Epitaph for Central Banking

I am happy to reproduce here a piece that was originally published in ‘Pragati’ – the magazine of the Takshashila Institution in January this year. The original is here.

An epitaph for central banking

by V Anantha Nageswaran — January 23, 2015 5:45 pm

The world needs to be prepared for the possibility that from 2015 onwards, global growth disappoints and asset markets become increasingly volatile as a prelude to commencing their long overdue decline.

IMF revises global growth down

The International Monetary Fund (IMF) cut the global GDP growth forecast for 2015 by 0.3 percent from 3.8 percent to 3.5 percent percent. It is just the beginning of the year and hence this is just the beginning for downward forecast revisions for global growth. It has just started.

There is plenty of room for further downgrades. One, the Eurozone growth forecast has only been marginally revised down from 1.3 percent to 1.2 percent for this year. There is plenty of room to go down, there. Second, the Fund has raised its growth forecast for the US from 3.1 percent to 3.6 percent for this year. That is excessive. 3.1 percent was on the borderline between moderation and excessive optimism. Consensus optimism on the U.S. economy and the U.S. dollar is founded on flimsy grounds. Just because all other patients in a hospital are in coma, the ones who are awake do not necessarily become healthy. Optimism on the US economy is somewhat similar to this flawed logic.

The Fund pencils in a growth rate of 6.8 percent (revised down from the forecast of 7.1 percent made in October) for China this year falling to 6.3 percent in 2016. In the case of India, it foresees the opposite happening. It forecasts economic growth of 6.3 percent this year (2015-16 actually) and 6.5 percent in 2016-17. There is room for upgrade in the case of India, especially for 2016-17 and room for downgrade in the case of China for this year and next.

Our view is that there is complacency about US growth and smugness about China soft landing among economists. If China were serious about reforms, near-term economic pain is inevitable and may even be desirable. If China were not serious about reforms, then these forecasts may be too conservative but a hard landing sometime not far in the future is a very real risk.

Recent growth record was exceptional

We have long held the view that the global economy was due for a serious downturn. The crisis of 2008-09 could have been one. Massive policy intervention prevented it from becoming a deep and prolonged economic slowdown. Now, some are beginning to view it as a mixed blessing. We are more forthright. That would prove very costly. Thanks to the steadily declining rates of interest from the 1980s onwards, the world was awash with overinvestment in the wrong areas. They needed to be purged for the next, lasting economic expansion to begin. Governments and central banks never allowed that. Capitalism is dead without creative destruction. Policy intervention in the aftermath of the 2007-09 crisis did not save capitalism but only prepared the burial ground for it.

The growth record of the world economy, particularly that of the United States from 1982 until 2007, began to be taken for granted. The US economy suffered brief and inconsequential recessions in 1990-91 and in 200-01. Therefore, confidence grew in the minds of policymakers that economic cycles had been tamed. That was to prove wrong in 2007-09. Yet, the smugness has gone away. No responsible policymaker considered the possibility that the world economy might have experienced a one-off serendipitous combination of favourable factors that led to a quarter century of (nearly) uninterrupted economic expansion, principally in the US and largely in the global economy, thanks to the rise of China and India as well.

Further, the massive economic growth of the 1982-2007 period in the world economy was also largely due to the rise in global debt accompanied by financialisation of the world economy and globalisation. Recently, Bloomberg produced an animation chart that shows the average world temperatures for the last six to seven decades. New records in global temperatures were set with alarming regularity since 1980. It is no coincidence. The rapid rise in global temperatures was an inevitable consequence of rapid economic growth globally accompanied by rising use of fossil fuels.

In other words, much of the global growth of the last three decades borrowed from future growth. Payback time arrived in 2008. However, we managed to avoid making the payment. Policymakers are still trying to prolong the growth story, even while it is becoming increasingly evident that it is both infeasible and unsustainable.

Futile and wrong about growth

McKinsey Global Institute has said that global growth would slow from the average 3.6 percent of the last fifty years to 2.1 percent in the next 50 years mainly due to lower growth of labour force. However, it argues productivity growth could be ramped up to make up for low to non-existent labour growth. They acknowledge that inequality has risen in the last fifty years. However, they seem to be ignoring the very real possibility that the global environment is ill-equipped to handle further economic growth and that natural resources such as water are stretched thin in several parts of the world, most notably in Asia.

