The examination is over. For more than a year the European Central Bank has been shining a light on the books of the eurozone’s banks; this weekend it reported its conclusions.
The balance sheets of 25 institutions were found wanting; the ECB concluded that they need an extra €25bn between them to be able to withstand a nasty economic surprise. Two crucial questions remain. Has enough at last been done to fix the European banking system? And will this on its own be enough to ward off the threat of deflation that is hanging over the eurozone? Read more
In the years after the Great Recession of 2008-09, forecasts for global economic growth have persistently proven too high. This tendency has been particularly pronounced in the major emerging economies, where there has been a gradual realisation that long term trend growth potential should be revised downwards (see this blog).
In the developed economies, growth expectations have also proven persistently too high, causing an increasing focus on “secular stagnation”.
Three of my colleagues at Fulcrum have been examining the behaviour of long run GDP growth in the advanced economies, using developments of dynamic factor models to produce real time estimates of long run GDP growth rates. See the summary paper here by Juan Antolin-Diaz, Thomas Drechsel and Ivan Petrella, and the more academic version here .
The results (Graph 1) show an extremely persistent slowdown in long run growth rates since the 1970s, not a sudden decline after 2008. This looks more persistent for the G7 as a whole than it does for individual countries, where there is more variation in the pattern through time.
Averaged across the G7, the slowdown can be traced to trend declines in both population growth and (especially) labour productivity growth, which together have resulted in a halving in long run GDP growth from over 4 per cent in 1970 to 2 per cent now.
Some version of secular stagnation does seem to be taking hold. This may partly explain why, for the last five years, forecasts of G7 real GDP growth have been persistently biased upwards. Read more
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It is very striking that western commentators and investors have become extremely sceptical about any good news emanating from the Chinese economy. This week, for example, official economic data showed growth in gross domestic product at a quarterly annualised rate of about 8 per cent, with industrial production bouncing back in September from a weak reading in August. Yet markets were unimpressed.
Although this latest news clearly reduced the danger that China is entering a hard landing as the property sector adjusts sharply, many headlines proclaimed, correctly, that the economy is now growing at the slowest pace since the last recession. So is China bouncing back from a weak patch of growth, or is it headed for a prolonged slowdown lasting many years?
Actually, both are probably true. Cyclical fluctuations are occurring around a clearly slowing long-term trend for growth, and this can defy simple good news/bad news interpretations. At present, it seems that the latest cyclical slowdown is being controlled, despite the property crash. Read more
The extraordinary volatility in all financial asset classes in the past week can only be described as ominous. On Wednesday, the US ten year treasury, perhaps the most liquid financial instrument in the world, traded at yields of 2.21 per cent and 1.86 per cent within a matter of hours. This type of volatility in the ultimate “risk free” asset has previously been seen only in 2008 and other extreme meltdowns, so it clearly cannot be swept under the carpet.
A few weeks ago, investors had widely expected a strengthening US economy to lead to a rising dollar and a tighter Federal Reserve, with an amazing 100 per cent of economists saying they were bearish about bonds in a Bloomberg survey in April. Instead the markets have started to act as if the world is about to topple into recession, and an abrupt reversal of speculative positions has probably led to exaggerated market moves, in both directions.
Now that excessively large positions have been washed out, what is the underlying message from the past month of market action? Read more
Financial markets caught a nasty chill last week, when extremely weak activity data from Germany coincided with fears that the ECB could not overcome Bundesbank opposition to more aggressive quantitative easing. Then the IMF reported that there is a 40 per cent probability of a recession in the euro area within 12 months, along with a 30 per cent chance of outright deflation. Markets fear that policy makers in the euro area are once again losing control over their weakening economy.
Since markets often sniff out impending trouble before economists do, there is, as Martin Wolf warns, no room whatever for complacency. But, so far, the blip in global risk assets hardly registers on the Richter scale. Nor is there much evidence from published data of a major slowdown in global GDP growth up to now.
US domestic demand is strengthening, and the 20 per cent fall in oil prices since June will boost the oil importing economies markedly in coming months. Unless euro area policy is spectacularly dysfunctional, which I do not expect, the slide in the euro area should not be powerful enough to offset these expansionary forces. Read more
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Last week’s press conference by ECB President Mario Draghi left the markets disappointed and somewhat perplexed about the shift towards quantitative easing that had just been sanctioned by the governing council (GC). Because this was focused on private sector assets, in the form of asset backed securities and covered bonds, there were doubts about whether the new policy could be implemented in sufficient size to deal with the deflationary threat in the euro area.
