Published in the Nikkei Asian Review on 9/2/2016
Mr. Market is in a near-suicidal state of gloom. The imaginary person dreamed up by Benjamin Graham, the godfather of investment gurus, is petrified by the economic outlook. From the start of the year intense turbulence in the world markets for bonds, commodities and equities have signaled a growing risk of recession and deflation. The likelihood is that pressure will grow for a radical policy response.
Needless to say, the financial markets are not always right. Graham’s protégé, Warren Buffett, has termed Mr. Market “a drunken psycho” on account of his bewildering mood swings. Nobel Prize-winning economist Paul Samuelson famously quipped that the stock market had predicted nine out of the last five recessions.
Yet that is a stellar track record compared to the forecasting prowess of professional economists. According to Prakash Loungani, an economist at the IMF, “the record of failure to predict recessions is practically unblemished” both in the private sector and in international bodies like the IMF itself.
The three big risk factors – US monetary policy, China and the commodities complex – remain as opaque as ever. Although the US labour market still seems in reasonable shape, corporate profitability is weakening and inflationary expectations – as measured by the yield differential between inflation-adjusted and ordinary bonds – have plummeted to the lowest levels since 2009. Meanwhile the yields on lower quality corporate bonds have soared as investors prepare for a wave of bankruptcies. The Federal Reserve’s interest rate hike of December is already looking as ill-judged as the Bank of Japan’s tightening in 2007.
Despite some recent signs of stabilization, commodities prices remain at levels that spell deep trouble for companies and countries that produce them. The Bloomberg Commodity Index is no higher now than in 1991. Shipping rates for dry bulk carriers are at their lowest in 30 years, which portends a severe downturn for shipbuilding and associated industries.
All things being equal, lower prices for energy and other commodities constitute a transfer of income from producers to users, who are ultimately consumers in most developed and emerging economies. However in a “noflation” world in which nearly every central bank is falling well short of its inflation target the lower prices could serve to embed deflationary expectations, just as higher commodity prices embedded inflationary expectations in the 1970s.
Most commodity-producing countries have smallish populations which are unable to spend the money earned from their exports.The effect of the commodity boom which took off in 2003 was to exact a regressive tax on the incomes of consumers in the importing nations and transform the money into capital, which was then recycled into financial markets, prime real estate, contemporary art, sports franchises and so on. Turning that capital back into consumer income is ultimately a welcome development, but the process is likely to be highly disruptive in financial and, probably, geopolitical terms.
In China too there are signs of recent stabilization in indicators such as auto sales, but the deep downturn in trade continues. Most disturbing is the steady drain of foreign exchange reserves, which fell by half a trillion dollars in 2015. This is the result of the People’s Bank of China’s defence of the yuan in the currency markets, which comes in the face of relentless capital flight – the financial equivalent of “voting with your feet.” What is unsustainable must come to a halt at some point. The obvious denouement is a large-scale devaluation of the yuan, which would effectively export China’s excess capacity and deflation to the rest of the world.
STOPPING THE DEFLATIONARY DYNAMIC
How will policy-makers deal with the intensifying deflationary dynamic? Given the sullen political mood in most of the developed world, inertia is not an option. We can expect to see yet more radical experiments in monetary policy and a greater willingness to use fiscal policy.
The QE (quantitative easing) policies followed in the US, Europe and Japan have been massive in scale, but so far conservative in content. Back in 2002 then Princeton professor Ben Bernanke recommended the deployment of “helicopter money” – meaning a broad-based tax cut financed by the central bank – as the best cure for deflation. However during his chairmanship of the Federal Reserve, the focus was on the purchase of government bonds from financial institutions. Rather than entering the real economy, much of the money remained trapped in the financial system. In Japan and Europe too, the major banks have effectively been swapping government bonds for reserves at the central bank.
The move to negative interest rates in Japan and Europe is the first step to a more radical approach. In Japan’s case a further move into minus territory could bring negative rates to home mortgages, which should boost housing demand. The introduction of fees on large-scale corporate deposits – already mooted by one of the megabanks – would make Japanese companies think twice about their Yen 300 trillion cash hoard.
Some households may choose to hold more physical cash, thus shrinking the banks’ deposit base. That could be no bad thing, as the deposit base of Japanese banks is far too large in relation to loans. Consolidation of the regional bank sector, which contains too many sub-optimal outfits, is also a priority. Meanwhile Japan needs to take another look at fiscal policy. There should be no more consumption tax hikes until reflation has been achieved. Tax breaks for companies that raise wages and financial support for families with children should also be considered.
How will we know if these or any other policies are working? Not by studying the forecasts of the IMF, the OECD and private sector economists. As ever, there is no choice but to rely on the emotional state of the deranged alcoholic known as Mr. Market.