At sea with no lifeboats
Tuesday, 26 of May 2015
Stephen King (Chief Economist of HSBC Group)
Recently warned the success of the policies undertaken so far out of the recession.
"Hello, I’m Stephen King, I’m the Chief Global Economist for HSBC, I’m here today to talk about my latest Research report which is happily titled The Global Economy’s Titanic Problem, and this is a reference to the idea that the global economy is sailing across the ocean like an ocean liner but without the usual kinds of policy lifeboats to save us in the event of another recession.
You might say that a recession is unlikely at this stage, but it’s remarkable that we’ve already had six years of economic recovery in the US and that probably means we are closer to the next recession than we have been to the last recession.
As a consequence of that it is time for us to think about the ways in which policymakers may cope with another recession should it eventually arise. And the absence of lifeboats is really quite straightforward. If you look back through previous recessions in the US, the typical reduction in Fed funds during those recessionary periods is around about 5 percentage points. But given that Fed funds are virtually zero at the moment, it is absolutely clear that the Fed cannot deliver the same kind of conventional monetary stimulus, and at the same time fiscal policy is much more heavily constrained, because deficits are bigger, debt levels are much higher than they once were.
So in terms of conventional lifeboats, if you like, they are just not around at the moment. So we’ve looked in this paper at the other potentially unconventional life boats that you could use, ways of trying to deal with the possibility of the next recession. And the first of these, very simply, is trying to prevent that next recession from happening.
But of course what we are seeing is all forms of protection being applied to the financial system, particularly the banking system, through higher capital ratios and liquidity ratios, a whole range of macro-prudential policies. But the reality over the last 30 or 40 years is that it is difficult to predict why recessions happen, they have a variety of different causes so even if you prevent a repeat of the global financial crisis, there are other ways in which a recession can come through. There is no guarantee that a recession can easily be delayed.
The second possibility is to use quantitative easing to go back to that kind of story and of course some central banks are still doing that, most obviously the European Central Bank and the Bank of Japan. But QE has its costs, one of which is that it’s creating a bigger and bigger gap between what we loosely describe as financial hope and economic reality. That equity valuations in particular on some measures are becoming ever more stretched and that is partly because of the impact of QE, and persuading investors to take more and more risks with financial assets even though those higher values of financial assets are not translated through into decent economic growth.
Another option is to use inflation targeting in a much more flexible way. The Japanese should have done this in the late 1980s when their economy was booming, when asset prices were going through the roof. But when inflation itself was actually much much lower than conventional targets today. And given that inflation is currently quite low, maybe there’s a case for saying let’s be more relaxed about that, let’s tighten policy to cope with, for example, rising financial asset prices.
The problem today though is that things are much more ambiguous than they were in the 1980s because Japan back then, didn’t just have rapidly rising asset prices, it had very very strong growth and we haven’t really got that in the Western world today.
The next option? To use fiscal policy, but given that deficits are still pretty big and in particular that debt levels are pretty much out of control in some cases, that could be difficult to persist with over the medium term – unless we have a repeat of the Japanese experience over the course of the last 20 years or so.
And certainly looking at the experience of the US recently the fact of the matter is that with an ageing population with higher pension bills and higher healthcare bills it looks likely, even without further fiscal stimulus, that government debt will continue to rise rapidly, as a share of GDP over the next few years.
The fifth option is to use a combination of monetary and fiscal policy, effectively using the kind of helicopter money model that you see in text books but which has frankly never been adopted in many countries other than those that have gone down the route of hyperinflation. And that shows you exactly the problem with this kind of policy, which is that it might lead to a level of mistrust of monetary and fiscal institutions so great that it unleashes unexpected inflationary forces within economies, and therefore it’s not likely to be pursued.
And the final option is the idea of structural reform to try to make sure structurally that interest rates end up significantly higher. And one way to do that is to raise retirement age, to actually reduce the need for people to save for their retirement, by making their retirement shorter. Of course this is deeply unpopular politically, but economically it makes sense. Of course here the problem is that politics and economics don’t always combine particularly well, and the chances of this actually happening are probably quite low.
All in all I’m really forced to conclude that the lifeboats aren’t really there. And therefore if there were to be another recession it would be a potentially worrying event, and more perhaps than has been the case in the past.
Then the final question is what could be the trigger for another recession, and I mention four in the piece, these are not forecasts they are simply risks, but the first of these is simply the idea that wages, let’s say in the US, accelerate against a background of still significant disinflationary pressures and the profit sharing GDP begins to come down and equity prices crumble as a result.
And the second is the idea that there are problems in the non-bank financial sector, something which the IMF has recently referred to, all sorts of unfunded future liabilities for pension funds and insurance companies, creating uncertainty there.
The third possibility is a significant slowdown in China perhaps with some negative effects coming through to other parts of the emerging world, and the final difficulty is that the Federal Reserve actually ends up doing a kind of self-imposed problem, a self-imposed recession by raising interest rates prematurely as the Bank of Japan did back in 2000 and the ECB in 2011 in a desperate attempt to try and get rates back up which allows them to be cut, it actually becomes the cause of the next recession.
So all in all we have a Titanic sailing across the ocean without the usual lifeboats we have to hope that the iceberg doesn’t eventually hit."
By Stephen King