A deflationary world
This is a post about the conventional world economy, particularly the USA and the UK.
Both economies have been suffering from low-wage employment growth. Unemployment, normally a clear indicator of a failing economy, has fallen; and so have wages.
Both have had major financial crises and both governments have had to stage bank rescues.
The Eurozone and Japan are also primarily in sync with this movement. The Eurozone has suffered worse because it has had less QE.
There are a few differences, cultural, institutional, but essentially, the whole developed world has been stagnating since at least 2008, with the underlying malaise probably starting as much as a decade earlier.
The facts are that despite the key commodity (oil) being at well-above-average real price levels for most of that time, inflation has remained low and wages have fallen. We have, essentially, been living through deflationary times, saved only by quantitative easing. Without the actions of both the Federal Reserve and the Bank of England, things would have been much, much worse over the last six years. Unfortunately, QE could not solve the underlying problems and now it is being withdrawn, they are likely to emerge with a vengeance next year.
I could be wrong; I often am and in this case I really hope so. But I don’t think so.
Classical economic theory (on all sides of the fence) says that recessions are the consequence of inadequate demand. Keynesian analysis says that the way to deal with that is for government to increase spending and/or reduce taxation during a recession, thus putting more more money in people’s pockets and increasing demand. These two things aren’t, however, equivalent. On the liberal right, tax-cutting is the preferred mechanism because it lets people, not governments, decide how to spend the money and determine where the demand goes; the interventionist left favours more public works (the Mersey Tunnel, the Tennessee Valley Authority, re-arming for the second world war). Intervention means that the money is actually spent; individuals and companies, as is their right, don’t always choose to do so, particularly when there’s deflation about. The monetary authorities (central bankers) respond to this by devaluing money, making real interest rates negative. This is normally a strong incentive to spend, after all, why keep the money in the bank losing value? One of the problems of today’s global economy is that consumers, and particularly companies, haven’t been spending their money.
Quantitative Easing (QE): blowing bubbles
QE is a emergency lever used by central bankers to devalue money when the interest rate lever has come to the end of its range. Global interest rates have been near-zero since the crash. The central bankers create money to buy bonds from financial institutions. Creating money without creating a corresponding amount of stuff inevitably devalues it, which is the point of the exercise. However, QE has operated at a scale far beyond that originally intended.
The problem with QE is that it is used to buy assets: government securities, commercial paper, and in the US in particular the toxic securitised debt that had triggered the first crisis. This has the result of pushing up asset prices. Suppose a bank holds $1bn of toxic debt, which it sells to the Fed. The result is that it has $1bn of cash instead of the toxic debt. That needs to go somewhere; held as cash, it will decline in value. So it spends it on other assets. Up to a point, this is a good thing. For related reasons, banks have been under great pressure to “strengthen their balance sheets”, since many had to be rescued during the crash. New international rules on capital adequacy have come into force and QE has helped them meet the requirements, most clearly in the USA. German refusal to let the ECB do much in the way of QE, allied to the Eurozone’s structure, means that some Eurozone banks have found it harder to pass the new stress tests. But beyond a point, it is a bad thing: it pushes up the price of assets, creating asset bubbles. There are lots of these around the world, fuelled mainly by dollar QE. London property is one. If the bubbles are relatively local, they can burst without bringing the system down. The market for luxury property in Istanbul – definitely a QE bubble – has been hit by regional unrest. But the collective effect of asset bubbles bursting is that investors lose money and the effect of the QE evaporates. A significant factor here is the way insiders offload inflated assets just before the bubble bursts, thus passing off the losses to schmucks, or retail investors as they are more politely known.
The underlying problem is much more serious and none of the actions of the authorities since 2008 have done anything to address it. It is structural, based on continued weakness of real productive industries outside the newly-industrialising countries. Growing income inequality creates a large class of people able to afford only the most basic goods and another, much smaller class of super-rich people with nowhere to put their money. Together, these two groups’ spending isn’t enough to support a prosperous middle-income, working class. Making money by making useful stuff has been eclipsed by making money from inflating assets. Austerity policies have exacerbated and prolonged the structural problems.
I continue to believe that QE was, perhaps is, a necessary evil, but not a sufficient response to the structural failings of the global economy. On its own, all it has done is disguise the intrinsic deflationary phase; that needed addressing by significant state intervention on capital infrastructure projects.
The end of QE without solving the underlying deflationary nature of the economy threatens to bring deflation out into the open. That’s what I’m worried about for next year, although I believe that it’s more likely that central bankers will resume QE to prevent that particular disaster. I really don’t think they have a choice; it’s governments who need to act.