What are we bet­ting on?

Financial Mirror (Cyprus) - - FRONT PAGE -

When I con­sider the prospects for the global econ­omy and mar­kets, I am taken aback by the ex­tent to which the world has col­lec­tively placed a huge bet on three fun­da­men­tal out­comes: a shift to­ward ma­te­ri­ally higher and more in­clu­sive global growth, the avoid­ance of pol­icy mis­takes, and the preven­tion of mar­ket ac­ci­dents. Though all three out­comes are un­doubt­edly de­sir­able, the un­for­tu­nate re­al­ity is that they are far from cer­tain – and bets on them with­out some hedg­ing could prove ex­ceed­ingly risky for cur­rent and fu­ture gen­er­a­tions.

The first com­po­nent of the bet – more in­clu­sive global growth – an­tic­i­pates con­tin­ued eco­nomic re­cov­ery in the United States, with a 3% growth rate this year bol­stered by ro­bust wage growth. It also as­sumes China’s an­nual growth rate will sta­bilise at 6.5-7%, thereby en­abling the risks posed by pock­ets of ex­ces­sive lever­age in the shadow-bank­ing sys­tem to be grad­u­ally de­fused, even as the econ­omy’s growth en­gines con­tinue to shift from ex­ports and pub­lic cap­i­tal spend­ing to­ward do­mes­tic con­sump­tion and pri­vate in­vest­ment.

Another, more un­cer­tain as­sump­tion un­der­pin­ning the bet on more in­clu­sive growth is that the eu­ro­zone and Ja­pan will be able to es­cape the mire of low growth and avoid de­fla­tion, which, by im­pelling house­holds and busi­nesses to post­pone pur­chas­ing de­ci­sions, would un­der­mine al­ready weak eco­nomic per­for­mance. Fi­nally, the bet as­sumes that oil-ex­port­ing coun­tries like Nige­ria, Venezuela, and es­pe­cially Rus­sia will fend off eco­nomic im­plo­sion, even as global oil prices plum­met.

Th­ese are bold as­sump­tions – not least be­cause achiev­ing th­ese out­comes would re­quire con­sid­er­able eco­nomic rein­ven­tion, ex­tend­ing far beyond re­bal­anc­ing ag­gre­gate de­mand and elim­i­nat­ing pock­ets of ex­ces­sive in­debt­ed­ness. While the US and China are sig­nif­i­cantly bet­ter placed than oth­ers, most of th­ese economies – in par­tic­u­lar, the strug­gling eu­ro­zone coun­tries, Ja­pan, and some emerg­ing mar­kets – would have to nur­ture en­tirely new growth en­gines. The eu­ro­zone would also have to deepen in­te­gra­tion.

That adds up to a tough re­form agenda – made all the more chal­leng­ing by adjustment fa­tigue, in­creas­ingly frag­mented do­mes­tic pol­i­tics, and ris­ing geopo­lit­i­cal ten­sions. In this con­text, a de­ter­mined shift to­ward markedly higher and more in­clu­sive global growth is far from guar­an­teed.

The sec­ond com­po­nent of the col­lec­tive bet – the avoid­ance of pol­icy mis­takes – is sim­i­larly ten­u­ous. The fun­da­men­tal as­sump­tion here is that the untested, un­con­ven­tional poli­cies adopted by cen­tral banks, par­tic­u­larly in ad­vanced coun­tries, to re­press fi­nan­cial vo­latil­ity and main­tain eco­nomic sta­bil­ity will buy enough time for gov­ern­ments to de­sign and de­liver a more suit­able and com­pre­hen­sive pol­icy re­sponse.

This ex­per­i­men­tal ap­proach by cen­tral banks has in­volved the con­scious de­cou­pling of fi­nan­cial-as­set prices from their fun­da­men­tals. The hope has been that more buoy­ant mar­ket val­u­a­tions would boost con­sump­tion (via the “wealth ef­fect,” whereby as­set-own­ing house­holds feel wealth­ier and thus more in­clined to spend) and in­vest­ment (via “an­i­mal spir­its,” which bol­ster en­trepreneurs’ will­ing­ness to invest in new plant, equip­ment, and hir­ing).

The prob­lem is that the cur­rent eco­nomic and pol­icy con­fig­u­ra­tion in the de­vel­oped world en­tails an un­usual amount of “di­ver­gence.” With pol­icy ad­just­ments fail­ing to keep pace with shifts on the ground, an ap­pre­ci­at­ing dol­lar has as­sumed the role of shock ab­sorber. But his­tory has shown that such sharp cur­rency moves can, by them­selves, cause eco­nomic and fi­nan­cial in­sta­bil­ity.

The fi­nal el­e­ment of the world’s col­lec­tive bet is rooted in the belief that ex­ces­sive mar­ket risk-tak­ing has been tamed. But a pro­tracted pe­riod of pol­icy-in­duced vo­latil­ity re­pres­sion has con­vinced in­vestors that, with cen­tral banks on their side, they are safe – a belief that has led to con­sid­er­able risk-po­si­tion­ing in some seg­ments of fi­nance.

With in­ter­me­di­aries be­com­ing re­luc­tant to take on se­cu­ri­ties that are un­de­sir­able to hold dur­ing pe­ri­ods of fi­nan­cial in­sta­bil­ity, mar­ket cor­rec­tions can com­pound sud­den and dra­matic price shifts, dis­rupt­ing the or­derly func­tion­ing of fi­nan­cial sys­tems. So far, cen­tral banks have been will­ing and able to en­sure that th­ese pe­ri­ods are tem­po­rary and re­versible. But their ca­pac­ity to con­tinue to do so is limited – es­pe­cially as ex­ces­sive faith in mon­e­tary pol­icy fu­els lever­aged mar­ket po­si­tion­ing.

The fact is that cen­tral banks do not have the tools to de­liver rapid, sus­tain­able, and in­clu­sive growth on their own. The best they can do is ex­tend the bridge; it is up to other eco­nomic pol­i­cy­mak­ers to pro­vide an an­chor­ing des­ti­na­tion. A bridge to nowhere can go only so far be­fore it col­lapses.

The na­ture of fi­nan­cial risks has mor­phed and mi­grated in re­cent years; prob­lems caused by ir­re­spon­si­ble banks and threats to the pay­ment and set­tle­ment sys­tems have been sup­planted by those caused by risk-tak­ing among non-bank in­sti­tu­tions. With the reg­u­la­tory sys­tem fail­ing to evolve ac­cord­ingly, the po­ten­tial ef­fec­tive­ness of some macro­pru­den­tial poli­cies has been un­der­mined.

None of this is to say that the out­look for mar­kets and the global econ­omy is nec­es­sar­ily dire; on the con­trary, there are no­table up­side risks that could trans­late into con­sid­er­able and durable gains. But un­der­stand­ing the world’s col­lec­tive bet does un­der­score the need for more re­spon­sive and com­pre­hen­sive pol­i­cy­mak­ing. Oth­er­wise, eco­nomic out­comes will re­main, as for­mer US Fed­eral Re­serve Chair­man Ben Ber­nanke put it in 2010, “un­usu­ally un­cer­tain.”

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