It's spring, so it must be time for green shoots (unless, of course, you live in the southern hemisphere, in which case the seasonal metaphor is utterly irrelevant). Like a good version of swine fever, economic buds appear to be turning up all over the place. In the US, we have seen a welcome bounce in consumer confidence and a more positive clutch of manufacturing indicators. In Britain, consumer confidence posted its highest reading in a year (although the survey was carried out before Alistair Darling's heavily-criticised Budget). Japan posted its first increase in industrial production in several months, as did South Korea. China is doing particularly well, with public infrastructure spending rising rapidly and bank lending growth accelerating. Meanwhile, stock markets have surged ahead and there are encouraging signs that the worst of the lending drought is over.
So why do I feel so uneasy about the world economy's prospects? After all, interest rates are low, governments are encouraging (or coercing) banks to lend and budgetary polices have become increasingly generous. Given the amount of policy stimulus now on offer, surely there is every chance that we are about to see a sustained recovery in global economic activity. The dynamics of the latest economic crisis are, though, very different from past experiences. Recoveries are sustained typically because policymakers are able to nurse economies back to health. The US had a recession in 1991 but the Federal Reserve carried on cutting interest rates throughout 1992. Another (mild) recession struck in 2001 but, even with recovery in 2002, the Fed persisted with rate cuts all the way through to 2003.
This recession, though, is much deeper. Over the past couple of quarters, we have witnessed the most catastrophic decline in America's gross domestic product (GDP) in post-war history. Already, though, the US central bank's key policy rate is down to zero. The Fed has, thus, already run out of room on conventional monetary policy: it can offer nothing more on short term interest rates. The same is also true for the UK.
I'd like to think more can be done with fiscal policy, yet governments are already borrowing unprecedented amounts of money which will have to be paid back by future taxpayers. Partly, this is a legacy of previous excess. The US and UK governments, in particular, chose to carry on borrowing earlier in the decade when a more sensible approach would have been to have saved up for a rainy (or recessionary) day. With budget deficits already up to 12 or 13 per cent of GDP, it is difficult to see how fiscal policy can offer much more support. Unless economic activity rebounds quickly, governments will soon find themselves having to raise taxes and cut public spending.
We are left, then, with so-called unconventional policies, the most important of which is quantitative easing. This, though, may not be as effective as it appears to be in the textbooks. Quantitative easing typically involves the creation of money which is then used to buy government and corporate bonds. With so much additional money sloshing around the system, the idea is to lower the cost of borrowing to households and businesses by getting money into the economy without necessarily having to rely on the ailing banks.
Quantitative easing also, though, lowers the costs of borrowing for governments. The temptation for politicians to borrow too much becomes that much greater and all the benefits of central bank independence disappear out of the window. Financial market turbulence ensues, reflected in either higher bond yields or currency crises. Either way, the ability to steady the economic ship erodes remarkably quickly. And, to the extent that central bankers insist on using "unconventional" language, the public is left with the impression that policymakers have simply run out of good ideas. Imagine a doctor telling you the hospital has run out of conventional medicines and that, from now on, you will be treated with herbal remedies: better than nothing, perhaps, but not necessarily the sort of move that is going to inspire an upsurge of confidence.
The biggest single problem, though, is the degree to which the world economy has already collapsed. Part of the decline is a short-term phenomenon as companies desperately cut their production to get rid of unwanted inventories. Already, there are welcome signs that this particular aspect of the downswing is drawing to a close. However, even if production recovers in the months ahead, it will still be the case that the level of demand in the world economy will likely be way lower than anyone expected just a few months ago.
One way to capture this problem is through the use of so-called "output gaps", which try to indicate how far the level of demand has deviated from its long-term trend rate of growth. Output gaps are to the whole economy what measures of capacity utilisation are to manufacturing.
Output gaps cannot be estimated with any real precision. However, they do say something about the possible scale of an economic problem. In March, the Organisation for Economic Co-operation and Development (OECD) published a set of interim economic forecasts which, among other things, included some estimates of output gaps across the world's major developed economies. The numbers are startlingly large. For the OECD countries as a whole, output in 2010 is estimated to be 8.5 per cent below its long-run trend. Never before in the post-war period has there been such a shortfall of demand.
Three implications stem from this. First, even if we are now seeing some green shoots, companies will struggle to make profits. The level of activity is now much more depressed than businesses had been planning for in recent years, leaving their revenues very low relative to their costs. Second, the hit to profits will force companies to think about further cost cuts, implying a squeeze on wages and a sustained increase in unemployment. Third, with inflation around the world already very low, persistently low levels of demand could all too easily lead to deflation. Deflation involves not just falling prices but also tremendous downward pressure on wages. Those households which have borrowed a lot will struggle. After all, the last thing you need when you are trying to pay off a mortgage is a pay cut. In normal circumstances, of course, central banks can respond to the deflationary threat by cutting interest rates but, in the US and the UK, that option no longer exists. We are back, then, to hoping that the economic homeopathy of quantitative easing will come up trumps.
I am not disputing the existence of green shoots. Their fecundity, though, is not yet guaranteed. The level of activity is remarkably low. It wouldn't take much for inflation to turn into deflation. We have reached the limit with traditional monetary levers and we are not very far away from the limit with fiscal levers as well. I hope that earlier policy moves will have a lasting positive effect. At this stage, though, it is far too early to give the economic patient a clean bill of health.
Stephen King is managing director of economics at HSBC
stephen.king@hsbcib.com
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