Central banks can stave off recession
If this episode turns into a recession, then it will be a needless recession without cause
Monday 14 September 1998
When attempting to understand the behaviour of asset prices, such as stockmarkets, the standard practice is to start by forecasting economic variables - GDP growth, inflation, interest rates and the like - and then use this economic backdrop to estimate the "appropriate" level of asset prices. In other words, this procedure implicitly assumes that the direction of causation runs mainly from the economy to asset prices, rather than the reverse.
At present, however, it is not clear that this procedure is valid. In many economies as far removed as South East Asia and the United States, the asset market "tail" has been wagging the economic "dog". Large movements in currencies, bonds and stockmarkets have occurred without an obvious trigger from economic "fundamentals", and these changes in asset prices have then altered the economic fundamentals themselves. For example, the rise in world stockmarkets has clearly boosted economic growth in the developed economies, notably in the United States. If the recent financial turmoil continues, it could equally puncture the health of the US economy.
This is far from being a new phenomenon. It is well known that virtually all asset prices, whether in foreign exchange markets or stockmarkets, are subject to large variations when "risk premia" change. The risk premium is essentially a fudge factor, which incorporates anything which might explain a change in the degree of risk aversion by investors.
A rise in the risk premium on stocks relative to bonds, for example, implies that investors now require a higher expected return on stocks in order to compensate them for running the additional risk inherent in equity investments. An increase in the risk premium inevitably involves a fall in share prices, since this is the only way that the expected future return can be immediately increased.
What does all this have to do with the current plight of the world economy? It is in fact crucial, since wild variations in asset prices are being driven by unpredictable fluctuations in risk premia, and this in turn is dominating economic behaviour.
If we accept this line of argument, it suggests that there might be more than one "equilibrium" into which the world economy could settle in the next 18 months. A happy equilibrium could exist in which equity risk premia remain under control, asset prices therefore stay tolerably high, and the growth of western economies remains acceptable, with strong domestic demand offsetting further emerging market shocks.
On the other hand, a much less happy equilibrium could also be reached, in which a rise in equity risk premia punctures world asset prices and leads to recession. The ultimate implication, of course, is that changes in equity risk premia and therefore in share prices could prove self-justifying, in the sense that they could produce an economic out-turn that subsequently validates the level of share prices.
The experience of the past 12 months amply illustrates how financial market risk premia can determine the behaviour of the world economy. The sudden turnaround in capital flows in Asia led to devastating recessions in the crisis economies of Thailand, Indonesia and Korea. These countries simply ran out of foreign exchange, and had to make emergency adjustments in their trade deficits.
The example of Asian melt-down then had contagion effects on other emerging markets, with global investors requiring much higher risk premia than before for accepting the risk of holding emerging assets. The consequent increase in the cost of capital simply could not be afforded by many governments (e.g. Russia), so the last resort options of debt default and hyper-inflation came onto the agenda.
Crucially, this havoc in emerging countries at first had little effect on the US and the European Union. While investors lost their appetite for risk in the new economies, they actually increased their risk appetite in the old world. Markets became very confident that inflation had disappeared as a problem on a global basis. Long term bond yields therefore fell sharply. This in itself boosted world equity prices but, more important, the equity risk premium relative to bonds also dropped, reflecting the fact that recession risks were thought to be low in the absence of any obvious inflationary pressure.
With Western bond and equity markets rising rapidly, domestic demand in America and Europe remained strong enough for the economies to shrug- off the direct trade effects of the first Asian shock.
All this has changed dramatically for the worse in the last few weeks. Events in Russia and Malaysia have served to increase emerging market risk premia still further, and this is now threatening to trigger a major financial calamity in Latin America. What is really different, however, is that the rise in risk premia in emerging economies has for the first time started to leak into Western financial markets. The precipitous decline in US and European share prices will damage economic confidence, and this could eliminate the previous immunity of these economies to further trade shocks from the new world.
All this is very odd, since the present environment in the world economy is not one in which equity risk premia normally rise.
According to recent work by Neil Williams of Goldman Sachs, global equity risk premia are generally linked to three important variables - inflation, real bond yields and the excess of world output over its long-term trend - and all of these variables are currently suggesting that equity risk premia should stay benign.
In a nutshell, with recession risks still very low, there should be no need for a world recession in order to control inflation. Knowing this, equity investors should be willing to accept more risk than normal.
But the problem is that equity risk premia are mercurial beasts, whose behaviour is not well understood. Although they are somewhat loosely linked to economic variables, they also have a life of their own, and can change by large quantities for long periods without much obvious cause. In other words, they can be driven by the vagaries and whims of financial market confidence.
It is not wise for policy makers to assume that these factors will always be well behaved. A new situation is arising, in which financial confidence could break, not because of the threat of inflation (which is the usual cause) but because large parts of the world are incapable of generating sufficient growth in demand, given previous financial market shocks.
If this episode turns into a world recession, then it will be a needless recession - a recession without an inflationary cause, and without even the consolation that it brings a cure for inflation. Instead, it might bring deflation.
There have recently been several examples of countries - Japan, Thailand, Korea etc - which have fallen into deep recessions solely because of swings in financial confidence and asset prices. The longer that the central banks of Europe and the US sit on their hands, the greater the chances that the rest of the world will follow suit.
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