Crash Course Part 3: The Age of Stagnation?
By Satyajit Das
The first is the Lazarus economy, where the strategies in place lead to a strong recovery.
The US leads the way. Europe improves as the required internal transfers and rebalancing takes place with Germany accepting debt mutualisation to preserve the Euro. Abe-nomics revives the Japanese economy. China makes a successful transition from debt financed investment to consumption. A financial crisis in China from the real-estate bubble, stock price falls and massive industrial overcapacity is avoided. Other emerging economies stabilise and recover as overdue structural reforms are made. Growth and rising inflation reduce the debt burden. Monetary policy is normalised gradually. Higher tax revenues improve government finances. There is strong international policy co-ordination, avoiding destructive economic wars between nations. Even a new, Bretton Woods-like international financial structure may be agreed.
Such an outcome is unlikely. The fact that current policies have not led to a recovery after 6 years suggests that they are ineffective. A general lack of demand combined with demographics, slower improvements in productivity, reduced rates of innovation, resource constraints, environmental factors and rising inequality is likely to constrain growth. Overcapacity, technological improvements, competitive devaluations and a lack of pricing power is likely to keep inflation low, despite loose monetary conditions.
Policy makers do not have instruments to deal with the identified economic weaknesses. Politically, the changes required are difficult, as it requires root-and-branch structural reform of labour markets, tax systems, welfare systems and the role of government in economies. Income and wealth distribution issues need to be addressed. The entire model of debt driven consumption and investment in a highly financialised economy requires radical overhaul. Given vested interests resistant to changes, it is unlikely that the required changes are feasible.
The second scenario is a managed depression, a Japan like prolonged stagnation.
Economic growth remains weak and volatile. Inflation remains low. Debt levels continue to remain high or rise. The problems become chronic requiring constant intervention in the form of fiscal stimulus and accommodative monetary policy, low rates and periodic QE programs to avoid deterioration.
Financial repression becomes a constant with nations transferring wealth from savers to borrowers, through negative real or increasingly nominal rates, to manage the economy. Competition for growth and markets drives beggar-thy-neighbour policies, resulting in slowdowns in trade and capital movements. While there are variations between nations, overall the global economy becomes zombie-lie, with entire nations, businesses and households trapped in a low growth, over-indebted state essentially on permanent life support. Resource allocation breaks down with more and more wealth trapped in low returning or unproductive activity.
Authorities may be able to use policy instruments to maintain an uneasy equilibrium for a period of time. But it will prove unsustainable over time. The ability to finance governments and stresses on central banks from excessive debt monetisation will ultimately constrain such strategies. In addition, asset price inflation and the growing debt burden encouraged by low rates will create dangerous financial instability.
The response of electorates to the reduction of living standards by stealth places political limits on this approach. Ultimately, a major correction may become unavoidable, as confidence in policy makers ability to control the situation diminishes.
The final scenario is the mother of all crashes. Financial system failures occur as a significant number of sovereigns, corporate and households are unable to service their debt. Defaults trigger problems in the banking system which leads to a major liquidity contraction, which in turn feeds back into real economic activity. Falls in employment, consumption and investment drive a severe contraction. Concerns about safety and security of savings create capital flight from vulnerable nations, banks and investment vehicles. The process continues in a series of iterations of increasing intensity.
Some historians view World War 2 as a continuation of World War 1 with an interval. Any new crisis is likely to be a further phase of the 2008 crisis, reflecting the fact that the causes remain largely unresolved.
The world is remarkably sanguine about the increasing risk of a new major crisis, which is not priced into markets. In April 2015, former vice chairman of the Federal Reserve Alan Blinder presented a novel argument against increased risk in his Wall Street Journal opinion piece. He argued that despite central bank activism, none of the hypothesized financial hazards had surfaced. In effect, as the absence of a crisis to date must mean that there was no risk and the policies were correct.
