Analysis of the global economy
About a decade ago….. I estimated the following simple formula for setting the federal funds rate:
Federal funds rate = 8.5 + 1.4 Core inflation – Unemployment
….Eddy Elfenbein has recently replotted this equation. Here it is:
via Greg Mankiw’s Blog: The Liquidity Trap may soon be over.
To arrive at an outlook for the year ahead we first need to analyze the big trends that endure for decades and in some cases even longer.
The number one dynamic over the last century has been the exponential rise in global population. It took 123 years for the world population to grow from 1 to 2 billion (by 1927) and only 12 years to grow from 5 to 6 billion (by 1999). Growth, however, is now slowing and we are predicted to rise from the current 7 billion to a peak of 9 billion in the 2050s.
At the same time we are faced with increasing scarcity of food and water. Advances in technology have improved crop yields, but increased meat consumption in China and other Asian economies will reduce overall output. The area of land required to produce an equivalent amount of edible protein from livestock is 4 to 5 times higher compared to traditional grains and legumes, and up to 10 times higher for beef. Diversion of land use for ethanol production will also restrict food output.
Global warming, whether man-made or a natural cycle, may also contribute to declining food production — through droughts, floods and depleting fish stocks.
We are also depleting global deposits of ferrous- and non-ferrous ores — as well as energy reserves of crude oil and coal — as global industrialization accelerates. Commodity costs can be expected to rise as readily available resources are depleted and we are forced to dig deeper and endure harsher conditions in order to access fresh deposits. Deep water ocean-drilling and exploration within the Arctic and Antarctic circles are likely to increase.
As energy resources are depleted, nuclear energy production is likely to expand despite current safety concerns. Development of technologies such as thorium fluoride reactors hold out some hope of safer nuclear options, but these may be some way off. Wind and solar energy are likely to remain on the fringe until technology develops to the point where they are cost effective compared to alternative sources.
Competition for scarce resources will increase tensions between major economic players, with each attempting to expand their sphere of influence — and secure their sources of supply. The Middle East, Africa, South America, Australia, Mongolia and the former USSR are all potential targets because of their rich resource base.
In addition to competition for scarce resources, we are also likely to see increased competition for international trade. Resistance to further currency manipulation — initiated by Japan in the 1980s and perpetuated by China in the last decade — is likely to rise. US Treasury holdings by China and Japan currently sit at more than $2.3 Trillion, the inflows on capital account being used to offset outflows on current account and maintain a competitive trade advantage by suppressing their exchange rate.
Another factor contributing to instability is the rise of democracy in some parts of the world. The Arab Spring is still in its infancy, but the development has no doubt caused concern amongst autocratic governments around the globe. Food shortages and rising global prices will act as a catalyst. The likely result is increased suppression in some autocracies and a rapid transition to democracy in others, like Myanmar. But the transition to democracy is never smooth — especially in countries with clear fault lines, such as language, religious, racial or cultural differences — and can lead to decades of conflict before some degree of stability is achieved.
On the other hand we are witnessing the decay of long-standing, mature Western democracies. Undue influence exerted by special interest groups with large cash resources — such as banks, big oil, and armaments manufacturers — force politicians to serve not only their electorate but their financial sponsors. Aging populations pose a new threat: large voting blocs who are not participants in the economic workforce will wield increasing influence over distribution of social welfare payments such as Medicare and Pensions. And politicians are increasingly guilty of over-spending, running up public debt and debasing currencies, in their attempt to keep voters happy and secure re-election.
The long term hope is that we evolve a more consensus-based form of democracy, along the lines of the Swiss model, and away from the excesses of the current winner-takes-all system.
The decay in Western democracy resulted in a massive debt binge over the last 3 decades, with private debt often growing at double-figure rates, accompanied by burgeoning public debt levels. The massive debt bubble far outstripped GDP growth, effectively debasing currencies and causing soaring inflation of consumer and asset (housing and stock) prices. The GFC marked the peak of the debt expansion and was followed rapid contraction as the private sector diverted income to repay debt. Debt contraction is catastrophic, however, and can cause GDP to fall by up to 25 percent as in the Great Depression of the 1930s.
The response has been a massive expansion of public debt as governments run deficits in order to offset the private debt contraction. Overall debt levels hardly faltered as government spending programs filled the hole left by private debt contraction. While this succeeded in plugging the gap, many Western governments are left with huge public debt and increasingly nervous bond markets.
Central banks such as the Fed and BOE stepped into the breach, purchasing government bonds with newly-created money. Apart from putting gold performance on steroids, central bank asset purchases had little impact on inflation because the effect was offset by the deflationary debt contraction. But cessation of the debt contraction would let the genie out of the bottle.
