Policymakers must abandon structural reform rhetoric and embrace fiscal stimulus
October 7, 2015
As the world’s financial policymakers convene for their annual meeting on Friday in Peru, the dangers facing the global economy are more severe than at any time since the bankruptcy of Lehman Brothers in 2008.
The problem of secular stagnation – the inability of the industrial world to grow at satisfactory rates even with very loose monetary policies – is growing worse in the wake of problems in most big emerging markets, starting with China.
This raises the spectre of a vicious global cycle in which slow growth in industrial countries hurts emerging markets which export capital, thereby slowing western growth further. Industrialised economies that are barely running above stall speed can ill-afford a negative global shock.
Policymakers badly underestimate the risks of both a return to recession in the west and of a global growth recession. If a recession were to occur, monetary policymakers lack the tools to respond.
There is essentially no room left for easing in the industrial world. Interest rates are expected to remain very low almost permanently in Japan and Europe and to rise only very slowly in the US.
Today’s challenges call for a clear global commitment to the acceleration of growth as the main goal of macroeconomic policy. Action cannot be confined to monetary policy.
There is an old proverb: “You do not want to know the things you can get used to.” It is all too applicable to the global economy in recent years. While the talk has been of recovery from the crisis, forecasts of future gross domestic product have been revised sharply downwards almost everywhere.
Relative to its 2012 forecasts, the International Monetary Fund has revised its estimate for the level of US GDP for 2020 downwards by 6 per cent, Europe by 3 per cent, China by 14 per cent, emerging markets by 10 per cent and 6 per cent for the world as a whole.
These dismal results assume no recessions in the industrial world and the absence of systemic crises in the developing world. Neither can be taken for granted.
We are in a new macroeconomic epoch where the risk of deflation is higher than that of inflation and we cannot rely on the self-restoring features of market economies. The effects of hysteresis – where recessions are not just costly but stunt the growth of future output – appear far stronger than anyone imagined a few years ago.
Western bond markets are sending a strong signal that there is too little, rather than too much, government debt. As always, when things go badly there is a great debate between those who believe in staying the course and those who urge a serious correction. I am convinced of the urgent need for substantial changes in the world’s economic strategy.
History tells us that markets are inefficient and often wrong in their judgments about economic fundamentals. It also teaches us that policymakers who ignore adverse market signals because they are inconsistent with their preconceptions risk serious error.
This is one of the most important lessons of the onset of the financial crisis in 2008. Had policymakers heeded the pricing signal on the US housing market from mortgage securities, or on the health of the financial system from bank stock prices, they would have reacted far more quickly to the gathering storm. There is also a lesson from Europe. Policymakers who dismissed market signals that Greek debt would not be repaid in full delayed necessary adjustments – at great cost.
Lessons from the bond market
It is instructive to consider what government bond markets in the industrialised world are implying today. These are the most liquid financial markets in the world and reflect the judgments of a very large group of highly informed traders. Two conclusions stand out.
First, the risks tilt heavily towards inflation rates that are below official targets. Nowhere in the industrial world is there an expectation that central banks will hit their 2 per cent targets in the foreseeable future. Inflation expectations are highest in the US – and even there it expects inflation of barely 1.5 per cent for the five-year period starting in 2020.
This is despite the fact that the market indicates that monetary policy will remain looser than the Federal Reserve expects: the Fed funds futures market predicts a rate around 1 per cent at the end of 2017 compared to the Fed’s most recent median forecast of 2.6 per cent. If the market believed the Fed on monetary policy it would expect even lower inflation and a risk of deflation.
Second, the prevailing expectation is of extraordinarily low real interest rates. Real rates have been on a downward trend for nearly 25 years.
The average real rate in the industrialised world over the next 10 years is expected to be zero. Even this presumably reflects some probability that it will be artificially increased by nominal rates at a zero bound and deflation. In the presence of such low real rates there is no sign that economies would overheat.
Many will argue that bond yields are artificially depressed by quantitative easing and so it is wrong to use them to draw inferences about future inflation and real rates. This cannot be ruled out. But it is noteworthy that rates are now lower in the US than their average during the period ofQE and that forecasters have been confidently – but wrongly – expecting them to rise for years.
The strongest explanation for this combination of slow growth, expected low inflation and zero real rates is the secular stagnation hypothesis.
It holds that a combination of high rates of saving, lower investment and increased risk aversion depresses the real interest rates that accompany full employment. The result is that the zero lower bound on nominal rates becomes constraining.
There are four contributing factors that lead to much lower normal real rates. First, increases in inequality – the share of income going to capital and in corporate retained earnings – raise the propensity to save.
Second, an expectation that growth will slow due to smaller labour force growth and slower increases in productivity reduces investment and boosts the incentives to save.