Mr Draghi was noticeably hesitant about giving any firm indication about the likely scale of the programme. Although private sector quantitative easing (QE) is likely to suit the needs of the euro area rather well, as I argued here, the absence of any firm guidance on scale certainly undermined the beneficial announcement effects of the policy change.
The ECB president addressed this issue on Thursday in an appearance at Brookings in Washington. This time, freed from the need to speak for the entire GC, he clearly changed his tune on the scale of the programme. But this highlighted the extent of the gap between his view and that of Bundesbank President Jens Weidmann, who presented his position in a revealing interview with the Wall Street Journal on Monday. It is far from obvious how this disagreement will be bridged. Read more
Tuesday’s extremely weak German industrial production figures published for August have come an awkward time for the German government. An informal “employment conference” including some EU leaders has been called by Italian Prime Minister Renzi, and it is scheduled to take place, amid little advance publicity, in Milan on Wednesday. This will presumably set the stage for the next European Council meeting on October23. In between will be the International Monetary Fund/World Bank annual meetings in Washington, when the German approach to economic policy in the euro area will be heavily scrutinised.
The official German line heading into these meetings is that the recovery is proceeding well, both in Germany and in the euro area as a whole, implying that the recent marked weakening in both gross domestic product and inflation data are just a temporary aberration. There is no sign that the Merkel administration is ready to change its longstanding formula for economic success in the eurozone: member states should stick to the fiscal targets in the Stability and Growth Pact, and should accelerate structural reforms, so that the expansionary monetary stance provided by the European Central Bank can bear fruit. Read more
The annual meetings of the IMF and World Bank will take place in Washington next week, with Christine Lagarde warning that the global economic recovery is “brittle, uneven and beset by risks”. Nowhere is this more true than in the euro area, where forecasts for GDP growth and inflation have both been revised progressively downwards, and where medium term inflation expectations are no longer consistent with the ECB’s inflation target.
ECB President Draghi’s remarkable speech at Jackson Hole in August seemed to offer a bold way forward, incorporating structural reform, fiscal easing and monetary expansion. Unfortunately, there have been few signs that political leaders are eager to co-operate with Mr Draghi on the first two of these three pillars, and even the third seems to have run into familiar obstacles on the ECB governing council. Read more
Much of the attention at the last policy meeting at the Federal Reserve was focused on the FOMC’s indication that interest rates would stay unchanged for a “considerable time”. But a more fundamental issue concerns another key phrase in the statement, which is the FOMC’s assertion that “there remains significant under-utilisation of labour resources” in the US. We are likely to find out more about this on Friday, when the US jobs data for September will tell us whether last month’s weak release was an aberration.
If there is still a large margin of slack in the labour market, despite tumbling unemployment figures, the Fed is unlikely to tighten monetary conditions very much in the next couple of years. Slack will also keep the wages share in national income low, thus boosting the profits share further. The utilisation of labour resources in America is thus critical not only for monetary policy, but also for the outlook for US equities.
The academic discipline of labour economics, which has not really been centre stage since the wage-push inflation of the 1970s, is therefore very much back in vogue. Empirical labour economists are needed to determine whether the decline in the official unemployment rate is providing the correct read on labour market slack and, if not, how to handle the problem.
This was the subject of a very timely conference at the Peterson Institute last week, which brought together many leading labour market academics, as well as key officials from the policy establishment in Washington and the wider Fed. The debate is available on the web, and is worth watching in full.
The overall message, which almost certainly reflects what the FOMC is being told by the academic and official economics community, was more dovish than I had expected.
Despite the fact that the official unemployment rate has fallen close to the Fed’s estimates of its “natural” or equilibrium rate, few empirical labour economists seem to believe, at least with any certainty, that labour resources are near full utilisation at present. Read more
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China’s economic rebalancing has been the main downside risk to global economic activity in 2014, and will probably remain so for the foreseeable future. The industrial production figures for August were the weakest seen since the 2008-09 recession, and they were followed by a statement from finance minister Lou Jiwei to the effect that there would be no change in economic policy “in response to one indicator”.
This echoed Premier Li Keqiang’s recent speech at the summer Davos meetings, which indicated broad satisfaction with the overall thrust of policy. “Just like an arrow shot, there will be no turning back”, he promised.
The possibility of a clash between a slowing economy and a Chinese administration that appears implacably set on a pre-determined course was not what the markets wanted to hear. Many western investors have long been predicting a hard landing for China, and do not need much persuasion to believe that it is finally at hand. But recent data do not suggest that it is happening yet. Read more