Global economy

As the eurozone crisis enters a critical phase, market attention is once more focused on the central banks to contain the crisis. They have promised in advance to provide unlimited liquidity to solvent financial institutions if necessary in coming weeks, which is now their standard response to financial shocks. However, the slowdown in global activity caused by the euro crisis may mean that they are thinking of acting more aggressively than that. A further large bout of unconventional easing is now on the agenda. 

With the Chinese economy seemingly in the midst of a fairly soft landing, global investors have not been paying much attention to China in recent months. However, all that will change as a result of the extremely weak Chinese activity data for April which were published last week. Asian equities and commodity prices have already fallen this quarter, and that will turn into a global problem if the April activity data are a harbinger of things to come.

The April data have not only shaken investors out of their earlier complacency, they have clearly affected policy makers too. The cut of 50 basis points in the banks’ reserve requirement ratio announced on Saturday suggests that the urgent need for a policy injection is at last being recognised. The question now is whether Chinese policy makers, in sharp contrast to their normally sure-footed behaviour,  have left it too late to stem the downward momentum in the economy, and especially in the property sector.  

“You cannot solve a debt crisis by creating more debt.” As Martin Wolf reminds us, this disarmingly simple statement has been of profound importance in shaping public attitudes to the economic crisis. The failure to make a compelling political argument against this proposition has been crucial in limiting the feasible scale of the fiscal response to the crisis.

Whether one looks at the US, the UK or the eurozone, an aversion to “more debt” has become a dominant political theme, as it did in the 1930s. Richard Koo, a leading student of the debt crisis in Japan, has even argued recently that it is impossible to respond adequately to a balance sheet recession in a democracy because the public dislike of “more debt” becomes so profound. 

A large and important change is underway in global economic policy. This change will determine whether the developed economies can grow their way out of recession. Although the new strategy has been tried before by individual economies, this is the first time it has been adopted on such a global scale. If it fails, it is far from clear that policy-makers have a ready-made alternative plan waiting in the wings. 

Mount Fuji, Japan. AFP/Getty Images

Mount Fuji, Japan. AFP/Getty Images

Until recently, Keynes’ notion of a liquidity trap was of great interest to macro-economists, but was viewed by investors as a rare aberration which, outside Japan, could be safely ignored. In the aftermath of the 2008 credit crunch, all that has changed. Many developed economies seem to be falling into a liquidity trap, and may stay there for several years. What does this imply about asset returns? (This blog is a slightly longer version of an article which first appeared in the FT’s Market Insight column on 24 January, 2012.) 

In the second half of 2011, the US economy appeared to buck the impact of the eurozone crisis, with American economic data surprising on the strong side in the final quarter of the year. But, as the new year begins, it seems improbable that economic activity in the US and the eurozone can remain so divergent for much longer.

Will the weakness in the eurozone eventually bring the US economy to its knees? Or will the greater resilience of the US win the day? The answer to these questions will determine whether the global economy will experience a double-dip recession in 2012.

The data released over the holiday period seem to be pointing in a more optimistic direction than markets have recognised. A year of above-trend growth certainly looks like a stretch in the present environment of fiscal tightening and global deleveraging. But the risks of a global double-dip recession appear to be receding, at least for now. 

Risk assets fell sharply in the month of September, with equities generally down by between 5 and 10 per cent, and commodities falling by even more than that. The best performing asset in the month was the US dollar effective rate, a clear symptom of the widespread flight to safety. The worst performers were equities in the BRICs, and cyclical commodities like copper. (See charts on asset performance here.)

What had appeared to be mainly a problem for European markets in August has therefore broadened considerably in the past few weeks. The financial markets have started to price in a global recession. They will be very sensitive to the next move in the economic data. So far, it is hard to tell whether a renewed recession has  been triggered, or whether the developed world has “only” become stuck in a period of prolonged stagnation. Either outcome would be bad enough for labour markets, and risk assets – but there would still be a large difference between them, which is why the question matters a lot.  

The Fed decision was fairly close to what was anticipated in this earlier blog – all “twist” and no “shout”. However, on balance, the statement was slightly more dovish than I expected. Concerns about downside risks to economic activity were at least as great as in last month’s FOMC statement, with new downside risks from financial strains being specifically mentioned, and this has swayed the majority of the committee to introduce a slightly more aggressive operation “twist” than expected. Inflation concerns, while marginally greater than in the August FOMC statement, are clearly insufficient to impress the committee, which remains biased towards further easing even after today’s announcement.

 

Mervyn King

Mervyn King. Image by Getty.

A few weeks ago, the big central banks were calmly embarking on their “exit” strategies from unconventional monetary accommodation. Then the global economy slowed but for a while inflation remained too high for the Fed or the ECB to consider further easing. Their hands were tied until inflation peaked. Recognising this, markets collapsed. But now that there are some tentative signs of inflation subsiding, the central banks are rediscovering their ammunition stores.

There are basically three types of action that they are considering. In order of orthodoxy, and stealing some of Mervyn King’s terminology, here is a taxonomy of possible measures:

1. Conventional liquidity injections

This is safe territory for the central banks, and they are willing to act swiftly and decisively if necessary. Yesterday’s injections of dollar liquidity into the European financial system are a case in point. Some European banks, especially those in France, were finding it very difficult to raise dollar financing, which they needed in order to pay down earlier dollar borrowings, and to make loans to customers in dollars. The resulting strains in the money markets were undermining confidence in the ability of these banks to remain liquid, and markets were increasingly unwilling to accept their credit. This presented a classic case for the ECB to inject liquidity, using conventional currency swap arrangements to raise dollars from the Fed. Although the ECB will incur a minimal amount of currency risk in the process, and will also incur some credit risk (which will be collateralised), this is very much business as usual for any central bank, as it was in 2008. 

A couple of months ago, financial markets realised that the developed economies were slowing sharply, while the policy response from central banks and finance ministries was slow, or confused, or in some cases, like the debt ceiling debacle in Washington, directly damaging. Since then, some policy makers have woken up and smelled the coffee. There have been significant policy shifts in the US, and at the ECB. But there has been no progress whatsoever in the eurozone sovereign debt crisis. Last week, that became by far the most urgent problem facing the global economy.