For the past week, I have put the Green Shootometer in the garden and have taken regular readings. The upshot is: the glass is definitely half empty – or half full. Let me explain.
So far, so bad
As is clear from the most interesting blog post by Barry Eichengreen and Kevin O’Rourke, and its recent update on VoxEU, the global economy is, as regards some key activity indicators (industrial production, world trade, world stock markets), tracking the Great Depression of the 1930s with frightening precision and tenacity (see also Martin Wolf’s recent column “The recession tracks the Great Depression” on this). They date the start of the current global contraction in April 2008.
But here’s the good news
However, somewhat to my surprise, central bankers and policy makers turn out to be capable of learning, even across generations. The lessons of the 1930s appear to have been learnt. New mistakes are being made all over the place, especially as regards moral hazard, the too-big-to-fail problem and other incentives for excessive risk taking in the financial sector, but that won’t become a serious problem until the next bust following the next financial and asset market boom and bubble.
Monetary policy has been vastly more expansionary in the current downturn that during the corresponding phase of the Great Depression, whether measured by official policy rates or by the behaviour of the world broad money stock. As regards the actions by the monetary policy makers, the behaviour of the narrow money stock (monetary base) or the size of the balance sheets of the central banks would show an even more expansionary thrust. Fiscal policy, unlike what happened in most of the 1930s is counter-cyclical.
In addition, the world has not launched a major trade war on itself. Perhaps I should have said ‘not yet’. Of the 19 nation states that made up the G20 at the London meeting on April 2, 2008, 17 had announced or introduced protectionist measures by the time of the November meeting in Washington DC. While none of these measures amounted to open warfare, recent words and actions from India and China are extremely worrying. In January, India banned the import of Chinese toys for a six-month period (supposedly because of safety concerns). When China threatened to take the issue to the WTO, India lifted the ban after two months. Last week, India’s Federation of Chambers of Commerce and Industry (representing SMEs) accused China of predatory pricing. Today’s Financial Times reports that China has introduced a ‘Buy Chinese’ policy. Even the watered-down version of the ‘Buy American’ policy enacted recently in the US caused considerable tension. The world is playing with fire, trying to export its unemployment problems to other planets.
Inflexion points and turning points
If you eyeball Eichengreen and O’Rourke’s updated Figures 1, 2, 3 and 4 (reproduced below), you may feel that we are just about at the point where things are not just getting worse more slowly (as regards the level of global production and trade) but may actually be getting better: we may appear to have moved past the inflection point to the turning point.
Source: Eichengreen and O’Rourke (2009)
Source: Eichengreen and O’Rourke (2009)
Source: Eichengreen and O’Rourke (2009)
Source: Eichengreen and O’Rourke (2009)
Whether that interpretation is correct depends in part on which activity index you look at. Unemployment will go on rising, possibly for several years. Both industrial production and trade focus on physical goods, rather than on services. Industrial production is a rather small share of global GDP (probably somewhere between 20 and 25 percent). It also tends to be much more volatile that the production of services, because industrial production is subject to the inventory cycle.
The inventory cycle overstated the severity of the downturn, especially in countries with relatively large manufacturing sectors, like Germany, Japan and Brazil. Because of the nice property of inventory stocks that they cannot be negative, there is a natural non-linearity on the down-side of the inventory cycle. So following world-wide de-stocking, a rebound in industrial production and GDP is all but a mechanical certainty. There remain two key unresolved issues. First, what target levels of inventories relative to planned or expected sales or production manufacturers, wholesalers and retailers will want to maintain. This drives the strength of the strength of the inventory rebound. Second, which components of final demand (private consumption, private fixed investment and government spending on good and services) will take over when inventory accumulation peters out again (exports are a source of ‘final’ demand for individual countries, but not for the world as a whole, since globally, exports equal imports).
Global financial markets have normalised, in the sense that spreads have return to the levels just before Lehman fell over. I must admit to feeling, in early September 2008, that financial market conditions were far from favourable, however. So cardiac arrest may have been seen off, the patient is not about to jump out of bed and do a horlepiep. Access to capital markets has been restored for many of the larger firms, but the cost of funding tends to be high. In part, the recent burst in capital market funding represents a diversion of funding demand away from the banks, which are generally still in a zombified state. It also tends to be unavailable to SMEs.
What are the prospects for final demand? Not too bright, I would argue, in the US. Households are traumatised by capital losses on equity; if they are homeowners, they will have suffered massive capital losses on their homes. While this negative wealth effect for households long housing (landlords) is balanced by a corresponding gain on those short housing (tenants), the collateral reduction caused by the house price collapse has short-term negative consequences for the ability to borrow. In addition, if the collapse in house prices represented at least in part the bursting of a bubble, the capital losses of the landlords are not matched by corresponding gains (in present discounted value terms) for tenants.
