Economic Watch

The global economy is in serious danger

A global ‘Draghi vow’ needed
Mario Draghi.jpg

The dangers facing the global economy are more severe than at any time since the Lehman Brothers bankruptcy in 2008 and as we enter a new macroeconomic epoch. (Read more)

The problem of secular stagnation – the inability of the industrial world to grow at satisfactory rates, even with very loose monetary policies – is growing worse in the wake of problems in most big emerging markets, starting with China.

This raises the spectre of a global vicious cycle of slow growth in industrial countries hurting emerging markets, thereby slowing Western growth further. Industrialised economies, barely running above stall speed, can ill afford a negative global shock.

Policymakers badly underestimate the risks of both a return to recession in the West and of a global growth recession.

If a recession occurs, monetary policymakers would lack the tools to respond, with essentially no room left for easing in the industrial world. Interest rates are expected to remain very low almost permanently in Japan and Europe and to rise only very slowly in the United States.

Today’s challenges call for a clear global commitment to the acceleration of growth as the main goal of macroeconomic policy, with more than just monetary measures.

The old proverb “you do not want to know the things you can get used to”, is all too applicable to the global economy in recent years.

Despite talk of recovery and putting the economic crisis behind us, gross domestic product forecasts are being revised sharply downward almost everywhere.

Relative to 2012 the International Monetary Fund has reduced its forecasts for US GDP in 2020 by 6%, for Europe by 3%, for China by 14%, for emerging markets by 10% and for the world as a whole by 6%.

These dismal figures assume no recessions in the industrial world and an absence of systemic crises in the developing world – neither of which can be taken for granted.

New macroeconomic epoch

We are in a new macroeconomic epoch where the risk of deflation is higher than that of inflation, and we cannot rely on the self-restoring features of market economies. The effects of hysteresis – recessions not just being costly but also stunting growth of future output – appear far stronger than anyone imagined a few years ago.

Western bond markets signal rather too little than too much outstanding government debt. Again, as things go badly, there is a great debate about either staying the course or opting for a serious correction.  

I am convinced of the urgent need for substantial changes in the world’s economic strategy.

From history we know markets are inefficient and often wrong in judgements about economic fundamentals and that policymakers who ignore adverse market signals inconsistent with own preconceptions, risk serious error.

That was one of the most important lessons of the financial crisis in 2008. If the pricing signal on the US housing market from mortgage securities, or those about the health of the financial system from bank stock prices are heeded, policymakers would have reacted far more quickly to the gathering storm.

In Europe policymakers also dismissed market signals that Greek debt would not be repaid in full, delaying necessary adjustments at great cost.

Lessons from the bond market

It is instructive to consider what government bond markets in the industrialised world are implying today. Being the most liquid financial markets in the world they reflect the judgements of a large group of highly informed traders. Two conclusions stand out:

  • The risks tilt heavily toward inflation rates below official targets. Nowhere in the industrial world is an expectation that central banks will hit their 2% targets in the foreseeable future. Inflation expectations are highest in the US at barely 1.5% for the five-year period starting in 2020. This, despite the market believing that monetary policy will remain much looser than the Fed expects in its own predictions. If the market believed the Fed’s monetary policy, it would expect even less inflation and a real risk of deflation.
  • The prevailing expectation is one of extraordinarily low real interest rates – the difference between interest rates and inflation. They have been on a downward trend for nearly a quarter-century with an expected average in the industrialised world over the next 10 years of zero.

Many will argue bond yields are artificially depressed by quantitative easing (QE) and so it is wrong to use them to draw inferences about future inflation and real rates.

It is noteworthy that bond yields are now lower in the US than their average during the period of quantitative easing and that forecasters were confidently – but wrongly – expecting them to rise for years.

There are four contributing factors that lead to much lower than normal real rates:

  • Increases in inequality – the share of income going to capital and corporate retained earnings – raise the propensity to save;
  • An expectation that growth will slow due to a smaller labour force growth and slower productivity growth, which reduces investment and boosts the incentives to save;
  • Increased friction in financial intermediation caused by more extensive regulation and increased uncertainty discourages investment; and
  • Reductions in the price of capital goods and in the quantity of physical capital needed to operate a business – think of Facebook having more than five times the market value of General Motors.

Emerging markets

Until recently, a major bright spot has been the strength of emerging markets making them substantial recipients of capital from developed countries that could not be invested productively at home.

The result has been higher interest rates than would otherwise be obtained, greater export demand for industrial countries’ products and more competitive exchange rates for developed economies.

