Economic Recovery and the Politics of Slow Growth

When the economic pie stops expanding, everyone wants their fair share and politicians are unfortunately only to keen to oblige

Slow economic growth is like hot weather – people become easily irritable and argue a lot.  This because, while economic growth makes it easier for everyone to feel better off, the opposite is true when the economy stagnates.  A sluggish economy leads to a shift in focus from creating more wealth to dividing up whatever is already there.  This creates fights over resources with people mostly looking out for themselves. 

Politicians pander to such self-interest among voters and constructive policy making goes out the window.  Voters are get all hot and flustered as the economic recovery since the global financial crisis has proven anything but balmy.  With the outlook for the economy not looking so bright for years to come, politics may continue to get people steamy under the collar.

Politics turns cold

Democracy is the best political system we have for ensuring the implementing of policies for the common good.  Politicians get elected by pushing a package of measures that the majority of voters believe will make them better off.  When times are good, policies tend to be aspiration in promoting economic growth with some resources also going to the less well off.  But things are not going so well, the focus of voters narrows to their own specific well-being.  As such, voters become less generous in terms of social spending and immigration while wanting the government to do more for them. 

The result is that politics become short-sighted and politicians pick more policies that target their own particular support base.  Honest assessment of the economic ills are typically in short supply while voters grow increasing frustrated as timid government policies can only provide limited relief.  Many voters have been tempted with the false hopes of more extreme policies offered by populist politicians.  However, turning back time with less government or less globalization will only create bigger problems rather than providing answers. 

The political infighting comes at a bad time for many developed countries who are increasingly feeling the heat of global competition.  This process was already underway with the rise of China and other emerging economies and the global financial crisis has been a further setback.  The narrow-minded politics currently prevailing in many countries will further hasten the relative decline of the West.  On top of this, government action is also hampered by economic theory that argues for less intervention in the economy. 

Still sweating it out

It is more than a tad ironic that it is now more than ever that positive and proactive government measures are needed more than ever.  This is because government has traditionally been the guardian of the long-term health of society.  The government has even more to offer at a time when businesses are not investing and gains in productivity (output per worker) are proving hard to come by.  Higher productivity is the main route to increases in wages and consumer spending at a time when low skilled work is carried out in developing countries.   

Yet, as described above, governments have been more of a hindrance rather than helpful with regard to the economy.  A push for austerity has dominated in many countries such as the UK despite going against the grain of economic theory.  In the place of increasingly distracted politicians, central banks have take centre stage in reviving the economy (which comes with its own problems).  With minor squabbles often dominating politics, it may take time before governments and voters are ready to sweat over the big issues.  Like a muggy summer that never seems to end, the combination of economic and politic malaise is not a problem that will go away any time soon.

Central Bank – Emperor's New Clothes

With the myth of its power having been shattered, central banks need to get nasty to win back respect

Central banks are looking a bit naked as if stripped of their power.  Previously, central bankers such as Alan Greenspan were held in awe and ruled over the hearts and minds of investors.  This position of power stemmed from the perceived ability to soothe the fire-breathing financial markets.  Yet, the global financial crisis and its aftermath have shown this to be but a myth.  Part of the problem was that central banks wanted to be liked and keep investors onside.  With its generosity proving its downfall, the naked emperor may need to stop being so nice.

Pretenders to the throne

This fall from grace has happened swiftly.  The powers of central banks reached their peak just before the crisis hit.  Quick to blow their own trumpet, economists talked of a “Great Moderation” – a prolonged period of steady and stable economic growth coupled with low inflation.   Central banks had also shown themselves willing to step in during moments of strife and prop up the stock market.  This won them a strong following among investors who could be sure that central banks would send in the cavalry if there was trouble. 

The proverbial crown slipped and fell dramatically with the global financial crisis.  Not only were central banks proved to be not suitable guardians of the economy but their capacity to rally at times of trouble was limited.  Low interest rates and quantitative easing offered little respite from the plague eating away at the economy.  The potency of central bank policy has been eroded as its primary source of power, the ability to print money, does not mean much in a world awash with money.

The problem was exacerbated by central banks not having the freedom to act as their almighty reputation might suggest.  Part of this was due to internal restraints such as a chronic (but misplaced) fear of inflation.  Such worries about rising prices keep central banks from unleashing their full firepower when faced with crisis.  In addition to this, politics also often acts to stifle central banks.  Germans’ heightened aversion to inflation has kept the European Central Bank from doing more.  The Federal Reserve has also had to be mindful that its actions did not draw ire from Republicans who are typically hostile to any government intervention. 

Cursed by hubris

It also became obvious with hindsight that central banks may have built their dominance on a dubious myth.  The “Great Moderation” may have just resulted from good luck rather than good management.  It is easy to keep inflation down when cheap goods are flooding in from China while money was cheap as China was sending a considerable portion of its earnings as reserves and sending it back to the US.  Yet, the misplaced belief in the rule of central banks over the economy lead to ignorance of risks that central banks thought they had slayed. 

Central banks were happy to live off this aura while also being generous in its dealing with investors.  Yet, this kindness turned out to have a cruel twist with the support shown by central banks to financial markets sowing the seeds of crisis.  Although lauded at the time, the reign of Alan Greenspan has instead been shown to be like a king trying too hard to please his subjects.  Over this period, the Federal Reserve kept interest rates too low while investors made merry amid a booming stock market.   

Better to be feared than loved

The unruly nature of financial markets coupled with the flood of cash sloshing around in global finance means that a guiding hand is needed more than ever.  Having been knocked from their high towers, central banks have to restore some assembly of order in a world where the pull of its ability to print cash is diminished.  It may be best to follow the words of Machiavelli, a renaissance philosopher who theorised on power struggles in Medieval Italy, in that it is better to be feared than loved. 

In this vein, if it was a need-to-be-loved that got central banks, and the rest of us, into trouble, it might be time to get nasty.  Taking a harsh line against any potential distortions in the economy (using macroprudential policies) would win more respect than being too friendly.  To rule with a firmer fist seems a better fit at a time when the consequences of financial excesses are so pertinent.  This would help to usher in a more peaceful period if combined with greater regulation to keep the banking sector from getting out of hand.  More stability may even get investors to appreciate the value of tough love.  