US demand has been supported by the Obama administration’s fiscal stimulus package. With the Federal deficit likely to be somewhere around 13 to 14 percent of GDP this year, and public debt building up rapidly, not just as a result of these deficits but also as a result of off-budget increases in government (contingent) liabilities associated with the myriad financial support and rescue packages cobbled together for the US financial sector (and selected bits of the rust belt real economy), there is no scope for a further fiscal stimuli financed by debt issuance, unless this debt issuance were monetised by the Fed.
Monetary policy has been extraordinarily expansionary, with the official policy rate as close to zero as makes no difference and large-scale quantitative and credit easing. This too is pretty much an exhausted set of policy instruments, except in conjunction with a fiscal stimulus. Tax cuts or increased transfer payments financed by the issuance of Treasury debt that is purchased and monetised by the Fed is the real-world version of helicopter money. There exists a scale for those operations large enough to stimulate demand. The problem is their reversibility, once the output gap closes and inflationary pressures begin to build again. Increases in public spending on real goods and services could also be monetised by the Fed. Again this will stimulate demand but is subject to the same reversibility or exit problems as helicopter drops of money.
All crossborder US banks, and probably most larger purely domestic US banks are now de-facto guaranteed against insolvency by the US government. This is the moral hazard disaster I referred to earlier: too big and too politically connected to fail. Even where it could have been used (for Federally insured deposit-taking banks), the US authorities have not invoked the special resolution regime for commercial banks to force the unsecured creditors to recapitalise the big banks, through mandatory debt-to-equity conversions, haircuts or similar measures. Instead the tax payer was made to pick up the tab.
But at least new capital has gone into the banks on a reasonable scale. The US stress tests, cautious though they were, did lead to banks going to the market and successfully raising capital. The fact that the methodology and the results of the stress tests are in the public domain also help build confidence.
Many silly things have happened also. Two attempts at getting the toxic assets off the banks balance sheet (the first one under Paulson through the TARP, the second one under Geithner through the PPIP) have failed. This failure to adopt a consistent bad bank approach (let alone pursue the alternative good bank(s) approach), means that the surviving banks still have some of the toxic rubbish on their balance sheets, which inevitably acts as a drag on new lending.
Allowing 10 banks that had received public capital injections to repay the government is pandering to banks chomping at the bit to get the government out of their hair and return to the bad old ways that brought us the financial crisis. Perhaps a couple of banks were truly in a position to repay the government, without impairing their ability to act as banks, that is, to engage in new lending. The remaining banks will act to varying degrees like zombie banks – surviving, but engaging in little new lending and other business likely to stimulate activity and support a dynamic changing economy. Following the Japanese example of recapitalising gradually out of operating profits generating in no small part because of explicit or implicit government guarantees of bank funding and high private lending rates is likely to lead to a Japanese-style lost quinquennium or even a lost decade.
The UK’s recession has turned out to be less deep than I feared and anticipated. In part this is due to the large fall of sterling (still 20 percent weaker than before the downturn, despite the recent gains). This good news, if it sticks, is qualified by the likelihood that any recovery will be slow and meek. Household consumption has been remarkably resilient, but given the state of the UK household balance sheet, it is hard to see consumer demand growth being the internal locomotive. Private investment, including residential and non-residential construction, is bound to remain weak for the foreseeable future. Government spending will have to be cut soon in real terms if a public finance Armageddon is not to befall the country, which is in dreadful fiscal shape. Tax increases are also all but unavoidable if fiscal-financial sustainability is to be restored.
Like the US banks, the UK’s banks are surviving but to varying degrees zombified. Even those banks that have managed to stay out of the clutches of the state have had to engage in so much defensive balance sheet restructuring that they are falling way short in their supposed role as conduits for inter-mediation between households and non-financial enterprises. There have been stress tests in the UK, but neither the methodology or the results have been put in the public domain. They have therefore been quite useless as regards restoring confidence. In addition, the tests were performed by the FSA, which does not yet have the personnel capable of performing a proper stress test. Historically, it has been a box tickers organisation, dominated by lawyers and accountants – both quite useless skills as regards stress tests.
As in the US, moral hazard has been king in the government’s approach to providing financial support to the banking sector. Concentration has increased and the too big and too politically connected to fail problem has never been more acute.
The Euro Area has performed remarkably badly in this downturn. This is partly due to the ECB, whose policy stance has been less expansionary than that of the Fed and the Bank of England. Its official policy rate still stands at 1.00 percent, around 100 basis points above the level it should be at, and the Eurosystem has expanded its balance sheet less than the Fed and the Bank of England. A more serious problem is that addressing the solvency of the banking system in the Euro Area has not yet begun in earnest. There have been government capital injections (or announcements of such) when banks were about to fall over (Commerzbank and assorted Landesbanken in Germany, ABN-Amro and ING in the Netherlands, and many other banks in Belgium, Ireland, France, Italy and now Spain), but it has been even less systematic and on a smaller scale than in the US.
In addition, the Euro Area banks have managed to keep the problem assets they have on their balance sheets under wrap. No stress tests whose methodology and/or outcomes are in the public domain have been performed. The European Commission now wants a uniform set of EU-wide stress tests, but only to give it and supervisors/regulators a sense of what the risk-map is, not as a prelude to mandatory capital raising and/or a restructuring of funding strategies.