Here is how I believe these big trends will impact on 2012. I do not claim to have a crystal ball and it may be amusing to review these predictions at the end of the year:
I wish you peace and prosperity in the year ahead but, most of all, the good health to enjoy it.
Regards,
Colin Twiggs
Banks are borrowing at 1% from the ECB and then lending the money back to the ECB at 0.25%. Or to put it another way, they are taking a substantial loss on their dealings with the central bank.
Why on earth would they do this?
Well, as I’ve said many times before, it is because they would rather be sure their money is safe and easy to get their mitts on, than take the risk of obtaining a higher interest rate by lending the cash to other banks…..
But actually for me there is a more troubling ECB statistic – which is that eurozone banks last night borrowed 15bn euros overnight from the central bank (and a little less on Monday but a bit more at the end of last week).
Why does this matter?
Well the European Central Bank has just pumped an astonishing amount of new loans into the banking system. And yet there are some banks out there which are still short of cash – and are unable to borrow it from other banks, financial institutions or commercial customers.
Key euro zone bank-to-bank lending rates continued to drop on Wednesday, pulled down by the ECB’s recent record injection of almost half a trillion euros of ultra-long and ultra-cheap three-year liquidity. Euro zone banks received 489 billion euros late last month in the first of two opportunities to access the long-term loans — operations the ECB hopes will minimise the chances of them responding to the region’s debt crisis by slashing lending.
via Bank-to-bank Euribor rates extend post-ECB cash drop | Reuters.
Wall Street’s biggest banks expect the Federal Reserve‘s 0% interest rates to persist into at least 2014, and see good odds the Fed will provide additional stimulus to the economy in the near term, according to a Federal Reserve Bank of New York survey of primary dealers.
…..The median expectation that the Fed could provide additional stimulus in the form of bond buying that would push the balance sheet beyond its current $2.9 trillion level stands at 60% over the year.
via Big Banks See Better Than 50/50 Odds of QE3 – Real Time Economics – WSJ.
To pay down liabilities like these would require the permanent allocation of an additional 8% of GDP. Where would we find the will to do that? I suspect as a result that we will see real decreases in Medicare benefits — things that won’t be eligible for payment. Hospice care will be indicated at higher frequency when healing an old person would be costly. So just be aware that something has to change, either taxes have to rise, or Medicare benefit levels have to fall.
via 2011 Financial Report Of The U.S. Government – Seeking Alpha.
A lack of demand is causing the weak economy rather than uncertainty over taxes, regulation and economic policies, according to Alan Krueger, the chairman of President Barack Obama’s Council of Economic Advisers.
via White House’s Krueger: Lack of Demand Holding Back Economy – Real Time Economics – WSJ.
The debt binge since 1975, fueled by an easy-money policy from the Fed, has landed the US economy in serious difficulties. Wall Street no doubt lobbied hard for debt expansion, because of the boost to interest margins, with little thought as to their own vulnerability. There can be no justification for debt to expand at a faster rate than GDP — a rising Debt to GDP ratio — as this feeds through into the money supply, causing asset (real estate and stocks) and/or consumer prices to balloon. What we see here is clear evidence of financial mismanagement of the US economy over several decades: the graph of debt to GDP should be a flat line.
The difference between domestic and private (non-financial) debt is public debt, comprising federal, state and municipal borrowings. When we look at aggregate debt below, domestic (non-financial) debt is still rising, albeit at a slower pace than the 8.2 percent average of the previous 5 years (2004 to 2008). Public debt is ballooning in an attempt to mitigate the deflationary effect of a private debt contraction. Clearly this is an unsustainable path.
The economy has grown addicted to debt and any attempt to go “cold turkey” — cutting off further debt expansion — will cause pain. But there are steps that can be taken to alleviate this.
If private debt contracts, you need to expand public debt — by running a deficit — in order to counteract the deflationary effect of the contraction. The present path expands public debt rapidly in an attempt to not only offset the shrinkage in private debt levels but also to continue the expansion of overall (domestic non-financial) debt levels. This is short-sighted. You can’t borrow your way out of trouble. And encouraging the private sector to take on more debt would be asking for a repeat of the GFC. The private sector needs to deleverage but how can this be done without causing a total economic collapse? The answer lies in government spending.
Treasury cannot afford to borrow more money if this is used to meet normal government expenditure. Public debt as a percentage of GDP would sky-rocket, further destabilizing the economy. If the proceeds are invested in infrastructure projects, however, that earn a market-related return on investment — whether they be high-speed rail, toll roads or bridges, automated port facilities, airport upgrades, national broadband networks or oil pipelines — there are at least four benefits. First is the boost to employment during the construction phase, not only on the project itself but in related industries that supply equipment and materials. Second is the saving in unemployment benefits as employment is lifted. Third, the fiscal balance sheet is strengthened by addition of saleable, income-producing assets, reducing the net public debt. Lastly, and most importantly, GDP is boosted by revenues from the completed project — lowering the public debt to GDP ratio.
