Economic Recovery – Reasons to be Pessimistic

The economy seems to be picking up so why are economists still so dour?

Economists are not known for being moody but many are depressed when it comes to the state of the global economy.  This seems out of place at a time when economic recoveries in some countries are showing signs of taking hold and stock markets are setting record highs.  The mood among economists was already negative after being caught out by the global financial crisis.  Are economists right to be worried or just hung up on past mistakes?

Why so glum?

My father inquired, after a recent post on my blog, why my views had to be so downbeat.  Given that much of the business cycle is driven by the sentiment of consumers and businesses, his line of thinking was that the economy would jump back to life if we could all just be more positive about the future.  People would spend more while companies would invest and take on more workers.  All we would need is economists to tell us that everything will be alright.

The problem is not that economists are always a grumpy bunch.  The problem is the opposite – that economists have been overenthusiastic in the past.  This optimism was fuelled by a belief that economic theory could provide a route to a steady rise in prosperity.  Instead, economists have been chastened as a result of their previous ideas being proved wrong by the global financial crisis.  The crisis has also focused minds on what can go wrong.  Now, even periods of prosperity are seen to have a darker side and to create the seeds for trouble in the future.

Grumpy for a reason

It may just be the case that economists are caught in a crisis of confidence.  There is a core belief among economists that markets have the ability to correct themselves.  This means that any periods of weak economic growth should only last until the economy gets back on its feet again.  There is much data on the economy to get excited about.  Consumer spending is up, buoyed by the job market recovering faster than expected.  The worst of the crisis seems to be behind us and stock markets reflect this new upbeat outlook.

Yet, economists have learnt their lessons and know better than to place too much trust in the data.  Behind the numbers lurks a less cheerful story.  Investment by companies is low with few businesses seeing opportunities to expand despite balance sheets laden with cash.  One reason for this is that labour productivity is weak.  This means that the extra earnings for companies from employing more workers are likely to be poor.  Low labour productivity also implies that wages are not likely to rise much which raises concerns about whether households will struggle to pay off rising levels of debt.  A lack of new innovations suggests that investment and productivity may not improve for a long time to come, prompting talk of prolonged stagnation.

When the markets are not functioning normally, it is typically the government that steps in to correct any problems.  However, the governments in many countries have been more hindrance than help.  Mismanagement of government finances, slow and timid responses to crises, and a lack of forward-looking policies are common complaints.  With voters lacking genuine alternative political parties, politicians have become engrossed in petty political positioning rather than constructive policy making.  Managing the economy has been left to central banks which has caused its own problems. 

This is why Your Neighbourhood Economist is one of many who struggle to find reasons for cheer.  It would be great to be caught up in the euphoria that has taken hold of the financial markets but economists have been burnt too badly to get carried away.  Only time will tell if the gloom among economists is warranted.

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

What’s up with inflation?

Inflation has been given a bad name but redemption may be at hand as high levels of debt mean developed economies could benefit from more inflation.

Inflation has been treated with the same disdain as smelly socks – an unfortunate factor of life that is tolerable at low levels but too much may be the sign of something more serious.  This stems from periods in history when inflation has wreaked havoc such as when hyperinflation in the 1930s in Germany resulted in prices skyrocketing to levels so high that Germans would go grocery shopping with a wheelbarrow full of cash.  Inflation eats away at the value of savings with higher prices meaning that the same amount of money can no longer buy as much.  But the flip side of this is that inflation also reduces the value of debt.  With the high level of debt among the most pressing concerns in many developed economies, inflation no longer seem so bad and there has been a shift in views that will affect anyone with savings or debt which is almost everyone.

The first signs of a change came from the Federal Reserve which has two goals as the central bank of the United States, low inflation and full employment.  A focus on clamping down on inflation had resulted in employment being less of a concern for the Federal Reserve, but as central banks everywhere have been asked to help out with sluggish economic growth, the Federal Reserve is paying closer attention to the job market in the United States.  In December, the Federal Reserve announced that it would keep interest rates close to zero until unemployment had fallen from its current level of 7.75% to 6.5% or until inflation was forecast to top 2.5% which is higher than the target rate of inflation of 2%.  A key role of any central bank is to signal its intentions so as to manage expectations for inflation and the Federal Reserve has shown that it will be more tolerant of inflation if that helps to lower unemployment.