No mystery behind banks behaving badly

Banks were misbehaving in the lead up to the global financial crisis but the blame lies elsewhere

Many fingers have been pointed (and fists waved) at the banking sector.  Bankers have been receiving massive pay-outs despite having acted irresponsibly in getting us into trouble.  While they deserve much of the blame for our current woes, it is like blaming students who are left in charge of running their own school.  Bankers were left to run their own affairs on the mistaken assumption that they could do so responsibly.  But the few rules in place to keep banks from acting out proved insufficient.  This raises the question – why were banks given so much leeway in the first place?

A recipe for trouble

Banks are in business to make money.  The most common way for a bank to do this is to loan out money at a higher interest rate than they pay to get access to the funds.  Given these basic guidelines, anybody running a bank would lend out as much money as possible.  This would not be a problem if there was only a relatively fixed amount of cash to go around.  To make more loans, a bank would have to get its hands on more cash which would involve higher costs if spare funds were in short supply.  The extra charges for banks would then result in higher interest rates and this would put off some potential borrowers.

Unfortunately, this is not how things work in finance.  Instead, using tricks such as electronic money, banks can create as much money as they want.  Any limits to lending have been further diluted as banks have come up with ways of getting loans off their books.  Financial wizardry has enabled loans to be repackaged as bonds and sold off to investors.  Such bonds (known as mortgage-backed securities) were popular due to a combination of a decent rate with seemingly little risk.  With lots of money sloshing around the global economy before the financial crisis, investors did not bother to delve into what the bonds actually entailed.

Banks had reduced their lending standards to include sub-prime borrowers as they no longer had to worry about whether the loans were actually repaid.  So what investors got were bonds that would drop in value once the debt-fuelled property boom came to its inevitable end.  The situation was made worse by the way in which bankers were paid.  Their substantial remuneration packages were linked to profits giving bankers an extra impetus to undertake risker actions.  Levels of pay got out of hand as it was easy to make money by tapping into the demand for credit. 

Even if bankers themselves were motivated to cash out after quick gains, it was thought that prudent business practices would keep banks running through thick and thin.  Yet, the number of banking bailouts showed that bankers favoured short-term profits (and big bonuses) over long-term survival.  With the government and the central bank expected to step in if banks got into trouble, it was worth taking extra risks as there were millions to be made and only the possibility of losing their jobs if things backfired.

No one in charge

With it seemingly obvious that bankers were heading for trouble, there was a glaring need for oversight and regulation.  Despite this, banks were increasingly given a free rein following a couple of decades of deregulation of the finance industry.  A wave of free market ideology had convinced a generation of politicians that any government interference would hamper the industry.  The result was that the finance sector was put on a pedestal and afforded the status of teacher’s pet as a source of tax revenues as well as jobs for skilled workers.

Any attempt at oversight typically succumbed to something known as “regulatory capture” where the government agencies designed to monitor the banking sector are too closely intertwined with the banks.  This is because personnel move back and forth between government and finance, always keeping the industry’s best interests at heart.  Even the central banks that were charged with ensuring financial stability did not find fault with the banks.

Instead of taking on the inherent problems in the banking system, central banks developed a narrow focus on inflation.  Interest rates were the main tool with which central banks attempted to rein in the vagaries of the finance sector.  But higher interest rates only target the demand for loans rather than the supply of credit from banks (who actually make more money when interest rates rise).  Interest rates went up too slowly to stave off the credit boom as easy loans from banks opened the way for us to get ourselves deeper into debt.  Given too much freedom, we can all get into trouble and banks have shown themselves to be no exception. 

Animal Spirits – Caging our Wild Side

Money can bring out the worst in people so it might be time to rein in the finance sector which offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the feeling is likely mutual).  According to economic theory, we are thought to act in a rational manner, assessing how best to spend our cash like calculators with legs.  Not only is this an overly simplistic view but it has resulted in economists ignoring how our emotional sides affect the economy.  The global financial crisis is an example of what can happen when animal instincts such as greed and fear take over.  Economists need to take a closer look at how our emotions can drive the economy and how we can be saved from ourselves. 

Reality is messy

Economics is the study of allocating scarce resources.  It focuses on how consumers make the most from what they have.  At the same time, competition between firms ensures that products are priced efficiently so that as much output as possible can be generated from limited input.  Economists would like to think that our sober side helps keep everything running as it should.  But when money (and everything that money brings with it) is involved, our primal nature can take over with ugly consequences.

The worst of our traits kick in over booms and busts.  When times are good, we hear stories of people making easy money and we want in too.  Like greedy kids in a candy store, we buy a second or get shares in the latest stock market fad in the belief that prices are sure to rise further.  Prices will climb as the lust for more wealth attracts more and more victims.  But with gains in asset prices typically outpacing the rest of the economy, this can only last for so long. 

When asset prices start heading downwards, fear is the overriding response.  Companies slash plans for investment and lay off staff in order to stay in business.  Consumers also retrench by cutting back on spending and asset prices slide downwards as higher prices no longer seem sensible.  Assets often end up being sold off at bargain prices as cash is needed to pay off debt taken on during better times.  Fear also reached chronic levels among banks who would not even lend to each other in the aftermath of the global financial crisis.

How we get ourselves in trouble

Change is a necessary part of an economy developing over time as certain sectors expand while others wither away.  But what Keynes labelled our “animal spirits” result in periodic bouts of instability that can hamper the expansion of any economy over time.  Rather than dealing with our insecurities, most economists choose to ignore them.  A common argument used by economists is that financial markets constantly adjust to new information and reflect the true value of any assets.  Yet, sharp drops in stocks or house prices cannot be reasonably explained away with this line of thought.

The devastating effects of our emotions getting the best of us are evident in the wake of the global financial crisis.  Instead of ignoring base instincts, economists should be thinking of ways to rein them in.  One of the key ways for greed and fear to influence the economy is through the finance sector.   Banks are geared to generate as much borrowing as possible but their loans more often than not go toward speculative investments in property or stocks.  Such lending creates unnecessary instability with the economy as a whole suffering as boom turns to bust.

