FUTURES IMPERFECT

If the next contraction of the world economy comes sooner than expected, what will be left in the kitty to fend it off?

Ron Derby column

When the most recent global recession occurred, the responses of the world’s central bankers were based on the experiences of the Great Depression of the early twentieth century. They applied all sorts of monetary policy measures to keep liquidity in financial markets and ensure a return to growth. Especially in developed climes, rates dropped to record lows — to near zero levels in the US. The Bank of England responded in a similar manner and eventually, so did the European Central Bank.

It is about six years since that crisis, and in that time we’ve been introduced to the Japan-inspired experiment of quantitative easing (QE) to boost ailing economies. For the most part, the attempts have saved us from the worst of the recession; the US economy is now on a stronger trajectory, and the UK’s as well. But there’s an uncomfortable question: what tools are left in the vaults of the world’s leading central banks to rescue the global economy should the next contraction come sooner than expected?

It’s clear that this world is not immune to bouts of contraction. Economists who suggested in the early part of the new century that the days of economic booms and busts were a thing of the past were greatly mistaken. So when the next bust comes, what will be left in the kitty to fend it off?

Chief global economist at HSBC Stephen King asks this question in his report titled “The World Economy’s Titanic Problem”. In it, he argues that although the US economy has been driving along, there isn’t much in the way of insurance for it when it crashes.

And if history is a guide, King says, the world’s biggest economy is closer to the next recession than we care to think.

The triggers singled out in his report are a rise in US wages leading to a falling profit share and a major stock market decline, systemic failures within the non-bank financial sector, major weakening of the Chinese economy and a premature attempt by the Federal Reserve to normalise monetary policy.

These are threats that are very real. We’ve seen Chinese numbers, and what we have to consider is what monetary policy can now do to save the economy from this eventuality. The bazookas have been fired.

With rates at near zero, it’s no longer possible for a similar response to the ones used in the 2008 dip or any of the previous dips after the Second World War. QE, in truth, has really amounted to stimulus for asset prices and has fed very little into the nuts and bolts of the real economy.

The reason the conditions are so different now to what they were in times past, is that most times of economic recovery have been followed by a normalisation of monetary policy, meaning interest rates have risen.

But in the years since the past recession, what we have had is a tentative recovery, and mainland Europe is very much still in a vulnerable state — along with the whole emerging world, it seems. In line with the uncertain recovery, interest rates remained at record lows.

What the world’s central bankers haven’t been able to do with this sluggish economic recovery is restock ammunition, and the world’s governments haven’t managed to rein in their budget deficits.

The Fed which, as a custodian of the reserve currency, takes the lead on monetary policy, hasn’t been able to normalise rates in the past few years because the global crisis was the worst slowdown in the economy since the Second World War, with the US gross domestic product falling 4,2%. Should the US recovery stall or, worse yet, fall into a recession, there is now very little it can do to soften the impact.

Central bankers won’t be in a position to save us, nor will highly indebted governments, who simply aren’t able to spend the globe out of trouble.

That’s the difficult question faced by the Fed’s Janet Yellen as she seeks to get the US back to normality.

The world needs to return to it, but with a recovery so fragile, and a very connected global economy, to act too swiftly may take the US economy back to a cold winter without the tools to ensure it’s a short one.

…the world’s biggest economy is closer to the next recession than we care to think