Europe and the global malaise
This isn’t a recession yet, but the headwinds are strong. Europe and China are slowing down, and the U.S. may follow suit. Hence, despite any kind of rhetoric, I tend to see the germs of global concerns finding their way into decisions made by the Fed. True, monetary policy requires a period of six to nine months to run its course, and the Fed should move ahead of the curve. However, it isn’t that simple. The US economy isn’t a closed one, after all. For one thing, the ECB won’t be able to make any significant decisions throughout the year, and China can’t implement a pervasive public spending package to reshuffle cards. Hence, slowdown is imminent. The European story is further engrossed by political problems such as Italy and Brexit, but more importantly its malaise runs deep. Instead of replicating recent European and global data, such as the global PMI, I will offer glimpses of politico-economic analyses here, relegating data to the graphics qua illustrations.
The idea of a ‘united states of Europe’ is very old indeed, dating back to the end of the 19th Century. In those days, it was considered a socialist ideal. The debate between internationalism and nationalism continued in the run-up to the WWI. In 1914, even socialist parties rallied behind their governments and voted in favour of war credits. That was the end of the original meaning and intent of European internationalism, and the idea of a European Union went into the dustbin of history at that time. It came back with a vengeance after WWII, but not under any kind of socialist banner as was envisioned in the 1890s. Instead, it was capitalism that paved the way for such a union. The idea was indeed workable, although perhaps not so much through a fullfledged federalism, but rather in the form of a more flexible monetary union of enforceable contracts. It is still workable, and it still works.
Or does it? ‘Europe after the crisis’ was supposed to be the latest release in movie theatres throughout the globe in 2018. Perhaps not in London, at a time when the famous Globe Theatre was not yet ready for the new season. Instead, it was Continental Europe that was about to display its new tricks, coupling up with the U.S. as the second largest economic and monetary zone, at a time when both regions were clearly out of the Great Financial Crisis. Not so. The situation has quickly deteriorated. Italy seems to have fallen into the grip of right and left-wing populists. Campaigns to shore up the public sector have proven counterproductive.
China and the US
China has always run a trade surplus against the U.S. and other industrial countries, but a deficit against Japan, Taiwan and other Asian countries. The U.S., however, is in a deficit against almost every bloc. What China has had in the past was a large inflow of foreign financial capital linked to foreign direct investment. The problem with China is that this was an inflow of financial capital that it probably didn’t need and couldn’t safely absorb, given the already high rate of saving and its underdeveloped and incomplete financial markets. This was back in 2005-2007. The common prescription against running huge current account surpluses didn’t seem applicable back in the old days, because there was no sign of the allegedly legendary trade and current account surpluses anywhere in the available figures ten to 12 years ago. The fuss about devastatingly huge Chinese trade surpluses is largely a myth because it was always considered a fact of life. The repeated attempts of forcing China to appreciate the Renminbi from 2003-2007 didn’t work, and after the 2007-2009 Crisis attitudes have changed. A more targeted approach is destined to protect some sectors in the US, but it may as well prove to be counter-productive.
There is also the following argument. An intertemporal approach to the current account suggests that the U.S. would need to run trade surpluses to reduce this imbalance. Obviously, part of the adjustment could take place through a change in the returns on U.S. assets held by foreigners relative to the return on foreign assets held by the U.S. Importantly, this wealth transfer might have already occurred through a depreciation of the dollar. Almost all U.S. foreign liabilities were (are) in dollars, and approximately 70 percent of U.S. foreign assets were in foreign currencies. A back of the envelope calculation indicates that a 10 percent depreciation of the dollar repre-
sents, caeteris paribus, a transfer of 5 percent of the U.S. GDP from the rest of the world to the U.S. For comparison, the U.S. trade deficit on goods and services was only 4.4 percent of GDP in 2003. The current account deficit was higher than the trade deficit because of transfers. With large gross asset and liability positions, a change in the dollar exchange rate could transfer large amounts of wealth across countries. And it did! The U.S. has already benefited from prolonged episodes of dollar weakness. So, things aren’t necessarily what they appear to be. Any approach that fails to consider capital gains and losses on the net foreign asset position, such as valuation effects, would be misleading in a world of instantaneous financial capital flows. The currently massive gross cross-holdings of foreign assets and liabilities make sure that asset price movements largely affect highly leveraged country portfolios. What this implies should be obvious. There is room for large wealth transfers across countries that alter asset price dynamics. Balance of payments reports the current account at historical cost, and the same consideration applies to the national income accounts. For countries that either issue huge chunks of debt in foreign currencies, or for countries that hold large amounts of assets in foreign currencies –China and Japan are now good cases in point– it is imperative to take into account valuation effects.