Raghuram Rajan, Governor of the Reserve Bank of India, recently wrote an article titled, ‘Bracing for Stagnation’. Given his official position, he wrote with restraint. However, it is not hard to detect the sombre message underneath: “… overall, there is a palpable sense of gloom in the developed world, a feeling that growth is unlikely to take off in the foreseeable future. If secular stagnation persists, these countries will have to undertake painful structural reforms, figure out how to restructure their promises (debts, social-security commitments, and pledges to keep taxes low), and distribute the resulting burden…. After the city of Detroit filed for bankruptcy in 2013, it had to make tough choices between servicing its pensioners or its debt, keeping its museums open or its police force intact. As 2015 begins, similar difficult decisions may become increasingly common.

Simply put, two steps are needed for a lasting and healthy revival of global growth. One is the realisation that, in the near-term, growth has to be slow and even decline and that it will be for the good of the global economy. Second, a restructuring of world investment, production and consumption has to happen for the next phase of growth to be more sustainable. The chances of these two happening appear, unfortunately, very remote. Policymakers are not trying to encourage growth through productivity and innovation but through asset prices caused by monetary expansion.

The US launched three rounds of money printing. The Bank of Japan is at it. The European Central Bank is about to join them (having made feeble attempts to do so with little success in the last two to three years) with renewed determination later this week. The US might yet surprise the world with another round of money printing. In fact, we should expect it.

These persistent efforts at reviving economic growth have only managed to drive a wedge between stagnant underlying economies and buoyant asset prices. Continued money printing might deepen the wedge for a little longer. That too would eventually stop as the recent decision by the Swiss National Bank to stop playing this game attests. Many financial players were caught unawares and incurred huge losses. This will now happen with increasing frequency as the costs of excessive risk-taking, facilitated by central banks, begin to manifest. Thus, in the end, central banks’ money printing will have failed both on economic and financial market fronts.

It is apt to end this section with a chilling prognosis by Wolfgang Streeck before we conclude this piece:

“While we cannot know when and how exactly capitalism will disappear and what will succeed it, what matters is that no force is on hand that could be expected to reverse the three downward trends in economic growth, social equality and financial stability and end their mutual reinforcement. In contrast to the 1930s, there is today no political-economic formula on the horizon, left or right that might provide capitalist societies with a coherent new regime of regulation, or regulation. Social integration as well as system integration seems irreversibly damaged and set to deteriorate further. What is most likely to happen as time passes is a continuous accumulation of small and not-so-small dysfunctions; none necessarily deadly as such, but most beyond repair, all the more so as they become too many for individual address. In the process, the parts of the whole will fit together less and less; frictions of all kinds will multiply; unanticipated consequences will spread, along ever more obscure lines of causation. Uncertainty will proliferate; crises of every sort—of legitimacy, productivity or both—will follow each other in quick succession while predictability and governability will decline further (as they have for decades now). Eventually, the myriad provisional fixes devised for short-term crisis management will collapse under the weight of the daily disasters produced by a social order in profound, anomic disarray.”

Implications for Asia

The global growth slowdown thesis – led by almost all major economic zones and nations in the world – will have mostly adverse implications for East Asia. East Asia had thrived in a world that was rapidly globalising in the 1980s and 1990s. The East Asian crisis of 1997-98 stopped them in their tracks. Then, economically, they lost out to China in the new millennium.

However, financial markets recovered thanks to easy money. But, that too would be in jeopardy if bubbles in Western stock markets crash, as they must eventually. This will be bad news for small economies like Singapore and Hong Kong because they have relied on finance and real estate construction to drive growth in recent years. Other small economies like Malaysia and Taiwan will be next in line. South Korea may benefit, to an extent, from economic slowdown or collapse in China and a failed monetary experiment in Japan. But, a global stock market crash would turn that into a Pyrrhic victory or consolation. Relatively large economies with new leadership like Indonesia and India may fare somewhat better. How much better will boil down to domestic leadership and luck.

In sum, the world needs to be prepared for the possibility that from 2015 onwards, global growth disappoints and asset markets (particularly stock markets) become increasingly volatile as a prelude to commencing their long overdue decline. In other words, central banks fail spectacularly.

(This article was completed around midnight on Wednesday, January 21, 2015 – a day before the European Central Bank was set to announce that it was launching its own version of Quantitative Easing or printing money to boost asset prices.)

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