Year: 2015

The European Central Bank (ECB) has finally launched a policy of quantitative easing (QE). The key question at this stage is whether Germany will give the ECB the freedom of manoeuvre needed to carry out this monetary expansion with sufficient boldness. Though QE cannot produce long-term growth, it can do much to end the ongoing recession that has gripped the eurozone since 2008. The record-high stock market levels in Europe in late January, in anticipation of QE, not only indicate growing confidence, but are also a direct channel by which monetary easing can boost both investment and consumption.

But some observers, such as Nobel Laureate Paul Krugman and former US Treasury Secretary Larry Summers, continue to doubt whether QE can really be effective. As Krugman recently put it, a “deflationary vortex” is dragging down much of the world economy, with falling prices causing an inescapable downward spiral in demand. The World Bank and International Monetary Fund seem to agree, as both recently lowered their growth forecasts a few notches.

Though QE cannot produce long-term growth, it can do much to end the ongoing recession that has gripped the eurozone

Pessimists argue that the world economy suffers from an insurmountable shortage of aggregate demand, leading to a new secular stagnation. Monetary policy is seen to be relatively ineffective, owing to the notorious zero lower bound (ZLB) on nominal interest rates. With policy interest rates near zero, the argument goes, central banks are more or less helpless to escape the deflationary vortex, and economies become stuck in the infamous liquidity trap. In this scenario, the demand insufficiency feeds on itself, pushing down prices, raising real (inflation-adjusted) interest rates, and lowering demand further.

This perspective has been prominent among Keynesian economists in the US and the UK since 2008. Krugman argues that Japan was only the first of the major economies to succumb to chronic deflation, back in the 1990s, and has now been followed by the EU, China, and most recently Switzerland, with its soaring franc and falling prices. The US, in this view, remains near the vortex as well, prompting the Keynesians’ repeated calls for more fiscal stimulus, which, unlike monetary policy, is seen by the pessimists to be especially efficacious at the ZLB.

Glass half empty
In my view, the pessimists have exaggerated the risks of deflation, which is why their recent forecasts have missed the mark. Most notably, they failed to predict the rebound in both the US and the UK, with growth rising and unemployment falling even as deficits were cut. Without a proper diagnosis of the 2008 crisis, an effective cure cannot be prescribed.

The pessimists believe that there has been a large decline in the will to invest, something like the loss of “animal spirits” described by Keynes. Even with very low interest rates, according to this view, investment demand will remain low, and therefore aggregate demand will remain insufficient. Deflation will make matters worse, leaving only large fiscal deficits able to close the demand gap.

But the causes of 2008’s deep downturn were more specific, and the solutions must be more targeted. A large housing bubble preceded the 2008 crisis in the hardest-hit countries (the US, the UK, Ireland, Spain, Portugal, and Italy). As Friedrich Hayek warned back in the 1930s, the consequences of such a process of misplaced investment take time to resolve, owing to the subsequent oversupply of specific capital (in this case, of the housing stock).

Yet far more devastating than the housing bubble was the financial panic that gripped capital markets worldwide after the collapse of Lehman Brothers. The decision by the US Federal Reserve and the US Treasury to teach the markets a lesson by allowing Lehman to fail was a disastrously bad call. The panic was sharp and severe, requiring central banks to play their fundamental role as lenders of last resort.

As poorly as the Fed performed in the years preceding the Lehman Brothers’ collapse, it performed splendidly well afterward, by flooding the markets with liquidity to break the panic. So, too, did the Bank of England, though it was a bit slower to react. The Bank of Japan (BOJ) and the ECB were, characteristically, the slowest to react, keeping their policy rates higher for longer, and not undertaking QE and other extraordinary liquidity measures until late in the day. Indeed, it required new leaders in both institutions – Haruhiko Kuroda at the BOJ and Mario Draghi at the ECB – finally to set monetary policy right.

It’s not all bad
The good news is that, even near the ZLB, monetary policy works. QE raises equity prices; lowers long-term interest rates; causes currencies to depreciate; and eases credit crunches, even when interest rates are near zero. The ECB and the BOJ did not suffer from a lack of reflationary tools; they suffered from a lack of suitable action. The efficacy of monetary policy is good news, because fiscal stimulus is a weak instrument for short-term demand management. Ironically, in an influential 1998 paper, Krugman explained why. He argued at that time, and rightly in my view, that short-term tax reductions and transfers would be partly saved, not spent, and that public debt would multiply and create a long-term shadow over the fiscal balance and the economy. Even if interest rates are currently low, he noted, they will rise, thereby increasing the debt-service burden on the newly accumulated debt.

With all major central banks pursuing expansionary monetary policies, oil prices falling sharply, and the ongoing revolution in information technology spurring investment opportunities, the prospects for economic growth in 2015 and beyond are better than they look to the pessimists. There are rising profits, reasonable investment prospects for businesses, a large backlog on infrastructure spending almost everywhere in Europe and the US, and the opportunity to finance capital-goods exports to low-income regions, such as sub-Saharan Africa, and to meet the worldwide need for investment in a new, low-carbon energy system.

