This is an excerpt of the July 2013 Longbrake Letter. To read the letter in its entirety, click here.
Increasingly it is looking like the global economy is at an inflection point. Economic trends that have held sway for much of last four years appear to be giving way and whiffs of turbulence and change are emerging, such as China’s short-lived liquidity crunch last month. The global equilibrium of sorts that developed in the wake of the global Great Recession was one engineered by massive public policy intervention. In China it was aggressive state stimulus of investment. In the U.S. it was a combination of Keynesian deficit spending initially and a flood of monetary policy driven liquidity. In Europe initial fiscal stimulus quickly led to sovereign solvency issues and a response to deal with these issues through a combination of austerity, bailouts and massive liquidity injections. The list of interventions goes on with Japan the most recent major economy to embrace significant government policy intervention in an attempt to revive a deeply troubled economy.
These interventions generally had two effects – one good, but the other was not because it involved denial. The interventions did lead to a semblance of normality, calmed financial markets and probably avoided global depression. So, in that sense the interventions were constructive. However, the policies pursued more often than not did not address deep-seated structural flaws and imbalances in the global economy. In effect, policies papered over problems.
1. European Union
Europe steadfastly refuses to address fundamental governance flaws in the makeup of the European Union and its common currency, the euro. As a consequence it is only a matter of time before the European Project endures a great cataclysm.
Germany’s economic policies are self-serving and in the context of the euro currency union are contributing to the deep depressions gripping many peripheral European Union members. Even France is wobbling.
China bootstrapped its phenomenal growth by linking its currency to the dollar and pursuing trade-based mercantilist policies. While those policies were essential in the early going to galvanize China’s economic breakout, an economic model driven primarily by investment by repressing consumption, which is what China did, leads in the long run to unsustainable imbalances.
When the global Great Recession hit, Chinese policy makers doubled down by cranking up the state-driven investment economic model. Growth surged and many countries, particularly those that were resource rich, benefited handsomely. But as Hyman Minsky described in his “financial instability hypothesis”, overinvestment leads first to “speculative financing” which is often followed later on by “Ponzi financing”. When cash flows from real economic activity are not sufficient to support servicing of interest and principal on the credit used to finance the investment, momentum and state support can sustain the situation at the cost of ever growing imbalances.
China pretty clearly has been in the Minsky “speculative financing” phase for a while. But the recent explosion in credit growth while real growth rates are actually slowing suggests that China may have entered the “Ponzi financing” stage. This is the stuff of bubbles and short of massive state intervention, bubbles always burst eventually. An ever increasing number of dollars (renminbi) is required to generate a dollar of output. This is a telltale sign of the Minsky “Ponzi financing” phase. And that is exactly what has been happening in China over the last several months.
China’s leaders understand the need to transition the economy from one in which investment and exports have driven growth to one in which domestic consumption will eventually dominate. Such a transition is typical in a developing economy as consumer incomes rise and a large middle class evolves. This transition is also necessary for sustaining social and political stability. However, the transition which is in its early stages already appears to be resulting in a slowing in the rate of GDP growth. China reported that year-over-year GDP growth edged down to 7.5% in the second quarter.
While what needs to happen is clear, the new Chinese leadership will face formidable implementation challenges. This means that there will be plenty of bumps along the way and it is possible that the transition process will stall or move too slowly. The possibility of a hard landing, though unlikely, cannot be ruled out.
4. Resource-Based Economies
Growth in China’s demand for raw materials has already slowed. At the same time substantial increases in capacity to supply commodities are coming on line in many resource-based economies. Not surprisingly, prices of most commodities are falling. This is not a short-term phenomenon. Until recently rising prices for commodities partially offset powerful deflationary forces; falling commodity prices will now reinforce deflationary forces.
5. United States
Policy makers in the U.S. prevented potential depression by instituting deficit spending and pursuing aggressive monetary easing. But, both sets of policies have been insufficient to galvanize a robust economic recovery.
