporting by Stella Dawson; editing by Claudia Parsons)