If there is a shortfall of private investment, the problem is not really a lack of good projects; it is the lack of policy clarity and complementary long-term public investment. European Commission President Jean-Claude Juncker’s plan to finance long-term investments in Europe by leveraging relatively small amounts of public funds to unlock large flows of private capital is therefore an important step in the right direction.

Obviously, we should not underestimate the capacity of policymakers to make a bad situation worse (for example, by pressing Greek debt service beyond the limits of social tolerance). But we should recognise that the main threats to growth this year, such as the unresolved Greek debt crisis, the Russia-Ukraine conflict, and turmoil in the Middle East, are more geopolitical than macroeconomic in nature. In 2015, wise diplomacy and wise monetary policy can create a path to prosperity. Broad recovery is within reach if we manage both ingredients well.

At a time of lacklustre economic growth, countries around the world are attempting to devise and implement strategies to spur and sustain recovery. The key word is strategy: to succeed, policymakers must ensure that measures to open the economy, boost public investment, enhance macroeconomic stability, and increase reliance on markets and incentives for resource allocation are implemented in reasonably complete packages. Pursuing only some of these objectives produces distinctly inferior results.

China provides a telling example. Before Deng Xiaoping launched the policy of ‘reform and opening up’ in 1978, the country had relatively high levels of public-sector investment. But the centrally planned economy lacked market incentives and was largely closed to the global economy’s major markets for goods, investment, and technology. As a result, returns on public investment were modest, and China’s economic performance was mediocre.

The problem is that structural reforms are notoriously difficult to implement

China’s economic transformation began with the introduction in the 1980s of market incentives in the agricultural sector. These reforms were followed by a gradual opening to the global economy, a process that accelerated in the early 1990s. Economic growth surged ahead, and returns on public investment soared, reaching an annual growth rate above nine percent of GDP, shortly after the reforms were implemented.

The key to a successful growth strategy is to ensure that policies reinforce and enhance one another. For example, boosting returns on public investment – critical to any growth plan – demands complementary policies and conditions, in areas ranging from resource allocation to the institutional environment. In terms of effectiveness, the policy package is more than the sum of its parts.

Of course, the specific portfolio of policies varies depending on the stage of a country’s development; early-stage growth dynamics are distinctly different from those in middle-income and advanced countries. But the imperative is the same. Just as a developing China achieved rapid growth only when a comprehensive policy package was implemented, the advanced countries struggling to restore sustainable growth patterns today have found that incomplete policy packages produce slow recoveries and below-potential growth and job creation.

Different methods
Consider the post-crisis performance of the EU and the US. Though both have had their share of problems, the US is performing somewhat better (though it still faces major challenges in generating middle-income employment).

The difference is not that the US launched a large fiscal stimulus focused on public-sector investment; no such stimulus was implemented, though many economists, including me, believe that it would have generated a faster recovery and stronger long-term growth. Nor is the difference greater political effectiveness; few would say that the US Government is functioning well nowadays, given rising partisanship and sharp disagreement about its proper role.

The US economy has benefited from two factors: its greater structural flexibility and dynamism relative to Europe, and the broader mandate of the US Federal Reserve, which has pursued a far more aggressive monetary policy than has the European Central Bank. Though analysts differ on the relative importance of these two factors – and, indeed, it is difficult to weight them – it is safe to say that both played a role in facilitating the US recovery.

Europe is now placing a large bet on an increase in public-sector investment, using a combination of EU-level funding and national investment programmes, perhaps augmented by a modification of the EU’s fiscal rules. Given that public-sector underinvestment is a common cause of subpar growth, this is a step in the right direction.

But public investment is not enough. Without complementary structural reforms that encourage private investment and innovation – and thus enable economies to adapt and compete in a global, technology-driven economy – a public-investment programme will have a disappointingly weak impact on growth. Instead, debt-financed public investment will produce a short-run stimulus, at the cost of longer-term fiscal stability.

The problem is that structural reforms are notoriously difficult to implement. For starters, they face political resistance from short-run losers, including the companies and sectors that existing rigidities protect. Moreover, in order to ensure that such reforms ultimately benefit everyone, there must be a strong culture of trust and a determination to prevent more flexible arrangements from leading to abuses.

Finally, structural reforms require time to take effect. This is particularly true in the eurozone, whose members abandoned a crucial tool for accelerating the process – exchange-rate adjustments to account for different economies’ productivity levels – when they adopted the common currency.

Draghi’s proposal
ECB President Mario Draghi recently argued that, because individual EU countries’ growth-retarding policies have negative external effects, perhaps they should not have unimpeded control in certain policy areas. Though member countries’ financial supervisory authority is already being limited through centralisation of bank regulation and resolution mechanisms, Draghi’s suggestion is more far-reaching.

One wonders if Draghi’s proposal is politically feasible in the EU context. Even if it were, would it be necessary? All economies have sub-units across which economic productivity, growth, and dynamism vary considerably. Indeed, differentials in the quality of governance and policies seem persistent, even in economies that perform pretty well overall.

Perhaps part of the answer is to prevent sub-units – in the EU’s case, member countries – from falling short on reforms. But centralisation carries its own costs.