More creative ideas on monetary policy are coming from the newly appointed governor of the Bank of England, Mark Carney.  Carney achieved almost rock star status after a successful spell (due to skill or good fortune) as the governor of Canada’s central bank and his ideas are raising eyebrows.  Carney put forward the idea that central banks should target nominal GDP instead of inflation.  Typical GDP figures are quoted with the effects of inflation taken out but nominal GDP includes both growth in the economy and rising prices.  This would enable central banks to accept more inflation when the economic growth is slow by setting interest rates to be lower (or monetary policy to be looser) than would otherwise be the case.  While this new policy may be a bit too radial for the conservative world of central bankers, it is a part of Carney’s belief that monetary policy can have more of a role in lifting the economy out of the current stagnation and that there are unconventional policies which could be implemented instead of monetary policy simply aiming for a certain level of inflation.

More inflation will also help governments with high levels of debt.  If prices rise at a faster rate, this will increase the size of the economy in nominal terms and the amount of debt will shrink relative to the economy making it easier to pay off.  And it is not only governments with lots of debt but many households who purchased property during the housing boom are struggling with large mortgages and they too should get some cheer from higher inflation for the same reason.  Inflation will also been a boost to businesses that will have more scope to raise prices and will be tempted to borrow more for investment if interest rates are lower than inflation (also referred to as negative real interest rates).  But inflation has always been the enemy of frugal types (including Your Neighbourhood Economists) who have put money away and savers will be the big losers.  While it is unfair to penalise the responsible, the burden of debt on governments and on the economy as a whole in developed countries is currently so great that calls for more tolerance of inflation should be heeded.  Inflation need not be so bad after all.

More fighting talk

Along with the large amounts borrowed by governments, the younger generation are also set to be saddled with more debt which is not of their own making.

Talks of battles and fighting in the previous blog got Your Neighbourhood Economist thinking about a struggle so epic that it makes the currency wars seem like kids throwing toys in the playground (or, more literally, central bankers throwing money at the economy).  This fight pits a battle-hardened and organised army against a smaller force that increasingly has its back up against the wall.  So who is fighting over what?  It is a battle between old and young over pensions.  The money that government pay the elderly in their retirement adds a further weight to the mountain of debt already depressing the global economy but pensioners form a potent force in politics and loathe to give up what had been promised to them in the past.  Yet pensions that would have been tough to pay even in good times may be set to bankrupt a younger generation.

Pensions have traditionally been based on pay-as-you-go schemes where payments for pensioners come from the taxes paid by current workers.  This was an arrangement that was acceptable to workers to begin with because it was assumed that they would also be eligible for pensions after retirement.  This system relied on a growing population where the work force was expanding so that the burden of pensions was never too great.  This social contract has broken down due to the demographic accident of the baby boomers.  The surge in births following the end of the Second World War resulted in a bulge in the population due to the so-called baby boomers having fewer babies than previous generations.  The drop in child birth means that there will be fewer people in jobs paying taxes to fund the retirement of their parents’ generation.  Not only is the number of pensioners growing relative to the working age population, but the costs of pensions themselves are increasing as people live for longer.  The prolonged lives of the elderly will add bigger medical bills as well.  So something has to give – high taxes and less spending in other areas or a reduction in pay outs to the elderly.

As one would imagine, the baby boomers are not keen to give up what has been promised to them.  They believed that they paid their fair share of taxes, part of which funded the pensions of their parents’ generation, and now expect to receive the same treatment as they head into retirement.  Not only do baby boomers outnumber the younger generation but they also form a political force to be reckoned with.  The older generation have much higher voting turnout and are more politically active after experiencing dramatic changes during the post war years.  The young, on the other hand, are typically seen as being disillusioned with politics and can’t be bothered voting.

Politicians are aware of the potential shortfall in government finances with pension costs expected to balloon in the coming decades.  Baby boomers have added to the problem after years of voting for lower taxes.  There have been recent attempts to forge a solution through raising the retirement age but it is a political minefield (the new government in France even lowered the retirement age which was a reversal of the previous government).  Immigration would also help but voters in many countries can’t stomach the thought too many foreigners even if they are paying taxes.  So even though the elderly with their failing eye sight and walking canes may not seem to be able to wreck much havoc, they are set to demolish government finances. 