Fiscal policy was probably insufficient in size and definitely did not have an optimal composition. Too many dollars were spent on low multiplier activities. Investment in infrastructure was totally inadequate. Then, when the recovery proved to be feeble and deficits grew apace, it became easy for deficit hawks to capture the political momentum and institute austerity. This “prudent” fiscal policy will extend the length of time required for closing the output gap. Worse, the recent blunt cutting of government expenditures through the sequester is starving investment with the likely long-run result that the potential rate of growth in the U.S. will decline.
Other structural imbalances, such as growing income inequality, concentration of financial resources, allocation of financial resources (historical overinvestment in housing), and the aggrandizement of politically well-connected elites, have not been addressed and the potential long-run consequences of these imbalances appear to be growing.
Monetary policy, although it has the appearance of having been extremely accommodative, may not have been accommodative enough (see the discussions of financial conditions in Sections II and VI). Here, too, just as has been the case for fiscal policy, the failure of monetary policy to accelerate recovery is leading to a loss of political support. Federal Open Market Committee members and other Federal Reserve officials probably do believe that the economy is poised to grow more rapidly and, therefore, monetary policy accommodation will need to be phased out sooner than later. However, an early exit also would relieve intense political pressure. There are economic risks both to maintaining accommodative monetary policy too long and to not maintaining it long enough. But the political risks are primarily concentrated on the side of maintaining accommodation. Thus, the U.S. increasingly faces the risk of adding premature withdrawal of monetary stimulus to the policy mistake of instituting fiscal austerity and failing to support investment in infrastructure and research.
Japan has yet to come to grips with the challenges of an economy whose population and work force are shrinking. Its failure to understand this problem and develop effective policies assured 20 years of malaise and deeply embedded deflation.
Now nearly all the policy stops have been pulled out. Developing “third arrow” policies, which involve increasing competitiveness and growing the size of the labor force, are essential for dealing with the consequences of an aging and shrinking population. These policies are mostly conceptual at this juncture and will soon need to be turned into concrete programs. Aggressive fiscal and monetary policies are already having favorable impacts on growth and deflation, but their effectiveness will wane in time without effective “third arrow” programs.
7. Other Countries
The list of global imbalances could go on. For example, the recent rapid growth of the Indian and Indonesian economies may turn out to be the product of liquidity-driven financial flows seeking yield, rather than to deliberate enabling economic policies. If that turns out to be the case, since both of these countries have large trade deficits the recent reversal of “hot money” capital flows, if sustained, will put intense pressure on their ability to finance themselves with the dual consequences of increasing inflation and slowing growth.
8. Nouriel Roubini’s “New Abnormal”
Nouriel Roubini, the economist who correctly foresaw the consequences of the U.S. housing bubble and the global speculative frenzy it spawned, recently penned an article titled the “New Abnormal”.¹
Roubini notes that the theme of the “New Normal” has been embraced by many. The “New Normal” involves the presumption that economic progress will be slow but steady and will be supported by an abundance of central bank provided liquidity. But this “New Normal” involves papering over significant structural imbalances. Policy intervention has sedated the disease but it has not cured it. But in the absence of crises policymakers have lost fear, complacency has taken over. Ignoring serious issues does not make them go away. In fact, history suggests that problems tend to get much worse by virtue of neglect.
Roubini puts it this way: “… this situation is one that is not a stable equilibrium, is not even a stable disequilibrium. It’s an unstable disequilibrium. Take for example the Eurozone. You cannot have just a monetary union without banking, political, economic, fiscal union. Either you move towards more integration or you’re going to have more fragmentation and disintegration. So the situation we face right now in the global economy, same in the Eurozone, is of an unstable disequilibrium, therefore a new abnormal, that cannot be sustained. … liquidity has been like a drug, a palliative, it doesn’t resolve the disease, you have to do fundamental, structural changes that’s going to increase the productivity.”
Roubini concludes that: “The deeper questions that created the recent convulsions have not been answered, and the easing of so much useful fear will make them much more difficult to address. That’s why the uncertainty and volatility of the past half-decade is far from finished – and is almost sure to trigger new crises. We have entered the New Abnormal, a period in which every market assumption must be questioned and the wise investor is prepared to be surprised.”
¹Nouriel Roubini. “Roubini and Bremmer on Charlie Rose: Unveiling New Abnormal,” EconoMonitor, June 27, 2013.