It is no coincidence that the worst recession of a generation comes at a time when the finance sector has grown to dominate many developed economies.  Limiting the scope of banks, with more rules following decades of deregulation, would be a good place to start improving the system.  Measures such as taxes on financial transactions would also take out some of the volatility from markets for stocks and bonds by pushing investors to take a more long term view.  Such policies may lead to higher fees for loans and lower returns from investing but the costs of continuing with the status quo will only mount up.  Better to save us from ourselves than to let our passions run wild and cause even more havoc.

Greece – On the mend but still broken

The Greek government is selling bonds again but its debts require a further fix

Greece was always broken but it was not obvious until the Eurozone crisis.  With its increasingly shabby façade finally stripped away, Greece's dilapidated economy was shunned by investors and needed to be bailed out - twice.  But, with help from others, Greece is on the mend and recent progress has been rewarded by the Greek government regaining the ability to borrow from financial markets.  While this is a key step in putting the pieces back together again, a big chunk is still missing.

Shoddy foundations

The Greek economy had never been on the firmest footing.  A raft of regulations sapped the dynamism of the economy, making Greece an alluring holiday location but an unattractive place to do business.  To avoid cumbersome rules, companies typically remained small and often hide out in the shadow economy.  This resulted in Greece being mired in low productivity and chronic tax avoidance.

Investors were willing to overlook all of this once Greece joined the euro.  Despite its obvious faults, Greece was treated as if it were the same as any other country using the euro.  This gave Greece access to funds at a lower interest rate, triggering a boom in investment in property among other things.  The government joined in and ramped up spending on the assumption that the good times were here to stay.

Yet, what was seen as a blessing at the time proved to be the wrecking ball that was to bring down the house.  Cheap financing dried up with the onset of the global financial crisis and the weakened economy collapsed under the weight of excessive levels of debt.  The government needed to borrow more and more as the economy sank into recession but investors were no longer forthcoming with their cash. 

With no one willing to lend to the Greek government, the IMF and others stepped in to prevent a default due to fears that other countries in Europe would be put in peril.  The result was a prolonged economic slump as Greece struggled with the aftermath of its borrowing binge as well as with austerity measures needed to shore up the government’s finances.  The situation was so bad that Your Neighbourhood Economist was one of many who thought that the Greeks would leave the Eurozone lured by the illusion of an easy way out.

Major repairs still needed

The economic stagnation in Greece has continued with six consecutive years of recession leaving GDP around 25% lower.  Forecasters are now optimistic enough to predict that the Greek economy will grow slightly in 2014 with austerity measures expected to ease as government finances improve.  Another sign of progress is that investors are again willing to lend the government money.  The Greek government sold 3 billion euros worth of bonds earlier in April offering a yield of just under 5% after yields spiked to over 30% around two years ago.

Investors are keen to snap up debt from other peripheral countries in Europe.  This reflects brighter prospects for some countries such as Ireland and Spain.  Yet, in the case of Greece, it is more a reflection of a dearth of other investment options offering similar returns and of investors being more willing to take on risks.  That Greece can sell bonds again is a sign that the Eurozone crisis is over but the Greeks are still left with the harsh reality of excessive debt.

Exacerbated by the sharp drop in the size of the economy, the debt to GDP ratio is around 175% and still edging upwards.  Considering that the Greek economy is unlikely to generate enough of a surplus to pay off this debt, another bailout has always been on the cards.  The Greek people are also unlikely to be able to live with the burden that this brings.  Until the shackles of debt are removed, the Greek economy will never be properly fixed.

China and its growing pains

The Chinese economy is treated like a problem child by the media but does not deserve its bad reputation

Growing pains have led to a lot of bad press recently for both China and Justin Bieber.  The development of both has been closely watched for any signs they are going off the rails.  Bieber has been much maligned for bad behaviour as he shakes off a boyish image.  China has been the driver of growth in the global economy but may not continue to fulfil this role.  Just like Bieber, much of the new stories on China are negative but China is different in that it does not deserve the harsh treatment in the press.

Big trouble in little China?

Like a spoilt kid growing up in front of the media, a developing economy can always expect a few troubles along the way.  Even more so when every step is analysed in detail as has been the case with the once-in-a-generation rise of a new superpower (China, not Justin Bieber).  The Chinese economy always seems to be on the cusp of a breakdown according to many experts.

The current concern with China is the high level of debt amid a surge in investment.  Some of the money has gone into projects that have not panned out as shown by empty housing apartments and dodgy infrastructure ventures.  The bulk of wayward spending tends to turn up in out-of-the-way places, such as the far-flung regions of China.  Here, both private and public investment is driven more by politics than by financial fundamentals.

Local politicians need a growing economy to please their masters in central government.  Large building projects are a convenient shortcut to achieve this and banks can be cajoled into lending to maintain their political connections.  Banks have limited room to move in China due to regulations which limit the level of interest rates on savings.  This encourages savers to stash their money in what is referred to as the “shadow banking sector”.  These offer higher returns on savings and provide firms who are shunned by banks access to loans.  But being outside the normal banking system means that this sector is harder to keep tabs on and influence through policy.

Bigger worries elsewhere in the world

Talk of politicians pushing projects and shady banks does not seem to bode well for China, but its banking sector is likely to be no worse than Western banks.  Banks in the US pushed dubious mortgages throughout the global financial system during their own lending binge.  At least any direct ramifications of a banking meltdown will be mostly contained within China.  Yet, such worries fail to take into consideration one crucial factor – the controlling influence that is the Chinese government.

The government in China has both the willingness and the ability to step in and shore up the banking sector if required.  The Chinese government intervened with a massive fiscal stimulus in 2008 and 2009 as the global economy slowed.  In comparison, most Western governments only managed a half-hearted response to the global financial crisis.  A sluggish economy with high unemployment is not something that the Chinese government would tolerate as its own existence would be under threat.

Another positive for China is that any potential problems with its banking sector are not symptomatic of bigger issues.  The financing for debt in China does not come from overseas but through China’s own reserves.  Neither is the surge in investment causing the overall economy to overheat as evidenced by subdued levels of inflation and a relatively low volume of imports.  The contrast with countries making up the “fragile five” could not be starker.  China is likely to ride out any bumps in the future as it develops but the same may not hold true for the turbulent career of Justin Bieber.

Global liquidity: have we created a monster?

