Tuesday, 30 August 2011

An Unholy Trinity

Few would disagree with the view that the economies of the world are in turmoil. The news this summer has been dominated by the twin sovereign debt crises of the Eurozone and the US. The case of Europe is well rehearsed. The Eurozone has become a monetary union without an effective mechanism to deliver fiscal co-ordination. As a result, the weaker economies have been allowed to borrow beyond a prudent level with very little adverse consequences. Equally, the Euro provided a vehicle whereby the stronger Eurozone economies could power ahead faster than they otherwise would have done. An imbalance was created between the stronger and weaker Eurozone economies that has now become unsustainable.
Equally, the US has had a poor year to date. The American recovery started to run out of steam in the spring, the second round of Quantitative Easing ended in the first half of the year, and the question of fiscal stimulus and Federal debt has come under the spotlight. The key fiscal issue was the raising of the Federal debt limit. Eventually, a temporary compromise solution was found, but the process of reaching this compromise has demonstrated the polarised nature of American politics and has weakened considerably the position of President Obama. It was for this reason that the US credit rating was downgraded from AAA to AA+.
It could be argued that both of these crises have been exacerbated by weak political systems, and that political reform needs to underpin any effective recovery strategy. This is what we know about already. It has our attention. As a futurist, however, I am intrigued and concerned by what I don’t know. What are the factors that we are overlooking and which may appear important in the future? There are two other major issues that have attracted far less attention – mainly because they are a lot less pressing at the moment – the financial position of the US States and the fragility of the Asian banking system.
Our focus in North America this year has been with the US Federal debt. Another sovereign debt crisis currently developing concerns the finances of the US States. The position of the States reflects the Federal position in that effective deficit reduction is blocked by special interest groups, who obstruct both spending reductions and tax increases. As a result, the levels of State debt have risen considerably in recent years. This is fine, as long as lenders are willing to finance the deficit spending. If the reserve currency status of the US Dollar is weakened, then an immediate impact for the US States is likely to be an increase in the cost of borrowing and a greater unwillingness to lend to them. If the weaker US States were to experience probing by the markets at the levels that the weaker Eurozone nations have experienced this year, then it is likely that the consequences would result in a significant disruption to the US financial system. This vulnerability and the risk of the downside has not been factored into many current economic forecasts. It is possible that US Federal debt could be downgraded even further because of the parlous condition of State finances.
There are those who take the view that the emerging Asian economies – especially that of China - might prove to be the salvation of Europe and America. The size of trade deficits between China and both the Eurozone and the US rather argues against this case. Hopes for an export led recovery in Europe and the US both require an appreciation of the Chinese currency. This has happened to a certain extent – mainly as a device for the Chinese government to keep inflation in check – but nowhere near the degree needed to do the job effectively. The Chinese government continues to manage the exchange rate in a way that minimises the possibility of internal unrest rather than to alleviate recessionary conditions in Europe and North America. This is not set to change.
Monetary conditions within China now require a tightening. Effective action will take a great degree of finesse. The exact quantity of non-performing loans in the Chinese monetary system is unknown, but is thought to be much higher than in Europe, the US, and even Japan. Some estimates suggest that the degree of non-performing loans could be as high as a third of the assets on the balance sheets of Chinese banks. If the monetary authorities tighten too hard, this could expose the volume of these non-performing loans at exactly the wrong time, triggering a Chinese banking crisis. If the monetary authorities are lax in their tightening, then they might not deal effectively with the inflation that is weakening the Chinese banking system in any case. In either situation, a wobble in the Chinese banking system would have major global consequences. The risk of an event of this type has not been factored into many economic forecasts, which assumes ‘business as usual’ in China.
We are of the view that there are three systemic weaknesses in the global monetary system at present – in the Eurozone there is the possibility of disintegration, in the US there is the risk of ineffective debt reduction programmes at both the State and Federal level, and in Asia there is the risk of financial implosion caused by non-performing loans within the financial system. Together, they provide an ‘Unholy Trinity’ of problems facing the world economy. Their resolution requires a degree of political leadership that doesn’t appear evident at the moment, and a degree of consensus building at both the national and international level. To date, that co-operation has been lacking as the various parties have been unwilling to lay aside their narrow interests for a greater common good. For that reason, we are of the opinion that the current economic outlook is likely to be a lot rougher than it otherwise needs to be.
© The European Futures Observatory 2011

Saturday, 27 August 2011

The Output Gap In Pictures


This is a really useful chart because it shows a comparative estimate of the output gaps of various countries. In a previous post, we calculated the US Output Gap to be about 10%. Interestingly enough, this is a figure that The Economist has independently arrived at. What is of concern is the UK Output Gap, which is estimated at about 13%. We feel that this is a bit high, not because economic activity is greater than estimated, but because we feel that economic potential has been severely eroded by the recession.

