Monday, 18 November 2013

The world's economy is off-balance

Economists around the world are dusting themselves off after a bruising few years of terrible forecasts, messed up assumptions and missed diagnosis.Whether you have been on the Rogoff / Reinhart or Krugman side of the argument there are red faces all around. The simple problem is that economies are not meant to behave in the way they are.  We have got to a point where old models (classical, Keynesian or monetarist) don’t work and excuses just don’t wash.  The problem is that after five years of negative realinterest rates the world’s economy has been unable to return to “historic trend” levels of growth – we are still bumping along the bottom.  Most economists believe that interest rates can be set to create a sustainable equilibrium in the economy where growth, employment and inflation can be held in a positive balance.  The absence of the interest rate equilibrium after years of interest rates set near or at the lower bound of zero raises the question as to what the alternatives are to negative real interest rates might be?  Larry Summers the former Secretary of the Treasury of the United States made  an important speech on this subject a couple of weeks ago.

Larry Summers - tired of waiting for the recovery

Rather than banging their heads on the lower bound of interest rates Central Bankers have used Quantitative Easing – where central banks buy securities from banks to increase the money supply –this provides additional liquidity when interest rates can fall no further. These interventions were important in the immediate aftermath of the Lehman’s default, when there was no liquidity (the credit crunch), but don’t seem to have so much impact today.The great increase in the “central banking balance sheets” must raise the risk of asset bubbles or a big bust in the bond market.The wider problem with these policies of low interest rates and QE is that they are no antidote to the nightmare scenario – an economic death spiral where real interest rates remain at the lower bound, and a deflationary reaction creates a further squeeze on demand.
With interest rate equilibrium a thing of the past and many economies pinched up against the lower bound of interest rates we need to find some new options and interventions.  New approaches are needed as the problem low growth may last for a very long time, and will not solve itself through flexibility in prices and interest rates.  The reason for this is that the zero lower bound prevents interest rates from falling, and also checks prices adjusting downwards.  Therefore none of the normal forces for restoring equilibrium apply.  Unless we find an alternative there will be a need for ever-greater injections of monetary stimulus (presumably through QE) in order to avoid an ever-worsening recession. 
Most central bankers understand that a consequence of on-going QE will be increasing concerns about asset bubbles, or the risk of huge losses on bond market, hence the talk of tapering.  But if QE comes to an end with no alternative strategy in place the world may have to confront the idea tthat here can be no growth without QE, which would prompt a huge sell off and depression.  So we are between a rock and a hard place – we can’t drop interest rates any further and we can’t risk too much more QE and there dont appear to be any suitable alternatives.
Developing new strategies to promote growth require an understanding of what has caused this interest rate equilibrium to fail.  There are a whole range of ideas from: population aging, too much saving in the private sector and the rise of the internet.   More interestingly Larry Summers contends that we may have been in a continuous state of economic bubbles since the mid 90s and that these bubbles have masked the true rate at which the developed world is able to grow. Summers also believes that we may be in a world of “secular stagnation” where lower bound interest rates are insufficient, even with QE support, to create modest levels of real growth. Against this gloomy back drop there is a beacon of light the UK economy.
After being hit harder than most the UK economy has bounded out of recession with a spring in its step. Why should this be?  We are one of the most indebted nations, we have an enormous finance sector that has damaged our overall economy very badly and our main export market is the Euro Zone!  It’s not easy to answer that question; it may well be that finally the massive devaluation of Sterling in 2009 and the huge dosage of QE in 2009-11 are paying off.  More likely we have just been lucky and that the problems in Europe and nervousness in emerging markets (threats of tapering) have flooded the UK with Foreign Direct Investment (FDI), which has bounced us out of our malaise.  But this is an isolated event that won’t be repeated in other markets.
The really bad news is that global problem with lost interest rate equilibrium and the consequential secular stangation may be associated with three macro chnages in the worlds economy that will not be fixed any time soon.  These issues can be summarised as: 
1. A problem, that I have explored before, is the imbalance in labour share that has been building up in the West of a long period of time.  In the 80s nearly 75% of national income was made up of labour share – what governments and business paid their people –today this has reduced to nearer 60%.  This means that the owners of capital are increasingly taking a bigger share.  Unfortunately the top 1% may earn 25% of all income but they don’t spend 25% and this is squeezing the amount of demand that economies are able to generate.  The graph below clear show the long term dangere of low labour share - look for the trend for Japan.

Thanks to the Economist 

So we have a perverse situation where super wealthy may be part of the problem that is persisting relentless recession in the West. 
 2. The second issue is that of aging populations, who tend to consume less and when interest rates are low they consume even less. As world becomes increasingly populated by pensioners demand and growth must be effected

3. The final factor may be the growth of the internet, although some aspects of the intenet should support demand growth (ease of purchase and access to a wider market being two demand drivers) there is also the "problem" that the internet provides so much free entertainment (facebook, Twitter, etc) and although there are advertising revenues associated with this "free" entertainment they may not be a sufficient replacement for more traditional leisure time activities (sports, travel, shopping etc)

If the developed world can no longer grow at 3-4% annually we will all have some very difficult choices to make.

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