Will the developed economies recover (anytime soon?)

As the news of the Bank of Japan cutting short term rates to zero (again) trickled in yesterday it created lot of headlines. Along with it was a pledge to buy some billions of dollars of bonds. This is very similar to what the US Fed has been trying to do over the last two years.

The question for all of us today is whether the growth in the developed economies, specifically countries with huge fiscal and unemployment issues recover at all over the next several years. As all of us know the impact of any shot of antibiotic or of taking drugs is the maximum if one is not used to it or it has not been overused. However it loses potency over a period of time. Under normal times monetary policy used to work very well where in overheated conditions interest rates would be increased by the central bankers and the increased cost of funds would reduce demand, reduce inflationary expectations and cause a slowdown in the economy. On the other side the loosening of monetary policy would cause a demand revival.

However today, after two years of an ultra loose monetary policy by central bankers across the developed world combined with a huge dose of Fiscal stimulus which has caused the fiscal deficits of most of these countries go to all time highs, the recovery, if any seems to be extremely anemic. The shattered financial system of these economies which has been propped up by government funds is today in a situation where there is a process of deleveraging which is continuing on a continuous basis. This is typical of the situation after a financial crisis where risk aversion continues to remain high for a prolonged period of time.

On top of all of this we now have the Sovereign debt crisis, mainly in the Euro zone (as of now) where a combination of a shattered financial system, very high fiscal deficits, slowing growth, reducing tax revenues and high unemployment is leading to a situation where a number of countries are unlikely to be able to repay their dues on time. This issue after being a major concern in the month of May has now gone into the shadows as these countries are able to refinance and raise funds at this point of time. However, the real issue is not of refinancing but of servicing these loans that now come at interest rates upwards of 6% for countries like Ireland and Portugal. The Euro zone countries by setting up a huge fall back fund of hundreds of billions around six months back have postponed the problem to some future time. However the problem still remains as big as it was six months back. In the same time period the Euro has rallied 15% against the USD due to the excessive dollar printing by the US Fed.

The impact of the huge amount of money that has been printed by the US Fed has been more towards providing cheap funds to investors and speculators to invest into high yielding assets. The other help has been to the US Government for raising cheap funds in its bond auctions. This has created a huge upward move in emerging market securities and emerging market currencies. Given the fact that the investors of these countries are uncertain about the growth in their own countries this move is likely to sustain for a prolonged period of time and as long as the ultra loose monetary policy continues.

The price movement of gold indicates the uncertainties in the minds of investors. If deflation is the bigger concern in the developed world then why should gold prices be rising the way they are. The reason is simply that everyone is so scared of whatever is happening around them that they would rather play safe by putting some money into gold. Similarly we have seen huge rallies in a large number of agricultural as well as industrial commodities. Although the rally in agri commodities can be explained by crop failures, weather patterns etc., the sharp rally in industrial commodities at a time when demand is extremely subdued in the large part of the world is difficult to explain through fundamentals. The major reason is simply the flow of cheap money into these commodities.

In any case my main point at this point of time is that monetary and fiscal policy working at its maximum has just been able to stabilize the developed economies. Over the next several years the fiscal stimulus will need to contract. Given the fact that unemployment continues to be extremely high and capacity utilization continues to be suboptimal there is unlikely to be any major revival in these economies for the next several years. Central bankers like the US Fed and Bank of Japan by making statements that short term rates will be kept low for a prolonged period of time are also making people used to them and whatever people get used to stops being effective.

Running high fiscal deficits is feasible only under two circumstances. The first being this as a measure to kick start the economy and then withdraw as the revival takes root. The second is in countries that are growing rapidly where higher growth will take care of the higher deficit in the short run; however even in these countries it is not sustainable over the long run. The problems with countries like the US, Europe and Japan is that neither is the case. Given the fact that these economies are now on a slower than historic growth path (for the next decade at least) the only way to reduce deficits will be to increase taxes which will further slow economic growth. Consumption has been the biggest driver in most of these countries over the last several decades. However a combination of high unemployment, smaller salary increases, uncertainties on social security benefits & a higher saving rate will keep consumption down significantly below historical averages. Under the circumstances I find it difficult to share the optimism of any sustained recovery in these countries any time in the foreseeable future.

On the positive side this phenomenon will further strengthen the decoupling phenomenon and as the price behavior of emerging market securities and currencies feeds back to justify this phenomenon. As is always the case it is the price behavior rather than the economic logic that convinces most people about the theory and that seems to be playing out today.

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