Public debt would still rise, and bond market funding in the current climate may not be reliable. But this is the one time that Treasury purchases (QE) by the Fed would not cause inflation. Simply because the inflationary effect of asset purchases are offset by the deflationary effect of private debt contraction. Overall (domestic non-financial) debt levels do not rise, so there is no upward pressure on prices.
Infrastructure investment should not be seen as the silver bullet, that will solve all our problems. Over-investment in infrastructure can produce diminishing marginal returns — as in bridges to nowhere — and government projects are prone to political interference, cost overruns, and mismanagement. But these negatives can be minimized through partnership with the private sector.
Projects should also not be viewed as a short-term, band-aid solution. The private sector has to increase hiring and make substantial capital investment in order to support them. All the good work would be undone if the spigot is shut off prematurely. What is needed is a 10 to 20 year program to revamp the national infrastructure, restore competitiveness and lay the foundation for future growth.
There are no quick fixes. But what the public needs is a clear path to recovery, rather than the current climate of indecision.
Empirically, a long period of deleveraging nearly always follows a major financial crisis. Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.
Today, American aggregate non-financial debt is at levels similar to those last seen in the midst of the Great Depression. At 250 per cent of GDP, that debt burden is equivalent to almost US$120,000 for every American (Chart 1).
…..backsliding on financial reform is not a solution to current problems. The challenge for the crisis economies is the paucity of credit demand rather than the scarcity of its supply. Relaxing prudential regulations would run the risk of maintaining dangerously high leverage – the situation that got us into this mess in the first place.
As a result of deleveraging, the global economy risks entering a prolonged period of deficient demand. If mishandled, it could lead to debt deflation and disorderly defaults, potentially triggering large transfers of wealth and social unrest.
Managing the deleveraging process
Austerity is a necessary condition for rebalancing, but it is seldom sufficient. There are really only three options to reduce debt: restructuring, inflation and growth. Whether we like it or not, debt restructuring may happen. If it is to be done, it is best done quickly. Policy-makers need to be careful about delaying the inevitable and merely funding the private exit.
……Some have suggested that higher inflation may be a way out from the burden of excessive debt. This is a siren call. Moving opportunistically to a higher inflation target would risk unmooring inflation expectations and destroying the hard-won gains of price stability.
…..With no easy way out, the basic challenge for central banks is to maintain price stability in order to help sustain nominal aggregate demand during the period of real adjustment. In the Bank’s view, that is best accomplished through a flexible inflation-targeting framework, applied symmetrically, to guard against both higher inflation and the possibility of deflation.
The most palatable strategy to reduce debt is to increase growth. In today’s reality, the hurdles are significant. Once leverage is high in one sector or region, it is very hard to reduce it without at least temporarily increasing it elsewhere.
In recent years, large fiscal expansions in the crisis economies have helped to sustain aggregate demand in the face of private deleveraging. However, the window for such Augustinian policy is rapidly closing. Few except the United States, by dint of its reserve currency status, can maintain it for much longer.
…..The route to restoring competitiveness [in the euro-zone] is through fiscal and structural reforms. These real adjustments are the responsibility of citizens, firms and governments within the affected countries, not central banks. A sustained process of relative wage adjustment will be necessary, implying large declines in living standards for a period in up to one-third of the euro area.
…..With deleveraging economies under pressure, global growth will require global rebalancing. Creditor nations, mainly emerging markets that have benefited from the debt-fuelled demand boom in advanced economies, must now pick up the baton. This will be hard to accomplish without co-operation. Major advanced economies with deficient demand cannot consolidate their fiscal positions and boost household savings without support from increased foreign demand. Meanwhile, emerging markets, seeing their growth decelerate because of sagging demand in advanced countries, are reluctant to abandon a strategy that has served them so well in the past, and are refusing to let their exchange rates materially adjust. Both sides are doubling down on losing strategies. As the Bank has outlined before, relative to a co-operative solution embodied in the G-20’s Action Plan, the foregone output could be enormous: lower world GDP by more than US$7 trillion within five years. Canada has a big stake in avoiding this outcome.
Mark Carney: Growth in the age of deleveraging.
Comment: ~ One of the most important papers I have read this year. Mark Carney, Governor of the Bank of Canada and Chairman of the Financial Stability Board — established by the G-20 in 2009 to further global economic governance — maps out the hard road to recovery from the current financial crisis.
