The global economy is no Lazarus – the outlook is bleak

Any new crisis is likely to be a further phase of the 2008 crisis, reflecting the fact that the causes remain largely unresolved. A future downturn will be much worse this time around

Satyajit Das
Sunday 22 May 2016 12:09
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Emerging markets face difficulties and will not be a source of succour as in 2009
Emerging markets face difficulties and will not be a source of succour as in 2009

There are three possible scenarios facing the global economy. 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 six 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.

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 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-like, 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 may 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 slow reduction of living standards by stealth places political limits on this approach. Ultimately, a major correction will 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 problems are global with developed and emerging markets affected.

Some historians view World War II as a continuation of World War I 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. But a future downturn will exacerbated by several factors.

First, the problems now are larger and more global. Emerging markets face difficulties and will not be a source of succour as in 2009.

Second, there is now limited capacity of policy makers to respond.

The stabilisation since 2008 has been the result of fiscal deficits in combination with lower interest rates and QE. Today, strained government finances mean that running budget deficits on the scale that was done after 2008 will be more difficult.

In the US, rates were lowered from 5.25 per cent to zero, injecting around 20 per cent 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 fact that rates are much lower, in some cases negative, means that further monetary measures will be far less effective.

Third, faith in policy makers is waning as a result of their ineffectiveness in engineering a recovery on the scale promised.

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. The unintended financial consequences of monetary experiments on an unprecedented scale are unpredictable. The risk of policy errors or poor execution, such as premature increases in rates, or withdrawal of liquidity support, is increasing.

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.

They would do well to heed Cassius’s warning in Julius Caesar: “The storm is up, and all is on the hazard.”

Satyajit Das is a former banker and author. His latest book is A Banquet of Consequences published as Age of Stagnation.

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