Money in the financial system overwhelms all it encounters making it a growing threat that needs to be dealt with

We are being overrun – by money.  There may be worse things to have battering down one's door but a surplus of cash in the financial system can have scary consequences.  The financial system was set up to facilitate the movement of cash to parts of the economy where it is needed but has instead become a behemoth exerting a dominating influence over the creation of goods and services in the actual economy.

Quantitative easing feeds the beast by flooding the banking system with even more cash in the hope that a few crumbs will drop down into the actual economy.  However, not only is the financing no longer having the desired effect, but the extra money is becoming increasingly erratic and hard to control.  Policies are needed to yank banking back into line.

Money getting out of hand

Spare cash in the form of savings is the basis for economic growth.  Surplus from current production is invested to enable higher output later on.  Banks were first created to shift extra money elsewhere so that production could be expanded.  Yet, banks have gone beyond the basic operation of allocating money and moved into the business of making money from money.  This is a waste of resources considering our best and brightest could be put to better use.  But more than that, the colossal size of the financial sector is in itself a problem – it is like a giant trampling everything in its path.

Money is free to move around the globe on a whim.  Too much free-flowing cash turns into a menace in terms of stability.  The danger always seems close at hand – banks and others creating more cash out of thin air by increasing leverage when times are good while central banks unleash a mass of new money to shore up the economy when things turn bad.  Yet, money is not always forthcoming - the impact of the global financial crisis was exacerbated by a flood of cash fading to a trickle.

The money is out there lurking and waiting.  The skulking leviathan surfaces only in a few places but creates distortions wherever it emerges.  A clear example is the property prices in London and other places in the UK which are booming at a time when the underlying economy is stuck in a faltering recovery.  Emerging markets have also fallen victim to the ebb and flow of global finances due to their less developed financial markets and limited domestic savings.

Making money work for us

If massive money movements are causing chaos, it is only sensible to conclude that greater controls should be put in place to rein in the rampaging.  The current direction of policy on finance has turned to re-regulation after decades of deregulation gave banks the freedoms which allowed the phantom cash to wreak havoc.  The finance sector has railed against any restrictions, but the monster now rearing its ugly head cannot be left uncaged.

It is argued that free movement of money is essential despite the risks, as credit is cheaper as a result.  But even the cheap cash from central banks has not been enough to convince banks to lend which suggests that easy money does not bring the benefits previously thought.  This means that we should not fear the utilization of policies as controls over the movement of money, the separation of retail banks (which take in savings and give out loans) from investment banks (which deal in financial wizardry), or the introduction of higher standards for banks in each individual country.  Money in itself is not evil – it just needs to be kept in its proper place.

Your Neighbourhood Economist turns 100

Not much cheer considering how little progress in dealing with economic stagnation has been made since the blog began

There has not been much to celebrate of late but Your Neighbourhood Economist is happy to have reached a satisfying milestone – 100 blogs (not years).  This blog started by asking “so what is going on?” back in November 2011, lamenting weak growth in the global economy.  Little did Your Neighbourhood Economist (or many others) know that there would still be few signs of improvement over two years later.

Perhaps the only consolation is that things could be worse.  At least the Eurozone has not self destructed (yet) thanks to the European Central Bank stepping in.  US politicians also showed some surprising good sense despite all expectations to the contrary.  But the positives are few and far between.

Governments in many countries have too much debt to be able to boost spending which is leaving monetary policy as the main route out of the current weak economic growth.  However, expansive monetary policy has not been enough to generate much economic stimulus despite record low interest rates and loads of newly printed cash in the global financial system.  In fact, monetary policy may be doing more harm than good.  

Movements of surplus funds are creating havoc in emerging markets.  Uncertainty over the direction of monetary policy is a major obstacle in the way of a return to economic growth.  The costs of such policies are becoming more evident as the benefits are increasingly being called into question.

Central banks have struggled as the traditional tools of monetary policy have failed to have much of an effect.  New ideas have been tried (such as forward guidance) but the desired results have proved elusive.  Policy makers are getting side-tracked as new problems, such as concerns about deflation in Europe, draw their attention away from more pressing issues such as reforms.

Chances to celebrate may be a long way off so Your Neighbourhood Economist is glad for reasons to be cheerful (such as reaching 100 blogs) whenever possible.

Beware of a Flood of Funds

Surplus cash in the global financial system has a history of leaving havoc in its wake and quantitative easing may be making the situation worse.

There is a lot of cash sloshing around the international financial system at the moment.  Central banks are still buying heaps of bonds and there are few places in the actual economy where people are willing to invest money.  Not having cash around in the financial system can make life very difficult as shown by the credit crunch where lending by banks ground to a halt and the global economy came close to collapse.  But too much cash in the financial system can cause its own troubles.  Cheap credit is one of the causes of the global financial crisis.  More recently, emerging markets have been tested by the coming and going of a massive tide of global funds.  What can be done to ensure that more of the world is not drowned in an excess of cash?

It may seem strange but there is a lot of spare cash around at the moment but no one wants to use it.  Companies are hoarding money as business people are not confident in being able to make money through new investments, and consumers are paying off debt while being worried if their jobs are safe.  Adding to this, banks are reluctant to lend as new regulations are prompting banks to be more cautious about the amount of loans on their books. 

Central banks have tried to alleviate this problem by making it cheaper to borrow, firstly, through reducing interest rates to close to zero, and when this has not worked, printing more money with which to buy bonds.  The bond purchases also serve to further lower borrowing costs, but businesses and consumers currently seem averse to taking out fresh loans no matter how cheap it is to borrow.  Nevertheless, the bond buying continues with the Federal Reserve alone buying US$85 billion in bonds each month.  The extra cash is not going into the actual economy as there is no demand for it and it is free to be moved to anywhere in the world.

So this money is not like a still pool of cash where money can be drawn as necessary, but rather more like a tidal system where funds will flow in one direction for a certain period of time before switching to another direction depending on the alignment of economic factors.  Any free funds will always move in search of higher returns and the flows shift as economic circumstances change.  The transient nature of the funds creates economic problems due to the temporary effect of lowering interest rates and creating a surge in lending, only for the money to flow out again at the first signs of trouble.  These flows of cash now dominate the world economy like never before and can leave havoc in their wake (for more, see Where is all the money going?).  