So it seems likely that young people will be left to foot the bill and they are already paying the consequences of a system that is geared toward their elders.  The older generation has benefited from rising property prices through their lifetime but now youngster struggle to buy their first home and end up stuck living with their parents.  The job market is also tough as unions protect the jobs of current workers who are typically older while the young miss out on work as no new jobs are being created due to economic stagnation.  And when people from the younger generation do find work, they have to pay taxes which go toward pensions as well as putting money into pension accounts to pay for their own retirement – paying for pensions for both themselves and for their parents.  This may be the first generation in centuries that will be worse off than their parents.  And you thought it was tough growing up!

A New Inconvenient Truth

The reality which faces the West that politicians dare not speak of

The rise of countries such as China, India, and Brazil will be a tectonic shift in economic power but it is also a change that is long overdue.  The relative dominance of Europe and the United States in the global economy is a historical accident brought about by the early formation of capitalist economies in these parts of the world.  The response to these new challengers will define the role that the United States and Europe play on the global stage in the future and the initial signs do not look good. 

The Western world spearheaded by Europe and the United States have generated the bulk of the wealth in the global economy for most of the past century.  As early ago as 1990, the United States accounted for around 23% of global GDP and the countries which now constitute the European Union accounted for roughly 32% while respectively only making up 5% and 9% of the world’s population.  Yet, growth in the countries such as those grouped together under the label of BRICs (Brazil, Russia, India, and China) is the beginning of the end to this distortion in the distribution of global wealth.  The BRICs countries, who accounted for just 8% of global GDP despite making up 43% of the number of people worldwide in 1990, have seen their share of global GDP increase to 18% as of 2010.  The figures for the United States and the European Union have dropped back respectively to 23% and 26% in 2010 and this is a trend that will continue for decades into the future.

It is not that the economies in the United States and Europe have not been expanding in size but growth is not as easy to generate as elsewhere.  Loading up on debt helped to create a booming economy for a while but excessive lending eventually brought about a deep economic slump (for more info, refer to Tale of Two Recessions).  The global financial crisis has instead allowed other countries to catch up faster and to lay siege to the position of the United States and Europe at the top of the global pecking order.  The concentration of wealth in these Western countries has allowed them easy access to resources such as agricultural produce and mineral deposits from around the global as well as ready markets for their manufacturing goods.  But industrialization in countries which were previously just mainly sources of raw materials for the United States and Europe has given rise to competition – both in terms of other countries snapping up resources and of creating rivals to Western firms.  Economic power has also allowed Europe and the United States to shape global institutions to their liking. 

But this imbalance of wealth was never destined to last.  The gap between the rich and poor became too great and plummeting transport costs meant that goods could be manufactured anywhere.  The changes stemming from this will shape the world for generations to come and in ways which cannot yet be grasped.  Rather than bracing themselves to face the reality of this new challenge, both Europe and the United States have been embroiled in domestic issues as politicians struggle to deal with growing levels of debt. 

Economic theory espouses the benefits of free trade and an open economy where countries should specialise in what they are good at.  For the United States and Europe, this would be high-tech or high-value-added sectors such as product design, computer software, and precision manufacturing which make use of their skilled workers.  Yet, Western governments have shot themselves in the foot through mismanagement of their finances.  The resulting masses of public debt have restricted the ability of governments to invest in, for example, education which has suffered in many richer countries as governments focused more on cutting taxes.

Politicians in the United States and Europe need to be more honest with voters.  It is easy to convince voters that the good times will return and to try and hold off the inevitable.  But this will merely delay the day of reckoning and will make it so much worse than it needs to be when it does come around.  Many current policies, such as reducing immigration even for skilled overseas workers, run completely against what needs to be done and suggest that politicians either do not grasp the changes already underway or prefer to pander to the preferences of a public who is adverse to change rather than confront them with reality.  Sooner or later, this inconvenient truth will become apparent, but by then, it may be too late.

A New Year but Nothing to Celebrate

The New Year is typically a time for celebration and a chance for many to start anew, but for the global economy, things look set to get worse in 2012 and the light at the end of the tunnel still seems a long way off.  A slew of news items this week has highlighted this trend.