Nevertheless, the trade war story came at a time when LIBOR had been climbing towards the 2012 European sovereign debt crisis peak. Credit was more expensive, but also it was riskier because the LIBOR-OIS spread was widening. It is clear now that funding costs have already risen. What matters is the future path of funding costs. If it continued to rise, then we would have seen a new equilibrium on a global scale, because corporate debt and non-core bank liabilities would soar. Consumer credit lines that are considered riskier than others would perform poorly. Even if there is collateral, one wouldn’t like to extend a 10-year loan at a fixed local currency rate if the cost of funding is truly uncertain. As deposit and loan growth rates move hand in hand, it will be all the more problematic to get a long-term duration risk of less than three months’ deposit on a repricing basis. 120 months (loan) against 3 months (deposit) isn’t exactly a good match. It is obvious that funding costs for a bank’s overseas borrowing is a lot more important than a trade war. Because China will not jump head-on into an economic war of attrition, and because it is hard to imagine that such measures will be sufficient to contain China, it is more of a long-term and now fully acknowledged, perhaps even anticipated, eventuality.
All of these things have already happened. Now, in 2019, the global cycle is slowing down. The Fed may never return to its hiking cycle; not in 2019, not even in 2020. This isn’t just an all-American phenomenon. This is a global phenomenon. Similarly, China is set to move very gradually. Even if it keeps its GDP growth rate above 6 percent this year, the days when it was seen as never slowing down are largely over. Hence, there will be two effects. The ECB and the Fed won’t move, and quantitative tightening may even slow down. China can’t inaugurate a massive stimulus package, either. For the EMS, this is bad news. Germany can’t drive the EU alone. However, the good news is we can say goodbye to global interest rate increases.
The politcal landscape may change in the early 2020s
The 2018 Brexit referendum didn’t settle all scores. Those who favored Brexit and those who opposed it are now cross-fertilizing their party affiliations, supplying a divisive fault line among both the polity and the population. This is an identity crisis, but it is also a cultural issue. Cameron’s game backfired, and instead of solving a problematic theme within the ranks of the Conservative Party it helped create a European malaise. Now the whole thing looks like a convoluted parody of the olden days.
The situation all too often resembles the last years of peace before 1914, and this suggestion has been frequently repeated in the last few years. On at least two accounts does the political scene bear similarities with the distant past. First, Europe is laden with a renewed ascendency of radical -- this time, right-wing -movements. Second, in lieu of a rivalry between European powers there is now a prolonged war of attrition between the U.S. and China. Add to this a list of ‘proxy wars,’ the first and foremost case in point being Syria. ‘Proxy wars’ extend to relations with Iran; a die-hard theme of the ‘Cold War’ with Russia that can always reemerge. They also include sanctions, oil prices and all that. If war is not an option it is only because primo, the enemy (of the West) is a bit disparate and therefore almost is unknown and secondo, military technology is frighteningly advanced and can easily get out of control. Technology also traces a similar trajectory, not in its essence but because it grows by leaps and bounds. The economic and widespread applications of technology await maturity and/or need time, so old capital investments amortize themselves. We may see a totally different world in just a decade or so. In the meantime, right-wing populisms will occupy the political landscape, not only in middle-of-the road countries, but also in the developed ones. Europe is a case in point, but so, perhaps, is the U.S.