Δευτέρα, 8 Ιουνίου 2009

Has the threat of a Great Depression vanished?

Has the threat of a Great Depression vanished?

Still not convinced? Green shoots are sprouting into a jungle around the world. Consider a few of the economic indicators published in the past two weeks: British house prices have risen in two of the past three months. Japan has experienced its biggest monthly increase in industrial production since the Fifties. Consumer and business sentiment are rising strongly in the United States and Britain and are even showing some signs of life in Europe. In America, where all the trouble started, unemployment claims have fallen, durable goods orders and property sales have bounced back and house prices have stabilised, although not yet in the 20 boom-bust cities sampled by the Case-Shiller index, which the markets, in their wisdom, have chosen to emphasise. The list of bullish statistics could go on, but it can be best be summarised in the market's own judgment world share prices have enjoyed a three-month rally, led by commodities, retailers and financials, capital markets have re-opened, with record issuance of equities and corporate bonds, credit spreads have narrowed and government bond prices have fallen in exactly the way they did at the start of the recovery in 2003. Yet most economic commentators have remained sceptical or even contemptuous of all this evidence. Surely, they argue, the threat of another Great Depression could not just have vanished in a puff of statistics? Is anyone so naive as to think that a crisis caused by over-leveraging can be solved by government borrowing and money-printing?

Actually, some people are so naive. I have always believed, for example, that private sector de-leveraging can, in principle, be outweighed by fiscal and monetary expansion, provided that this is aggressive enough. I also felt that the Great Recession was not some divine retribution for the moral turpitude of greedy bankers and pampered consumers but actually an avoidable accident, caused mainly by the incompetence of the Bush Administration's handling of Lehman and Fannie Mae. From this standpoint, there is nothing surprising about the recent improvement in economic conditions. From a financial standpoint, the scepticism of media and market commentators is a cause for confidence, not concern. Bull markets always tend to “climb a wall of worry” because the inflow of money from sceptics as they become believers is what gives the uptrend its staying power. From this point of view, lurid media headlines can be regarded as encouraging. Nobody should be surprised that sterling shot up in response to the ludicrous story about a downgrade in the British Government's debt. Looking beyond the media hype, are there genuine reasons for worry? In meetings with businessmen and investors, I find anxieties focus on Seven Deadly Sins, which could yet set the world back on the path to economic perdition:

1. Rising bond yields could crush growth and produce a W-shaped recession.

2. America and Britain could follow Japan's experience, when government support for “zombie banks” thwarted economic growth.

3. Consumer and business de-leveraging, driven by collapsing property prices, could stifle any recovery.

4. Fiscal deficits could threaten government solvency or force central banks into printing money Zimbabwe-style.

5. Inadequate consumption in China, Germany and Japan could prevent a rebalancing of the world economy and create new asset bubbles.

6. Financial stability could be shattered by another bank crisis, probably in Europe.

7. Structural inflation, created by unions, protectionism and energy cartels, could turn a cyclical stagnation into long-term “stagflation”.

The first four are greatly exaggerated, but the last three may be understated. Let me explain:

Bond yields always rise in economic recoveries without causing W-shaped recessions. The only exception was the US in 1981, when the Fed increased overnight interest rates by ten percentage points to control runaway inflation - hardly likely in 2009. Moreover, stronger economic prospects have narrowed credit spreads. The price and availability of money for businesses and homeowners is improving, even as bond yields rise. Japan's experience of supporting “zombie” banks coincided with long-term economic stagnation. But the question is whether government support for weak banks caused economic stagnation or whether economic stagnation prevented banks getting stronger. The same question must be asked about an IMF study, which shows that recessions accompanied by banking crises last longer than others. These banking crises were accompanied by extreme fiscal and monetary contractions. In contrast, the Eighties' Third World debt crisis, when US banks traded their way out of insolvency, did not lead to recession but coincided with the strongest period of economic growth in history. Lost housing wealth probably does mean slower US and British consumption growth. But most of the increase in savings has likely already occurred. In the US, the household savings rate has risen from 0.1 per cent a year ago to 4.2per cent, its highest level since 1994. Savings will probably rise until next year, but after that US and British consumption should grow in line with personal incomes. After that, most of the debt reduction will occur in the financial sector. Moreover, a further big fall in US house prices is unlikely since prices have already overshot on the downside. In Britain, recent signs of housing strength suggest that supply restrictions may have created a long-term up-trend in valuations. Fiscal and monetary policies do not pose anything like the threat generally believed. The deficits now planned by the US and British Governments follow many years of debt reduction relative to GDP. As a result, their debt burdens will remain well below the levels of 100 per cent of GDP, levels typical for much of the 20th century. There is no more reason to worry about fiscal solvency in the US or Britain than in Germany and France (see chart). The only large economies that could face genuine solvency threats are Italy and Japan and, significantly, their bond markets show no signs of alarm. Meanwhile, the near- doubling of central bank money in Britain, the US and the eurozone should not lead to inflation, unless it is lent to the private sector by banks. So far, this is not happening. Once banks do resume lending, monetary conditions will have to be tightened, by forcing commercial banks to hold higher reserves of central bank money than before. Now for the bad news. There remain three genuine reasons to worry about the medium-term outlook. A rebalancing of growth is required between consumers in America, Britain, Spain and Central Europe and producers in China, Japan and Germany. It is far from clear whether this will occur and the difficulty of achieving this rebalancing could trigger a financial crisis within the eurozone. Further ahead, it is possible that inflationary pressures will revive, even in conditions of high unemployment and low capacity utilisation, if global competition is thwarted by unions, protectionist governments or commodity cartels. A return to Seventies-style stagflation is a genuine medium-term threat. So if you want real reasons to worry about inflation, look at trade, energy and labour policies, not at public deficits and central banks.

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