America and the World Economy
Janet Yellen is nothing if not bold. As well as seeming to confirm that quantitative easing (QE) will be wound down (“tapered”) by $10bn each month, the new Fed chief has indicated that American interest rates may begin to move upwards about six months after the termination of QE, heading towards an eventual level of about 4%.
What Yellen is trying to do here is to set out a road-map back to economic normality. Can the US (and, by extension, the world as a whole) follow this route successfully? In other words, is this “the beginning of the end” of the Great Recession, or is it “the end of the beginning” of the post-growth denouement?
I’d like ask for your indulgence as, in a longer-than-usual post, I (a) summarise the economic state-of-play as I see it, (b) set out the principal risk factors, and (c) try to reach some conclusions about what happens next – and when.
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If successful, the Yellen Plan (as I’ll call it) would restore a measure of normality to a US economy that has been anything but normal since the 2008 banking crisis. You see, normal economies do not depend on printing money (which, if it is not reversed, is what QE really amounts to). Normal economies also have real (above-inflation) interest rates, because negative real rates largely preclude capital formation by disincentivising savers.
If Yellen’s bold move is successful, the normality to which the American economy would return would be “a new normal”, quite unlike that of most of the post-1945 era. Like much of the West, America is heavily indebted, and has become dependent on debt-financed consumer spending. Moreover, globalisation has gone a long way towards turning the US into a low-wage service economy.
Longer term, these weaknesses could be overcome, by expanding manufacturing, by driving productivity upwards, and by improving real wages so that American consumers (for which also read American workers) no longer have to depend on borrowing to sustain their standards of living.
But none of this can happen without capital investment, which in turn means that it cannot happen without saving. This is why, on anything other than a short-term perspective, the restoration of positive real interest rates is so important.
Yellen’s policy objectives, then, are emphatically the right ones. But what are the odds on her plan succeeding?
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To answer this, we need to look first at where we’re starting from. The 2008 banking crisis was partly psychological, in that it resulted from an almost-overnight panic at the sheer scale of debt in the financial system. But the underlying problem was that the escalation in the cost of energy had undermined the forward growth assumptions in which the system’s previously-relaxed attitude to the debt mountain had been founded. Debt isn’t a problem if your income is rising – but the equation changes completely if the price of oil surges from $20/bbl to $100/bbl. Significantly, oil prices haven’t slumped (or even fallen at all) since then, despite the worst economic downturn for at least 80 years.
The response to the 2008 crisis amounted to the rescue of the banking system by governments; the slashing of policy interest rates by central banks; and the cranking up of the printing presses. Debt has been transferred from the banks to the balance sheets of governments, savers’ returns have been pulverised by the low rates which have bailed out borrowers, and huge amounts of money have been added to the system.
The reality, though, is that hardly anything has really changed. Despite huge cash injections, the economy has done nothing more than limp along. QE hasn’t created inflation – yet, anyway – but it hasn’t created growth either. Total debt remains as high as ever, and quasi-debt commitments (such as pension and welfare promises) remain wildly unrealistic. Banks’ reserve ratios remain dangerously slender. With the solitary exception of US natural gas, the energy cost screw continues to tighten.
QE has had severely distorting effects. Japan has almost doubled its money supply (whilst simultaneously running a huge fiscal deficit), and the effect has been the opposite of what was intended (the trade balance has crashed, not improved, and growth hasn’t been restored).
Newly-minted US dollars have kept capital markets buoyant (in defiance of economic gravity) and have also flowed into emerging economies, but a string of these countries (including India, Turkey, Indonesia and South Africa) have now had to hike interest rates, sometimes to economically-crippling levels, to prevent that money flowing back out again in response to the Fed’s “taper”. Britain has returned to growth, but seemingly on the back of borrowing a lot more than £1 for each £1 of GDP increase.
In short, this looks like a case of “falling over a cliff in slow motion”. First it was the debt-addicted US and UK that got into trouble, as the “Anglo-American model” of unfettered credit creation detonated. Next came the Eurozone, where the economic illiteracy of the single currency (one monetary policy, seventeen budgets) was exposed by debt escalation and default risk. Now it’s the turn of the emerging economies, caught up in taper back-wash, and next could be China, where debt could turn out to be as much as US$24 trillion.
In this situation, risks abound. In Japan, Abenomics could end in disaster. Renewed debt escalation might undermine markets’ faith in the UK. The scale of Chinese debt could spook the markets. The severe over-valuation of capital markets could be undermined either by the taper or by a long-overdue global re-pricing of risk. One or more major currencies could crash. Recognition that the shale boom is a case of hype over substance could undercut economic confidence in the US. Finally, there is the risk of external shocks (at the moment, the Ukraine situation obviously comes to mind).
In other words, risks to the system are multiplying. If someone is walking through a field with one land mine in it, he might get lucky, but plant enough land mines in the field and the likelihood of at least one going off rises exponentially.
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In this situation – and Janet Yellen’s good intentions notwithstanding – about the most that the authorities globally can hope for is to keep plodding forward in the hope that we’ll learn new bomb-disposal techniques before we actually tread on a land mine.
Yellen may want to restore real interest rates, but that may not seem a realistic option for the UK, the Eurozone countries or many other economies, where the introduction of higher rates could be very painful indeed. If the US goes it alone on rates, the dollar could strengthen, with adverse effects on American trade.
In this situation, there are two ways that this could end. First, governments around the world could accept the need for higher rates, and could co-ordinate their monetary policies with the Yellen Plan – even though this would cause significant pain in the near-term, it could create a softer landing than the second option, which is to carry on with artificially-low rates in an effort to co-exist with excessive debt.
In fact, I think, the decisive factor here could be capital markets. At the moment, many asset classes (including equities and bonds) are defying economic gravity, resulting in a severe under-pricing of risk. The law of equilibrium suggests to me that, if risks are huge but the price of risk is abnormally low, risk pricing has to rise sharply, bringing markets tumbling down.
That, at any rate, is my conclusion. Something – Japan, perhaps, or Chinese debt, or political developments in Ukraine or elsewhere – could spook the markets.
At that point, Janet Yellen may have to execute a manoeuvre that, in the Vietnam war, was famously described as “a strategic advance to the rear”.