Governments and central bankers assume that they can control events. Investors believe that the authorities can implement measures that support the economy and asset prices. This faith may be misplaced.
Unwinding of the unsustainable excesses will be especially painful, much worse than 2008 for a variety of reasons.
First, the problems in 2016, such as debt levels, are much larger.
Second, the problems are now global with both developed and emerging markets affected. In 2008, the emerging markets acted as stabilisers to the weakness of developed markets, provided demand and also helping financing budget deficits in advanced economies.
Third, the downturn will exacerbated by the limited capacity of policy makers to respond. Fiscal measures are limited by poor public finances. Monetary policy may be used, with more money being pumped into money markets but with increasingly diminishing effects.
The stabilisation since 2008 has been the result of fiscal deficits in combination with lower interest rates and QE. In the US, rates were lowered from 5.25 percent to zero, injecting around 20% of income into the economy. This boosted economic activity and crucially avoided widespread defaults and collapse of the banking system, ensuring a short recession. The pattern globally was similar.
Today, strained government finances mean that running budget deficits on the scale that was done after 2008 will be more difficult. The fact that rates are much lower, in some cases negative, means that further monetary measures will be far less effective. In many economies, it is not clear why, with loan demand weak, banks will sell government bonds to central banks to receive negative returns on the cash proceeds. New initiatives (unconventional, unconventional measures), negative rates and ‘helicopter money’ may disappoint. Under current conditions, monetary policy will prove ineffective, the equivalent of Keynes’ pushing on a string.
Fourth, the problems will be accentuated by political stresses. Poor economic growth and high unemployment, especially youth unemployment, in Europe have created a volatile political environment. With existing political elites seen as captured by businesses, banks and the wealthy, electorates are turning to populism and political extremes in search of representation and solutions. The resulting policy uncertainty and inconsistency further suppresses recovery.
Finally, the geopolitical situation has also deteriorated sharply. The Middle East is characterised by tribal and inter-faith conflict, with the chaos and extremism spilling out from the region. A revanchist Russia threatens a new cold war. Disagreements within the European Union mean that complicates the security situation. In Asia, territorial tensions centred upon Chinese claims are rising. Increasing defence readiness or militarism, depending on interpretation, is an additional factor impinging on global growth. Even if actual conflict is avoided, sanctions and other forms of economic or cyber warfare complicates matters.
The balance between the benefits and risks of intervention is now unfavorable.
With real activity unresponsive, the unintended financial consequences of monetary experiments on an unprecedented scale are unpredictable. The decision by the Swiss National Bank to remove the ceiling on the Swiss Franc highlights the uncertainty. In Japan, emerging differences between the government and central bank over policy show the increasing tension. The negative response to negative interest rates is another case in point.
The risk of policy errors or poor execution, such as premature increases in rates, or withdrawal of liquidity support, is increasing. An intended or accidental breakdown within the Euro-zone potentially triggering a restructuring of the European single currency is no longer inconceivable. Global economic wars, entailing barriers to trade or capital movements as well as the ongoing currency devaluations, are likely as countries act independently consistent with their national.
The signs of breakdown are evident. The failure of existing policies are pushing central banks into more extreme and desperate action, such as negative interest rates (effectively paying people to borrow) and large currency devaluations. Actual market volatility has increased as valuations reflect anticipated central banks actions rather than fundamental values. For example, the fall in the yield of sovereign bonds reflects expectations of central bank purchases rather than true risk.
Deflationary pressures in commodities and industrial prices are increasing globally. Behaviours now are economically irrational. The magnitude and speed of adjustment in commodity prices, currencies and credit markets suggests that the correction may occur more quickly than people anticipate.
Most investors remain oblivious assuming that the risk is in the price or that they are prepared and will be able to adjust their portfolio in time.
© 2016 Satyajit Das
Satyajit Das is a former banker. His latest book is The Age of Stagnation (published internationally as ‘A Banquet of Consequences’ ). He is also the author of Extreme Money and Traders, Guns & Money**.**