This ebb and flow of funds is given as one of the reasons behind the global financial crisis.  The size of the pool of cash had swelled due to a glut of savings in Asia which were invested in the United States.  The resulting lower borrowing costs spurred on excessive lending which extended to sub-prime loans, eventually causing the near collapse of the financial system.  Almost the reverse has been the case in previous weeks.  Extra cash generated by the bond purchases by the Federal Reserves and other central banks had found refuge in emerging markets which had continued to grow in the aftermath of the global financial crisis.  But the tide turned with the paring back of quantitative easing in the United States, which is expected to result in higher returns from investments in the US markets. 

The worst of the effects have been experienced by India, Turkey, and Indonesia who had grown more reliant on the money coming in from overseas due to imbalances in their own economy.  But emerging markets have shored up their defences after having often been caught up in the wash of global finances.  Countries with developing economies often build up large foreign exchange reserves which are used to counteract the outflow of funds (which was ironically behind the glut in savings in Asia seen as responsible for the global financial crisis).  The use of controls which restrict the movement of funds have also become commonplace and are even somewhat sanctioned by the IMF (who are typically ideologically opposed to any limits on the free movement of resources).  Even the new range of banking regulations in the United States and elsewhere, such as rules on higher levels of capital buffers, can be seen as a buttress against the swirling forces of global finances.

However, the new measures being adopted in developed countries and in emerging markets have the goal of merely preventing the symptoms of the problems created by the surplus funds.  Furthermore, foreign exchange reserves and capital buffers come with their own costs – this money could be put to better use when the economy actually needs the extra funds.  Would it not be better to deal with the problem itself?  Central banks could come up with a way of soaking up the surplus money in the world’s financial system.  Considering the global scale of financing, this might require a new role for an international organisation such as the IMF.  It would also involve a rethink of quantitative easing and the tools available to central banks since the freshly printed cash from central banks has added another deluge of funds and has created problems of its own (see Perils of doing too much for more detail).  It would be a sad day for economists if the aggressive policies from central banks to revive the economy from the latest crisis sow the seeds of greater instability in the future.  

Good and Bad from Slowdown in China

When something is as inevitable as the growing dominance of China, the only option is to take the bad with the good.

It seems as if everyone is keen to know more about China.  The high level of interest is a result of both benefits and threats that China poses to the lives of us all.  China has an undue influence, be it the prices we pay for petrol or for running shoes, due to its dual role as a dominant consumer and producer in the global economy.  So slower economic growth in China and the reasons behind it will have effects that will ripple through the global economy.  But there will be good along with the bad and here is how it may play out.

Before starting on what might happen, it will be useful to look at the reason behind the slowdown.  The Chinese economy has reached a point of change in its development.  In the past, higher wages would prompt people employed in agriculture in rural China to move into the cities and work in factories.  This trend spurred the size of the economy to expand as these workers were being put to more economically productive uses compared to scratching out a living on small-scale farms. 

The first factories in China made basic goods such as clothing in the same way that the growth in textile factories was behind the Industrial Revolution in England around 200 years ago.  But as the economy has become more sophisticated, Chinese firms have invested massive amounts in new factories to produce more complex goods while the government has spent heavily on infrastructure.  But the driving force of growth came from the seemingly endless supply of cheap labour that would be put to use producing goods of higher and higher value.

But the end of economic growth fuelled by cheap labour and piles of investment seems near.  Rising wages in China are a sign that workers are proving tougher to find (refer to End of the end of the world).  Benefits from further investment are not as easy to come by considering the splurge in spending which lifted investment to around 50% of GDP compared to around 15% in the United States.  So the growth of a domestic consumer market as wages rise in China is seen as key as the next phase of economic development.  But the effects of this will not just be felt in China but across the globe. 

China has been the engine that is driving the meagre growth in the global economy.  Economies in places such as Germany and Australia have been kept perky by supplying machinery and minerals for the hungry Chinese economy.  Without this extra boost from China, the slowdown in the global economy would have been a lot worse even in countries which do not have links with China.  As such, a slowdown in China will be reflected in growth statistics across many other countries.  While the Chinese economy is still expected to expand by around 7% this year, the transformation of the Chinese economy from a manufacturing powerhouse to a consumer mecca is bound to be a bumpy ride and the effects of this on economic growth is still unclear (but there is good reason to be positive – see China brings out the Big Guns for more).

The economic rise of China has changed the shape of the global economy.  Everything from the price of coal to cows has been pushed upwards due to the seemingly insatiable appetite of the Chinese economy.  Much of the commodities have gone into providing the building blocks of the Chinese economy (steel girders and concrete slabs) and the fuel needed to drive the growing economy.  Less investment and slower growth will halt the upward rise in prices in some areas such as steel and other metals.  This will help lower construction costs all over the world and will be a blessing for places like Europe and the United States where investment has been weak. 

The slowdown in China is expected to provide other benefits for Western countries as well.  As shown by Chinese shoppers’ desire for luxury bags and shoes, demand for goods from overseas will increase as consumer demand picks up in China.  Whether it be producers of chocolate bars or fancy cars, there will be ample opportunities for Western firms to target Chinese consumers in the future as there will be strong demand for foreign goods until Chinese companies can build up their own brands.  The flipside of higher wages in China is that goods produced with a “Made in China” label will not be so cheap anymore.  Despite grumblings of firms faced with competition from exports, Chinese goods have been a boon for consumers in the West and have helped meagre pay packets go further.

For all of the good and bad, a slowdown is needed so that the Chinese economy does not implode under the weight of massive debts and reckless investment (for more detail, seeWhy China needs a slowdown).  The way forward will include some rocky patches but the rise of China is inevitable and will throw up challenges both within and beyond its borders.  Trying to fight it would be like trying to push back a rising tide – the only option is to make the most of it.

China brings out the big guns

Staying in control of a rampant economy is not easy but the Chinese government shows that it has the necessary firepower.

While investors follow the movements of central banks with one eye, their other eye would most likely be following the fortunes of China.  The rapid rate of expansion in the Chinese economy seen over the past couple of decades may be coming to an end with the era of cheap labour seemingly coming to an end.  But the centralized government in China has so far shown itself apt at managing the Chinese economy through its growing pains (see Why China need a slowdown? for related story).  Despite mounting concerns over economic growth in China, Your Neighbourhood Economist believes that the Chinese government has both the necessary firepower to point the economy in the right direction and the willingness to use it.