Third, increased friction in financial intermediation caused by more extensive regulation and increased uncertainty discourages investment.
Fourth, reductions in the price of capital goods and in the quantity of physical capital needed to operate a business – think of Facebook having over five times the market value of GM.
Emerging markets hit reverse
Until recently, a major bright spot has been the strength of emerging markets. They have been substantial recipients of capital from developed countries that could not be invested productively at home.
The result has been higher interest rates than they would otherwise obtain, greater export demand for industrial countries’ products and more competitive exchange rates for developed economies.
Gross flows of capital from industrial countries to developing countries rose from $240bn in 2002 to $1.1tn in 2014. Of particular relevance for the discussion of interest rates is that foreign currency borrowing by the private sector of developing countries rose from $1.7tn in 2008 to $4.3tn in 2015.
Developing country net capital flows fell sharply this year – marking the first such decline in almost 30 years, according to the Institute of International Finance, with the amount of private capital leaving developing countries eclipsing $1tn.
Any discussion has to start with China, which poured more concrete between 2010 and 2013 than the US did in the entire 20th century. A reading of the recent history of investment-driven economies – whether in Japan before the oil shock of the 1970s and 1980s or the Asian tigers in the late 1990s – tells us that growth does not fall off gently.
China faces many other challenges, ranging from the most rapid population ageing in the history of the planet to a slowdown in rural to urban migration. It also faces issues of political legitimacy and how to cope with unproductive investment.
Even taking an optimistic view – where China shifts smoothly to a consumption-led growth model led by services – its production mix will be much lighter, so the days when it could sustain commodity markets are over.
The problems are hardly confined to China. Russia is struggling with low oil prices, a breakdown in the rule of law and harsh sanctions. Brazil has been hit by the decline in commodity prices but even more by political dysfunction. India is a rare exception. But from central Europe to Mexico to Turkey to Southeast Asia, the combination of slowdowns in industrialised countries and dysfunctional politics is hurting growth by discouraging capital inflows and encouraging capital outflows.
What does all this mean for the world’s policymakers gathered in Lima for the IMF and World Bank meetings? This is no time for complacency. The idea that slow growth is only a temporary consequence of the 2008 financial crisis is absurd. The latest data suggest growth is slowing in the US and it is already slow in Europe and Japan. A global economy near stall speed – and slowing – is one where the primary danger is recession.
The most successful recent assertion of growth policy was Mario Draghi’s famous vow that “the European Central Bank will do whatever it takes to preserve the euro”, uttered at a moment when the single currency appeared to be on the brink.
By making an unconditional commitment to providing liquidity and supporting growth, the ECB president prevented an incipient panic and helped lift European growth rates – albeit not by enough.
What is needed now is something equivalent but on a global scale – a signal that the authorities recognise that secular stagnation and its spread to the world is the dominant risk we face. After last Friday’s dismal US jobs report, the Fed must recognise what should already have been clear: that the risks to the US economy are two-sided. Rates should be increased only if there are clear and direct signs of inflation or of financial euphoria breaking out. The Fed must also state its readiness to help prevent global financial fragility from leading to a global recession.
The central banks of Europe and Japan need to be clear that their biggest risk is a further slowdown. They must indicate a willingness to be creative in the use of the tools at their disposal. With bond yields well below 1 per cent it is very doubtful that traditional QE will have much stimulative effect. They must be prepared to consider support for assets that carry risk premiums that can be meaningfully reduced. They could achieve even more by absorbing bonds to finance fiscal expansion.
Long-term low interest rates radically alter how we should think about fiscal policy. Just as homeowners can afford larger mortgages when rates are low, government can also sustain higher deficits. If the Maastricht criteria of a debt-to-GDP ratio of 60 per cent was appropriate when governments faced real borrowing costs of five percentage points, then a far higher figure is surely appropriate today when real borrowing costs are negative.
The case for more expansionary fiscal policy is especially strong when it is spent on investment or maintenance. Wherever countries print their own currency and interest rates are constrained by the zero bound there is a compelling case for fiscal expansion until demand accelerates. While the problem before 2008 was too much lending, many more of today’s problems have to do with too little lending for productive investment.
Inevitably, there will be discussion of the need for structural reform at the Lima meetings – there always is. But to emphasise it now would be to embrace the status quo. The world’s markets are telling us with increasing force that we are in a very different world now.
Traditional approaches of focusing on sound government finance, increased supply potential and the avoidance of inflation court disaster. Moreover, the world’s principal tool for dealing with contraction – monetary policy – is largely played out. It follows that policies aimed at lifting global demand are imperative.
If I am wrong about expansionary fiscal policy, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But even if they materialise, standard approaches can be used to combat them.
If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years where growth stagnates but little can be done to fix it. It is an irony of today’s secular stagnation that what is conventionally regarded as imprudent offers the only prudent way forward.