Given the risk inherent in betting on policy convergence, labour mobility – which enables highly valuable human capital, especially well-educated young people, to leave lagging regions for those that offer more and better employment opportunities – could prove to be a critical tool for adjustment.

As it stands, labour mobility is imperfect in the EU. But, with language training and the implementation of something like the Lisbon strategy for growth and jobs (which aimed to create an innovative ‘learning economy’, underpinned by inclusive social and environmental policies), mobility could be enhanced.

But more fluid labour mobility is no panacea. As with every other element of a growth strategy, mutually reinforcing efforts are the only way to achieve success. Half a loaf may be better than none, but half the ingredients do not translate into half of the hoped-for results.

© Project Syndicate, 2015

When I consider the prospects for the global economy and markets, I am taken aback by the extent to which the world has collectively placed a huge bet on three fundamental outcomes: a shift toward materially higher and more inclusive global growth, the avoidance of policy mistakes, and the prevention of market accidents. Though all three outcomes are undoubtedly desirable, the unfortunate reality is that they are far from certain – and bets on them without some hedging could prove exceedingly risky for current and future generations.

The first component of the bet – more inclusive global growth – anticipates continued economic recovery in the US, with a three percent growth rate this year bolstered by robust wage growth. It also assumes China’s annual growth rate will stabilise at 6.5 (to seven percent), thereby enabling the risks posed by pockets of excessive leverage in the shadow-banking system to be gradually defused, even as the economy’s growth engines continue to shift from exports and public capital spending toward domestic consumption and private investment.

Another, more uncertain assumption underpinning the bet on more inclusive growth is that the eurozone and Japan will be able to escape the mire of low growth and avoid deflation, which, by impelling households and businesses to postpone purchasing decisions, would undermine already weak economic performance. Finally, the bet assumes that oil-exporting countries like Nigeria, Venezuela, and especially Russia will fend off economic implosion, even as global oil prices plummet.

Guessing game
These are bold assumptions – not least because achieving these outcomes would require considerable economic reinvention, extending far beyond rebalancing aggregate demand and eliminating pockets of excessive indebtedness. While the US and China are significantly better placed than others, most of these economies – in particular, the struggling eurozone countries, Japan, and some emerging markets – would have to nurture entirely new growth engines. The eurozone would also have to deepen integration.

That adds up to a tough reform agenda – made all the more challenging by adjustment fatigue, increasingly fragmented domestic politics, and rising geopolitical tensions. In this context, a determined shift toward markedly higher and more inclusive global growth is far from guaranteed.

The second component of the collective bet – the avoidance of policy mistakes – is similarly tenuous. The fundamental assumption here is that the untested, unconventional policies adopted by central banks, particularly in advanced countries, to repress financial volatility and maintain economic stability, will buy enough time for governments to design and deliver a more suitable and comprehensive policy response.

Higher stakes
This experimental approach by central banks has involved the conscious decoupling of financial-asset prices from their fundamentals. The hope has been that more buoyant market valuations would boost consumption (via the ‘wealth effect’, whereby asset-owning households feel wealthier and thus more inclined to spend) and investment (via ‘animal spirits’, which bolster entrepreneurs’ willingness to invest in new plants, equipment, and hiring).

The problem is that the current economic and policy configuration in the developed world entails an unusual amount of ‘divergence.’ With policy adjustments failing to keep pace with shifts on the ground, an appreciating dollar has assumed the role of shock absorber.

But history has shown that such sharp currency moves can, by themselves, cause economic and financial instability.

The final element of the world’s collective bet is rooted in the belief that excessive market risk-taking has been tamed. But a protracted period of policy-induced volatility repression has convinced investors that, with central banks on their side, they are safe – a belief that has led to considerable risk-positioning in some segments of finance.

With intermediaries becoming reluctant to take on securities that are undesirable to hold during periods of financial instability, market corrections can compound sudden and dramatic price shifts, disrupting the orderly functioning of financial systems.

So far, central banks have been willing and able to ensure that these periods are temporary and reversible. But their capacity to continue to do so is limited – especially as excessive faith in monetary policy fuels leveraged market positioning.

Balancing the odds
The fact is that central banks do not have the tools to deliver rapid, sustainable, and inclusive growth on their own. The best they can do is extend the bridge; it is up to other economic policymakers to provide an anchoring destination. A bridge to nowhere can go only so far before it collapses.

The nature of financial risks has morphed and migrated in recent years; problems caused by irresponsible banks and threats to the payment and settlement systems have been supplanted by those caused by risk-taking among non-bank institutions. With the regulatory system failing to evolve accordingly, the potential effectiveness of some macro-prudential policies has been undermined.

None of this is to say that the outlook for markets and the global economy is necessarily dire; on the contrary, there are notable upside risks that could translate into considerable and durable gains. But understanding the world’s collective bet does underscore the need for more responsive and comprehensive policymaking. Otherwise, economic outcomes will remain, as former US Federal Reserve Chairman Ben Bernanke put it in 2010, “unusually uncertain”.

© Project Syndicate, 2015