In its current state of development, the economy in China is still very much like the Wild West – lots of small firms battling it out in a gun fight to see who comes out on top.  This analogy does not hold so well when taking in consideration the giant state-owned companies which dominate parts of the economy or firms such as Huawei or Baidu who have already grown to the point where they are mostly above the fray. But China is a world away from having a few large firms dominate each industry as would be the case in most Western countries.  As such, competition is fiercer with big rewards awaiting those that can prosper.  The Wild West analogy also reflects the relative state of lawlessness in China where firms don’t have to worry as much about issues such as pollution, labour standards, and respect of intellectual property.

To add to the lawlessness, politics in China can seem at times as it is run by a bunch of gunslingers.  The higher levels of government are choreographed pieces of political theatre but politics at lower levels is more of a grubby battle.  Ambitious officials in regional government in China need to impress in terms of economic growth or social stability and can often become a law unto themselves whether it be taking land from farmers to build factories or getting local banks to splash out on loans to businesses. This incentive to create booming local economies can act against central government diktats even though both levels of government are controlled by the communist party. 

Banks themselves have also managed to avoid the rule of law and operate with a degree of impunity.  The government sets maximum rates for savers and minimum rates for borrowers with a big gap inbetween to help banks generate a profit.  This suits the major banks which are government owned but savers miss out due to meagre returns on any cash stashed away.  But banks keen to attract more deposits have come up with schemes to offer higher pay outs for investors and this extra cash has enabled the banks to lend even more.

The relative autonomy of local politicians and banks in China has fuelled a lending binge that has gone a bit out of control.  The ratio of debt to GDP has reached 200% which is well past the point when people start worrying.  The leaders in China have tried a softer approach such as signalling their disapproval but to little effect.  But the Chinese government has never shied away from stepping on toes and decided to bring out some big guns to put pay to the wayward banks.  At a time of year when all of the scheming by banks had left them short of cash, the central bank in China left banks to sort the cash shortfall out themselves despite typically acting as a source of funds in the past. The lack of money resulted in banks scrambling for cash and interest rates surged upward briefly topping 25% in the middle of June (search for SHIBOR spike for more info).  This created turmoil among Chinese banks, for whom not only were the central bank’s actions a complete surprise but the intentions behind the move were also a mystery. 

Some interpreted the actions of the central bank to be a brutal way of knocking banks into line but it will probably prove to be more fruitful than the policies of the their Western counterparts.  Whereas other central banks have struggled to maintain stability (see Why is the economy still stuck in a rut? for more on the limited influence of monetary policy elsewhere), China’s central bank is not afraid of drastic action to shake things up even if it will result in a bit of temporary chaos.  The spike in interest rates is expected to have put many banks into trouble but will be good for the banking system as a whole if it helps to reign in lending.  Officials in China are conscious of the need to keep the economy growing so that the Communist Party can maintain its grip on power.  It is this focus on the big picture rather than the fickle concerns of voters that will keep the Communists in power in what is destined to soon be the world’s largest capitalist economy.

Why is the economy still stuck in a rut?

As the last hope for an economic recovery, monetary policy has proven lacklustre at best and here is why things have not turned out as planned.

It has been more than five years since the onset of the global financial crisis but it still seems as if we are stuck cleaning up the mess.  The task of getting the economy back on track has been made even trickier with policy makers being side-tracked by a number of misadventures such as the Eurozone crisis and the fiscal cliff in the US.  Governments everywhere have been shackled by large debts and central banks have been relied on to save the day.  Despite having a better track record in the past, the inability of central banks to use monetary policy to fix the problems created by the unique circumstances of our current dilemma have prolonged the economic stagnation.  Your Neighbourhood Economist looks at why the central banks had to try new things and why even this fresh approach has not improved the outlook for the future.

Monetary policy had always provided a road map back to economic recovery in the past.  The directions were simple – lower interest rates would help get the economy back on the right path. The theory behind this was that making it cheaper for firms or households to borrow would give the economy a boost at a time when other sources of growth were flagging.  Interest rates could be topped up again once the economy had been kick started with inflation used as a gauge on the strength of the economy (i.e. low inflation suggests weak demand with rising inflation seen as a sign of an overheating economy). 

However, even interest rates close to zero have failed to gain traction amid the consequences of the global financial crisis.  There are two main reasons for this which relate to borrowers and lenders.  On the lending side, banks have shrunk their operations due to chronic uncertainty that pervaded both the financial well-being of the banks themselves and any borrower they might lend to – banks were unsure of the potential for losses on their own books, let alone those of other business which they may lend to.  A wave of new regulations also acted to hamstrung banks who reacted by lending less to lower the level of risk on their balance sheets with other options such as selling shares not available (this problem was most pronounced in Europe – see Another reason not to bank on Europe for more). 

Borrowers too weren't in the mood with many companies and households having already taken on too much debt during the years of cheap credit which led up to the crisis.  Uncertainty was another factor as wage earners worried about their jobs while firms were more concerned with their own survival rather than borrowing to expand their operations.  Rather than borrowing, the opposite was more likely to be the case as consumers paid down their credit cards while firms repaid their debt and kept cash for a rainy day.  A lack of willingness on both sides (lenders and borrowers) meant that more debt was out of the question no matter how low interest rates would be set.  This put pay to conventional notions of monetary policy and required a fresh approach.

Quantitative easing was taken on-board as a possible solution.  This involved central banks buying bonds to provide funding for banks and companies wanting a different source of cheap funding.  The bond buying also lowered the returns on these safer assets and pushed investors to put their money into more risky assets such as buying bonds of struggling countries in Europe like Greece or Spain.  The extra money in the global financial system was expected to help grease the wheels of banking which had seized up.  But little of this additional cash has reached the real economy and has been hoarded by banks or companies or has gone to pump up share prices.

The limited extent to which their policies fed through to the economy prompted central banks to throw more and more funds at the problem with the Federal Reserve in the US buying US$85 billion in bonds each month and the Bank of Japan pledging to double the money supply in two years (for more on this gamble, see All bets are ON).  The acceleration of monetary policy has not driven the economy much faster through the slowdown.  However, even just the notion of an eventual retreat by central banks has caused jitters among investors who have benefited most up to now from the real-world consequences of monetary policy (refer to Caution - Windy Road Ahead to see how monetary set the tone of stock markets).