The Euro Area banks have used every accounting trick in the book to avoid revealing the existence of troubled or toxic assets and marking them to market. The ECB recently estimated the additional capital required by the Euro Area bans at between €212 and €283bn. People close to the industry assure me that the true figure is at least twice that amount. So Euro Area banks are likely to be or become zombie banks to a much greater degree than their US and UK counterparts. They have revealed little, recognised less and are, to an unknown degree, still subject to material insolvency risk because of undeclared horrors on their balance sheets. Their high degree of leverage also makes them extremely vulnerable to further balance sheet deterioration as conventional household, industrial and commercial loans go belly-up in increasing numbers as the recessions deepens and lengthens.
I don’t understand the Japanese economy. Never have. Probably never will. I don’t understand why the official policy rate has been below 0.5 percent since 1995 – effectively in a liquidity trap. I don’t understand why, given that first fact, the stock of outstanding public debt has not been monetised to the point that Japan has an inflation rather than a deflation problem. I do understand, sort of, the inventory cycle Japan in going through and in which it now appears to have entered the inventory re-accumulation phase. Unless Japanese consumers have a major change of heart, however, it is hard to see Japan as a global locomotive.
The emerging markets are a very heterogeneous bunch. Their recent economic performance and prospects range from quite good (India, Turkey, Brazil since the end of the destocking implosion), to prima facie quite good (China) to pretty mediocre or bad (Central and Eastern Europe), to dismal (Russia).
Those emerging markets that (1) did not have their domestic financial sectors destroyed or excessively exposed to parent banks in the North Atlantic region; (2) are not excessively dependent on export demand and (3) are not too dependent on foreign funding are likely to do best and have a ‘V’-shaped recovery. India ticks all the boxes. Unfortunately for the rest of the world, it is still too small and too closed to be a global demand enging. Brazil is fairly export-dependent. Despite its strong net foreign financial investment position, its enterprise sector has a large foreign exposure, so there are vulnerabilities here. However, with unusually restrained fiscal policy and unusually responsible monetary policy, it had prospects for becoming the medium-sized engine that could.
China is the great unknown. It is big enough to make a global impact. It is, however, very export dependent. It will have to swicth demand towards domestic final demand, including consumption of non-traded goods and services. The potential is certainly there. The extravagant Chinese saving rate can be tackled in the household sector by introducing a nation-wide unfunded social security retirement scheme (possibly with a contribution holiday for a couple of years up front), with greater public funding of health care and with increased public funding for education. The state enterprise sector has been hoarding funds for a long time, and the Chinese government may finally be able to extract these surpluses.
There also is much scope for environmental investment, investment in light industry and residential investment. A key question is whether the Chinese authorities have the implementation capacity to steer this change in the composition of production and demand towards import-competing goods and non-traded goods and away from exportables. Given enough time, they no doubt can, but it is not obvious that it will be possible to achieve this right now – over a horizon relevant to the cyclical state of the Chinese and global economy. A map of government-sponsored investment programmes for China shows a marked concentration inland, which is consistent with the need redirection of final demand and production away from exports. Whether this is a wish list or a list of project likely to result in production during the next two or three years I don’t know.
Finally, there is the usual worry about the quality and bias in the Chinese statistics. In China, as in most authoritarian states, statistics are not primarily a source of information, but a policy tool and a propaganda instrument. Corroberation is therefore important. Chinese energy (electric power) consumption historically tracks industrial production and GDP quite well. Not so since the downturn began. Power consumption has been declining despite continuing GDP growth. As there has been no big push on energy conservation in China, either through prices or through administrative methods, this coexistence of rising GDP and declining power use is strange.
Bottom line is, I continue to have doubts about the strength of the Chinese growth performance, but would welcome confirmation that eight percent growth or more this year is truly achievable.
There are other indicators to support the view that the global economy may be turning. Commodity prices, including oil, are rising and well above their recent lows. This is consistent with the view that emerging markets, which are notoriously energy-inefficient, are likely to be the early demand drivers in the recovery.
Survey data, in the US, the UK and the Euro Area tend to be stronger than the hard data. Of course, the hard data are not hard at all, but just survey data several times removed. Against that, sentiment is fickle and volatile. A massive sense of relief that the world is not falling apart completely may get reflected in an up-tick of consumer sentiment but may not translate neatly into an increase in consumer spending. But on balance, there are more signs that the worst is over. There are also signs that the recovery whenever it started or may start, will be slow and reluctant. Recoveries without healthy banks are possible, but more difficult.
Those of you familiar with the lyrics, written by Claude “Curly” Putman Jr., of the country song and ultimate Schmachtfetzen ‘Green Green Grass of home’, will know that the last verse (spoken) starts:
“Then I awake and look around me, at four grey wall surround me
and I realize that I was only dreaming.”
As far as I’m concerned, I’ve been down so long, it looks like up to me.