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An uncertain world

By Laurence Neville

Today’s economic and financial environment is starkly different to the pre-2008 world. What do the world’s leading economists think are its main characteristics and how long will they endure?

 

The financial crisis ended years ago. But the economic and financial environment has not returned to normal: instead we’ve entered a new era. Its characteristics have evolved over the past five years – indeed volatility, uncertainty and change are important features of the new economic landscape. Nevertheless, a number of common factors, described below, can be identified:

Growth is feeble

In January, in a wearyingly familiar announcement, the International Monetary Fund (IMF) revised growth figures downward by 0.2 percentage points for both 2016 and 2017 to 3.4% and 3.6. [1] According to the United Nations’ World Economic Situation and Prospects 2016 report, the average growth rate in developed economies has declined by more than 54% since the crisis. [2] Christine Lagarde, the IMF managing director, describes the situation as the “new mediocre”.

“Before the crisis, any economist would have predicted that an economy with interest rates close to zero and no other major brakes on demand would see high growth rates and quickly overheat,” says Olivier Blanchard, senior fellow at the Peterson Institute for International Economics and former chief economist at the IMF. “Yet this is not what we have seen. The reason [is] found in mediocre medium-term prospects, which in turn affect current demand and growth.” [3]

Blanchard attributes the pedestrian medium-term outlook to a number of factors, many of which predate the financial crisis, such as an ageing population and slowing productivity growth (one argument is that the benefits of the most recent wave of IT innovations have been exhausted). Nouriel Roubini, professor at NYU’s Stern School of Business says that the burden of high private and public debts is also restraining growth. [4] The eurozone government debt-to-GDP ratio in the fourth quarter of 2015 was 90.8% compared to the pre-crisis low of 64.9% in the fourth quarter of 2007. [5]

Growth is feeble

Inflation is low

Low inflation has been the main goal of most developed economies for the past 30 years. Eurozone inflation has been below 1% since October 2013 – compared to a target of close to 2% – and for six months (most recently in February) has been negative. [6] Now, according to Roubini, “the challenge for central banks is to try to boost inflation”. [7]

Low inflation has the potential to lead to deflation (where prices fall), which hits investment and consumer spending. Very low inflation is less damaging but has similar effects. It makes it harder for consumers and companies to pay off debts – they are less eroded by inflation – and therefore hampers spending. It also makes it more difficult for firms to pass on costs and therefore potentially decreases margins.

Markets are volatile

Asset prices fluctuate constantly based on the balance of buyers and sellers. But “fluctuations are accentuated by patchy market liquidity,” according to Mohamed A El-Erian, chief economic adviser at Allianz and chairman of President Obama’s Global Development Council. [8] Liquidity in much of the bond market has been diminished by regulatory changes that have made it costly for banks to keep a large bond inventory.

While liquidity is important, investors’ decisions are based on the perceived value of assets and the flow of relevant news. In current markets, there are numerous factors that weigh on sentiment such as China’s slowing economy and geopolitical instability (especially in the Middle East). However, hanging over all markets is a driver that historically has been much less important: central bank policy.

In the absence of significant economic growth (which might increase corporate earnings and prompt higher asset prices), “today’s markets are heavily influenced by the direct and indirect involvement of central banks,” notes El-Erian. [9] Investors are now less concerned about fundamental value and more focused on second-guessing policy moves. As a result, asset prices are more correlated than in the past and so-called risk-on/risk-off behaviour has emerged, increasing volatility.

Markets are volatile

Monetary policy is unprecedented

Central bank policy now has a greater bearing on markets not just because other factors are less important but because policies have become more extreme. Quantitative easing (QE) has not led to rampant inflation as some feared. But it has also not revitalised the global economy by boosting consumption and investment as many hoped.

Nobel-winner and Columbia professor Joseph Stiglitz and Hamid Rashid, chief of global economic monitoring at the United Nations Department of Economic and Social Affairs, note that this is “partly because most of the additional liquidity [has] returned to central banks’ coffers in the form of excess reserves”. [10] Much of the rest of the liquidity has been invested in financial assets rather than the real economy. Consequently, QE has failed to spur growth and instead led to asset price bubbles.

In the currency markets, QE has also increased volatility by intensifying the differences in monetary policy between different countries and regions. Some currencies have also become more volatile because of commodity price falls, which have prompted commodity-exporting countries to cut rates as part of an (unstated) effort to weaken their currency and promote export-led growth. Some countries that do not export commodities have attempted similar strategies.

The benefits of other policy innovations, such as negative rates (now standard in Switzerland, Sweden, Denmark, the eurozone, and Japan), remain unclear. Instead of encouraging investment, negative rates appear to have encouraged banks and businesses to hoard more cash. Stiglitz quotes OECD figures that show the percentage of GDP invested in a category that is mostly plant and equipment fell from 7.5% in 2000 to 5.7% in 2014 in Europe and from 8.4% to 6.8% in the US. [11]

Stuck in a rut

Is the current economic and financial environment of low growth and inflation, volatile markets and central bank omnipotence permanent? Kenneth Rogoff, professor of economics and public policy at Harvard University and former IMF chief economist notes that “the most under-appreciated driver of market sentiment right now is fear of another huge crisis”. [12] The risk is that fear trumps faith in central banks’ power, resulting in markets and the global economy unravelling as corporates and consumers invest and spend less.

To date, central banks have been able to keep fear largely at bay but they haven’t been able to eliminate it. As Blanchard notes, the result is a weak recovery. [13] In the absence of major structural changes to tackle barriers to investment and improve productivity, which will be politically difficult to achieve, the outlook is most likely to be continued tepid growth.

 

  • [1] International Monetary Fund, World Economic Outlook, January 2016
  • [2] United Nations Development Policy and Analysis Division, World Economic Situation and Prospects 2016, December 2015
  • [3] Olivier Blanchard, Slow growth is a fact of life in the post-crisis world, Financial Times, April 13, 2016
  • [4] Nouriel Roubini, The Global Economy’s New Abnormal, Project Syndicate, February 2016
  • [5] European Central Bank Statistical Data Warehouse
  • [6] Ibid.
  • [7] Nouriel Roubini, The Global Economy’s New Abnormal, Project Syndicate, February 2016
  • [8] Mohamed El-Erian, Why Investors Face Roller-Coaster Markets, Bloomberg View, March 25, 2016
  • [9] Ibid.
  • [10] Joseph Stiglitz & Hamid Rashid, What’s Holding Back the World Economy?, Project Syndicate, February 2016
  • [11] Joseph Stiglitz, What’s Wrong With Negative Rates?, Project Syndicate, April 2016
  • [12] Kenneth Rogoff, The Fear Factor in Global Markets, Project Syndicate, March 2016
  • [13] Olivier Blanchard, Slow growth is a fact of life in the post-crisis world, Financial Times, April 13, 2016

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