To be frank, what we mean is that there are now youngsters who will never work because they haven’t developed the habit of working in their formative years. This is the human cost of recession – blighted lives. It is a legacy that far too many politicians forget about until social turbulence moves from being an abstract concept to being disorder on the streets.

© The European Futures Observatory 2011



Wednesday, 17 August 2011

The Risk Of Inflation

How close are we to seeing a bout of prolonged inflation in the US? This might seem an idle question, but it is one that has quite important consequences for the US economy in the medium term. The Federal Reserve has, over the past couple of years, undertaken a major monetary expansion to support the US financial sector. It has done so though a policy of historically low interest rates - which it has signalled will continue to 2013 - and a policy of quantitative easing - which has injected about $2.3 trn into the economy. To those of the monetarist persuasion, a roaring inflation is just around the corner.

This might not be the case. A monetary expansion might be a necessary condition for an inflation, but it is not a sufficient condition on its own. A monetary expansion also has to work with a combination of the right supply and demand conditions to produce an inflation. For us, the key question is whether or not those conditions prevail at the moment. There is no doubt that prices are rising on the supply side. In particular, food prices, heating costs, and transportation costs are pushing up prices on the supply side. And yet this cost push is not igniting the flames of an inflation on the demand side. Rather than seek higher wage settlements, consumers are accepting a reduction in their living standards instead. This is because a sluggish economy has had the effect of dampening down demand for goods and services. Companies are absorbing rising input costs for fear that end user price rises would drive away their customers.

In terms of economics, we are seeing a muted demand response to the monetary expansion owing to the size of the ‘output gap’. The output gap is the difference between what GDP currently is and what GDP could have been if the recession had not occurred. Using US Bureau of Economic Analysis figures (which are expressed in 2005 constant dollars), we estimate the output gap to be in the region of $1.5 trn. This is probably an overstatement of the gap because the recession is likely to have forced a number of economic participants out of the jobs market completely. Put another way, it implies that the US economy could grow up to about 10% this year before experiencing a profound number of inflationary pressures.

Of course, the risk of inflation might be low now, but it does remain in the medium term. Should the US economy return to anything like the trend growth path, then prices will harden and wage settlements are likely to start to creep up. We expect that the US politicians will allow inflation to take hold for a while. After all, the two ways to reduce the impact of the US Federal debt pile are economic growth and inflation. If the two are combined at the same time, then so much the better. However, it is easier to start a prairie fire than to put it out, and the prospect of an inflation being created deliberately for a short term gain may well come to be seen as politically irresponsible. For the moment, though, the risk of inflation seems to be quite low.

© The European Futures Observatory 2011

Tuesday, 16 August 2011

Joining The Dots

Sometimes, a bit of foresight is not what is wanted. As I was watching the riots in London, I was reminded of a piece that I wrote in 2008 about society moving from NICEY (the Non-Inflationary Continuously Expanding Years) to NASTY (the Non-Accelerating Socially Turbulent Years). The point is a simple one. When the economy is doing well, most improvements trickle down into most parts of society, and economics comes to dominate politics. When things are not going well in the economy, the pain is rarely shared equally, and politics become dominated by the social impacts of where the pain is felt. There was an element of this in the recent rioting in the UK.

The recent disorder in the UK, however, is not a game changer. We are currently about a week on from the disorder. The streets have been cleaned up, many businesses affected are operating again, and many of the offenders have been identified, arrested, and have made an appearance in court. In 2008, we were more concerned about the potential for unrest in China, which we felt would be a game changer. That is probably why it hasn’t happened. There are still bouts of unrest in the western provinces of Xinjian and Tibet, but nothing so far has threatened the stability and authority of the Chinese government. For this we are grateful.

Looking to the future, the risk of disorder remains, right across the world. We still rather imperiously divide the disorder into that we like, such as that in Libya, and that which we dislike, such as that in Bahrain. The root causes of the discontent – poverty, lack of opportunities, and sheer boredom – still remain. Until the world economy starts to grow again, this risk of disorder is unlikely to abate.

Those of us watching the future need to be mindful of this in our work.

© The European Futures Observatory 2011