Gross flows of capital from industrial to developing countries rose from $240 billion in 2002 to $1.1 trillion in 2014. Of particular relevance for the discussion of interest rates is that foreign currency borrowing by the nonfinancial sector of developing countries rose from $1.7 trillion in 2008 to $4.3 trillion in 2015.

This has now gone into reverse. According to the Institute of International Finance, developing country capital flows fell sharply this year for first time in almost 30 years and private capital leaving developing countries eclipsed $1 trillion.

No time for complacency

What does all this mean for the world’s policymakers?

The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. The latest data suggest slowing growth in the US, and it is already slow in Europe and Japan. A global economy near stall speed is one where the primary danger is recession.

The most successful macroeconomic policy action of the past few years was European Central Bank President Mario Draghi’s famous vow that the ECB would do “whatever it takes” to preserve the euro, uttered at a moment when the single currency appeared to be on the brink.

His unconditional commitment to providing liquidity and supporting growth prevented an incipient panic and helped lift European growth rates – albeit not by enough.

Any discussion has to start with China, which poured more concrete between 2010 and 2013 than the United States did in the entire 20th century.

A reading of the recent history of investment-driven economies – be it Japan before the oil shock of the 1970s and 1980s or the Asian Tigers in the late 1990s – tells us that growth does not fall off gently.

China faces many other challenges, from the most rapid population ageing in the history to a slowdown in rural-to-urban migration, issues of political legitimacy to how to cope with hangovers of unproductive investment.

Even an optimistic view – where China shifts smoothly to a consumption-led growth model led by services – its production mix will be much lighter. The days of it sustaining global commodity markets are over.

The problems are hardly confined to China, as Russia struggles with low oil prices, a breakdown in the rule of law and harsh sanctions, Brazil has been hit by the decline in commodity prices, but even more by political dysfunction.

India is a rare exception, but from Central Europe to Mexico to Turkey to Southeast Asia, the combination of industrial growth declines, and dysfunctional politics is slowing growth, discouraging capital inflows and encouraging capital outflows.

What is needed?

What is needed now is something equivalent to the ‘Draghi vow’ but on a global scale – a signal that the authorities recognise that secular stagnation, and its spread to the world, is the dominant risk faced.

After the latest dismal US jobs report, the Fed must recognise, what should already have been clear, that the risks to the US economy are two-sided:

  • Rates will be increased only if there are clear and direct signs of inflation or of financial euphoria breaking out; and
  • The Fed must also state its readiness to help prevent global financial fragility from leading to a global recession.

The central banks of Europe and Japan need to be clear that their biggest risk is a further slowdown, indicating a willingness to be creative in the use of the tools at their disposal.

With bond yields well below 1%, it is doubtful that traditional quantitative easing will have much stimulative effect. They must be prepared to consider support for assets such as corporate securities that carry risk premiums that can be meaningfully reduced and even to recognise that by absorbing bonds used to finance fiscal expansion they can achieve more.

Long-term low interest rates radically alter how we should think about fiscal policy – just as homeowners can afford larger mortgages at lower rates, government can also sustain higher deficits.

If a debt-to-GDP ratio of 60% was appropriate when governments faced real borrowing costs of 5%, then a far higher figure is surely appropriate today when real borrowing costs are negative.

The case for more expansionary fiscal policy is especially strong when it is spent on investment or maintenance. Wherever countries print their own currency and interest rates are constrained by the zero bound, there is a compelling case for fiscal expansion until demand accelerates to the point where interest rates can be raised.

While the problem before 2008 was too much lending, many more of today’s problems are caused by too little lending for productive investment.

Inevitably, there will be discussion of the need for structural reform – there always is. But to emphasise this now would imply embracing the macroeconomic status quo. The world’s largest markets are telling us with ever-increasing force that we are in a different world than we have been accustomed to.

Traditional approaches, focusing on sound government finance, increased supply potential and avoidance of inflation, court disaster. Moreover, the world’s principal tool for dealing with contraction – monetary policy – is largely played out and will be less effective if contraction comes. Policies aimed at lifting global demand are imperative.

If I am wrong about expansionary fiscal policy and such measures are pursued, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But if they materialise, standard approaches can be used to combat them.

If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years – growth stagnating with little to be done to fix it.

It is an irony of today’s secular stagnation that what is conventionally regarded as imprudent offers the only prudent way forward.

(This is a shortened version of an article in the Washington Post by Lawrence Summers, professor at and past president of Harvard University, US treasury secretary from 1999 to 2001 and an economic adviser to President Obama from 2009 through 2010. The full article can be read here.)



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