The International Monetary Fund (IMF) has lowered its forecast for global growth for 2012 to 3.3% compared to the 4.0% expansion which was predicted four months ago.  More significantly, the new estimate for growth is less than the 3.8% for 2011 which means that things are going to get worse for many countries.  Top of the list of those expected to have little to look forward to in the New Year is Europe.  The IMF expects a 0.5% decline for the Euro area in 2012 with Italy and Spain predicted to suffer falls in GDP of 2.2% and 1.7% respectively.  Things are even set to take a turn for the worse in Germany which grew 3.0% in 2011 but it only expected to eke out growth of 0.3% in 2012.

While certain circumstances in Europe, such as the turmoil surround government debt, are specific to the region, other drags on the economy such as cuts to government spending, high unemployment, and a lack of confidence are much the same elsewhere.  Figures out this week for the UK showed that the economy shrank by 0.2% in the last three months of 2011 with unemployment at a 17 year high.  The dip in GDP means that the UK could suffer a double-dip recession – a recession being technically defined as two three-month periods of negative growth with the double-dip referring to the economy being unable to build up sufficient momentum to recover from an initial recession and slipping back in a recession. 

But perhaps the most depressing of news this week came from the Federal Reserve in the US who announced that it does not expect to raise interest rates until late 2014.  This is good news for those borrowing money but for everyone else it is a signal that the US economy is not expected to register strong growth any time soon.  It is also a sign of the desperation of central bankers who dislike publishing forecasts for interest rates and in so virtually committing to a target range of 0% to 0.25%.

Central banks everywhere are having to come up with novel ways of trying to boost the economy through monetary policy (the setting of interest rates or the money supply) as other options using fiscal policy (increased government spending or lower taxes) are limited due to high government debt.  But central banks only have a limited arsenal and a promise to keep interest rates their current record low levels is one way to convince consumers and businesses to borrow but considering the lack of punch that the interest rate policy has had so far, central bankers will be setting much of 2012 and beyond coming up with new ideas on how to start providing us with better news.

So what is going on…???

Last week saw a couple of growth forecasts being cut as the lingering effects of the financial crisis continue to weigh on the economies of developed countries. 

The OECD, an organization which counts many of the richer countries as its members, downgraded its expectations for growth and now predicts 1.8% growth in the U.S. economy next year compared to 3.1% it forecast in May.  The euro zone is only expected to manage a 0.3% increase in GDP in 2012 opposed to a prediction of 2.0% growth just six months earlier.  The OECD points to factors such as firms putting off investment due to uncertainty over the direction of the economy as well as households spending less as they worry about jobs and weak returns on investments in stocks and property.  Deeper cuts in government spending are also seen as having a negative effect as many governments rush to lower their levels of spending.

The Federal Reserve, the central bank of the U.S., also published a lower forecast for U.S. growth.  The U.S. economy is predicted to expand by around 2.7% rather than the forecast centred around 3.5% growth which was released in June.  Unemployment had been expected to fall more quickly from its current level of 9.1% to near 8.0% next year, but is now forecast to only edge down to near 8.6%.  The forecast had been changed due to underestimation of the lingering effects from the financial crisis and the weak housing market.The weakness in the economy has prompted the Federal Reserve to state that it expects to keep interest rates close to zero until the middle of 2013.

The release of the lower forecasts suggests that even economists are struggling to come to terms with the impact of the financial crisis.  These effects are difficult to come to grips with due to the scale of the problems built up during the boom years when the easy availability of debt propelled asset prices (i.e. prices of stocks and property) to exorbitant levels.  It will continue to take time for these imbalances to work themselves out and for asset prices to adjust to suitable levels (i.e. fall).  The inability of politicians in both Europe and the U.S. to work constructively toward a solution is further compounding the problem.  But there may be little that the politicians could do anyway.  The typical tools for perking up the economy are either not available (high government debt means that politicians can’t spend to create growth) or are not proving that useful (options in terms of monetary policy have already been exhausted with interest rates near zero and central banks unable to print enough money).

So the answer is that no one really knows for sure how much this period of weak growth will continue for.  Economist tend to have faith in the market to create a setting where growth is possible but a return to a steady expansion may still be a way off due to the problems mentioned above.

The recent economic turmoil raises many issues, some of which I will try and deal with in this blog.  But if there are any particular topics you would like me to deal with or questions you may have, please let me know.

 (email: Your.Neighbourhood.Economist@gmail.com)