So the outlook for the stagnating economy is not good.  Governments remained mired in their debt with even relative bright spots such as the recovery in the US economy in peril when factoring in likely cuts to government spending in years to come.  Central banks have dug themselves into deep holes by trying to do too much and even the limited effects of monetary policy will be difficult to maintain (for more on why thus might be the case, see The perils of doing too much).  The result being that problems in the economy such as a shortfall in demand and uncertainty over the future continue to drag on consumer and business sentiment.  All it would take to ignite economic growth again is a commonly held belief that the future will be brighter.  But, considering all of the above, it is proving a hard sell.  

How Monetary Policy plays out in the Real World

The past week or so has shown hints of what is in store as the Federal Reserve hands back the reigns to the US economy.

The theory about the ramifications of the inevitable changes in monetary policy have been spelled out in this blog over the past couple of weeks (Caution - Windy Road Ahead) but market movements at the end of last week show how it will play out in practice.  Heavy selling last week was triggered by the rosy outlook painted by the chairman of the US Federal Reserve, Ben Bernanke, which was more upbeat than had been expected and is likely to signal that the end to bond buying by the Federal Reserve is nearer than many had thought.  It is worth taking a closer look at the reactions of the markets to get an idea of how future actions by central banks may impact on us all.

Bernanke’s statements around a week ago made the case that the economic recovery in the US was sufficient enough for the Federal Reserve to move forward with its plans to reduce its buying of bonds later in the year with a target of stopping completely in the middle of 2014. Pains were taken to get across the notion that the change in tact was not a tightening of monetary policy but just loosening at a slower pace and that any changes in monetary would depend on a continued recovery in the economy. Yet, because the bond buying by the Federal Reserve has become a crucial support holding up the prices of bonds and stocks, its imminent demise has rattled investors who were caught out by the bullish comments by Bernanke.  

The degree of surprise was spelled out in the sharp movements in the investment markets with prices of bonds plunging and the interest rate on 10 year US government debt jumping from around 1.5% to 2.5% (lower bond prices equate to higher interest rates). This will feed through into the real economy as government debt is typically the benchmark for which all other interest rates in the economy are set. The result will be higher interest payments for mortgage holders which will act as a damper on the promising recovery in the housing market in the US. The higher costs for borrowing will also be a point of concern for companies who are thinking of making new investments.

There are further negatives for the US economy from the changes in monetary policy – the ensuing volatility in the stock market will make households worry about their pensions and other investments making them less likely to spend. A slower pace of bond buying will result in a fall in the amount of new currency getting into circulation which will raise the value of the US currency.  A stronger dollar will make life more difficult for exporters, many of whom are already struggling in the global marketplace. 

This all puts the Federal Reserve in an awkward position of its own actions creating a headwind blowing in the opposite direction of where it is trying to get to – an end to its role of propping up the economy. Bernanke is trying to lessen negative effects of its bond buying plans by outlining in advance a clear schedule for its changes in policy. But the Federal Reserve also needs to ease concerns that it will act too fast and has allowed itself flexibility to modify its plans if the economic recovery weakens. The overall effect is the level of certainty which is craved by many investors will remain out of reach, and the twists and turns of monetary policy will be played out in jumpy markets that will keep everyone on their toes.

The perils of doing too much

Central banks have been recruited to stave off economic disaster but they may have been forced into overplaying their hand.

The global financial crisis has propelled central banks into prominent roles in fighting off recession while politicians have been slow to act.  Being the last remaining stalwart against economic disaster, central banks had to go further and do more than would have ever been previously conceivable due to their limited range of policies.  Even though the efforts of central banks have some effect in keeping the global economy afloat, the jury is still out with regard to the distortions left behind by the actions of central banks as well as their new roles as backstops for the global economy.

Most central banks have been given independence over the past few decades due to the notion that this will aid them in their central goal of reigning in inflation.  The theory behind this is that politicians would be tempted to use the tools of monetary policy – setting interest rates and the level of money supply – to boost economic growth and their re-election chances to the long term detriment of the economy.  So independent economists at central banks were given the reigns of monetary policy and a target for inflation of typically around 2% to ensure that a safe pair of hands would be in charge.  The typical cycle of monetary policy involved interest rates rising during periods of strong economic expansion to keep lending in check while a weaker economy prompted cuts to interest rates in order to make borrowing easier. 

The global financial crisis that struck in 2008 involved what could be deemed to be a perfect storm.  Politicians had got caught up in the bubbly state of the economy and government spending got out of hand backed by tax revenues that were later found to be just a temporary fill-up.  This was not just confined to a few countries but the Bush administration in the US, the Labour government in Britain, and many countries in Europe were running large budget deficits at a time when common sense would have suggested putting money away during the good times.  So when the banks got themselves into trouble and required help from tax payers, government finances were already stretched and there was nothing left in the coffers to bail out the economy. 

A crisis of confidence hit the global economy with spending by consumers and investment by companies being cut back due to the chronic uncertainty of whether the banking sector was going to collapse.  Your Neighbourhood Economist would argue, with a good dose of hindsight, that the typical Keynesian policies of an increase in government spending would have been the best response to the global slowdown with government making up for the shortfall in demand from elsewhere.  Government spending could have made up for the shortfall in demand, but the mismanagement of government finances meant that this option was not available.

Monetary policy was always going to be a struggle (a bit of hindsight coming in useful here too) as the activities of the central banks during recessions, such as boosting lending, are generally transmitted through the financial system.  Yet, banks everywhere were fighting for their own survival instead of being concerned about the tinkering of central banks in the background.  The weak translation of monetary policy into positive effects on the actual economy has resulted in the extent of the actions of the central banks having to be ramped up to have an effect.  The most obvious example of this is the recent announcement by the Japanese central bank that it plans to double the money supply in Japan which would be beyond belief even just a few years ago (for more, see All bets are ON). 

Even though the worst seems to be over, central banks are still in a difficult situation in terms of getting out of the role of being the guarantors of the economy.  The massive scale of their involvement in the economy will make an orderly retreat fiendishly difficult due to possible economic hiccups in the future and uncertainty over how the economy will respond.  Even if this Herculean task is pulled off with minimal problems, a new precedent has been set where central banks will now ride to the rescue if the economy goes bad. 

This situation is made worse by politicians who have shown themselves to only look short-term in their focus when dealing with such problems as the Eurozone crisis in Europe or the fiscal cliff in the US.  The expanding responsibilities of central banks may find them overextending themselves to the detriment of the good work they have achieved so far such as keeping a lid on inflation.  Central banks have overachieved during the global financial crisis considering their initial remit but should not have to be relied on to save the day.  Economists are not meant to be super heroes.

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.

Caution – Windy Road Ahead

Trends in the stock market are hard to spot at the best of times but upcoming changes to monetary policy will add a few extra twists and turns.

Trying to work out the right time to buy or sell shares is like driving at night with a busted headlight – only some of the road ahead is visible and it is best to proceed with caution.  Evidence suggests that even the so-called experts struggle to negotiate the markets better than anyone else.  Everything from nutty dictators in North Korea to the latest iPhone can throw the markets into disarray.  The task of investing in stocks has been made even more difficult due to extra funds in the financial system stemming from central banks everywhere printing money.  The actions of the central banks has given shares an extra boost but the resulting gains are expected to fade with more cash likely to be less forthcoming as the global economy improves.  With monetary policy now dominating movements in the stock market, the prospect of changes by central banks are likely to leave investors hanging on the edge of their seats.

The basic premise of shares in a company is that it entitles the owner to a portion of the profits in that company.  The value of shares will rise or fall depending on the company’s ability to generate profits in the future.  While profits also rely on circumstances at each individual company, it is the state of the economy in which companies operates that tends to dictate the direction of the stock market.  So it may seem like somewhat of an anomaly that some stock markets such as in the US are hitting record highs at a time when the outlook for the global economy is so dismal.  The reason behind all this is monetary policy. 

Central banks were quick to slash interest rates to close to zero with the onset of the global financial crisis, but when the low interest rates were having little effect in terms of the prescribed goal of boosting lending, a new policy of quantitative easing was adopted.  Central banks started to print money and use this to buy bonds with the hope of making borrowing even cheaper.  Yet in spite of all of these efforts, consumers and companies have been stuck in a cautious mood and loathe to part with their cash which they have stashed away instead. 

The surplus funds end up being invested in assets such as bonds and stocks.  Bonds would be the preferred investment due to being a safer bet amid these turbulent times, but with central banks spending billions buying up bonds (which increases prices and reduces returns), the meagre pay-out from bonds has seen funds flow instead into the stock market.  The extent of these cash flows is such that it is vagaries of monetary policy that have come to dominate the direction of share prices.  The underlying health of the economy only registers to the extent to which it has an effect on the bond buying of central banks and has created a paradoxical situation where bad news regarding the economy is good for shares as weak economic growth translates to continued action by central banks.

The return of growth in the global economy may help to cushion any weakness in share prices as the central banks wind down their operations.  In theory, steady economic growth ensures that corporate profits increase over time, and thus, the value of stocks is typically on an upward trend.  But with the possibility of ups and downs in the global economy, shares may end up being overpriced depending on the extent of a potential correction in the market due to the change in monetary policy.  The potential for a correction in the stock markets makes it tricky to call whether it is a good time to buy or sell with the added uncertainty likely to make for a bumpy ride if you have the stomach for it. 

Close your eyes and hope for the best

Some advice for how to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when writing, but like many people, has a certain amount invested in the topics that are mentioned on this blog.  For most of us, it is our employment which can make us vulnerable to the ups and downs of the global economy.  But for some who have a bit stashed away here and there, putting any extra cash to good use is a tricky predicament at this time.  It seems to be like riding a roller coaster in the dark – hence the title of this article – is the best investment advice that Your Neighbourhood Economist could come up with and here is why.

Investment options can be categorised into two types (or a mixture of both) – safe or risky.  With many countries in the developed world still suffering a hangover from the aftermath of the global financial crisis, it would seem as if the clever move would be to go down the safe route.  But the safe option - bonds - has been jumped on by so many investors that returns from bonds have hit record lows in many places, such as debt from countries like Germany or the UK, which are seen as refuges from the turmoil elsewhere. Even the banks with their own problems are paying out higher interest rates than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has been migrating to riskier options with higher returns with shares being the obvious example of a riskier investment.  As such, some of the indices for the big stock markets such as the Dow Jones in the US have hit record highs.  This may seem a bit strange considering the doom and gloom surrounding the outlook for the global economy but it is a phenomenon which has been engineered by central banks across the globe.  Their policy of printing loads of cash has been targeting increased lending and a boost to the prices of assets that you and I might hold such as real estate or stocks.  This increase in asset prices is meant to help us open up our wallets and be more willing to spend (a phenomenon referred to as the “wealth effect”) despite the lingering possibility of job losses and sluggish increases in wages. 

There is a fatal flaw in this scenario that makes investing in this seemingly booming market for stocks even more of a risk.  Central banks will have to shut off the flow of cash sometime.  The main concern for central banks is inflation and keeping it at a sufficiently low level.  But more money, when people actually spend it, leads to higher prices which will be the result of the central bank policies once economic growth returns in earnest.  So the flow of extra cash from central banks which has pumped up share prices will end at some point in time over the next few years.

The timing all depends on the state of the economy in different countries with the Federal Reserve in the US already signalling that it will soon taper off its buying of bonds depending on a continued fall in unemployment.  The European Central Bank has its monetary policy on hold for the moment as the economic situation in Europe gradually improves but may act if another crisis kicks off, while the central bank in Japan has ramped up its monetary policy with the stagnating economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the metaphorical roller coaster ride of investing in the stock market.  There has been a big drop in the market with the financial crisis and the upward turn as share prices bottomed out, but where to next?  To complicate matters, it is the cash coming out of the central banks more than the actual state of the economy that seems to dictate share prices.  This has led to a paradoxical situation where the stock market can fall due to positive news on the economy as robust economic growth would prompt central banks to shut off the flow of cash.  

The result is a lot of twists and turns ahead as the market players try to assess the future of monetary policy, the direction of the global economy, and how other investors will react amongst all of this.  What is bound to ensue is a lot of screaming over both the good and bad.  But with few other easy investment options available, there may be little else to do but invest in stocks, close your eyes and hope for the best.