The clear and present danger
The world economy has large and growing excess savings, according to the International Monetary Fund (IMF):
The world savings rate has surpassed its modern-era high of 24pc. This is the killer in the global system. It is why we are at imminent risk of tipping into a second, deeper leg of intractable depression. The International Monetary Fund (IMF) expects the savings mountain to rise yet further next year as the governments of Europe, Britain, and the US tighten belts, in unison, by up to 2pc of GDP. [The Telegraph]
It's also not too hard to figure out why. In many places, households are repairing their balance sheets and these are now increasingly joined by governments in an effort to keep public finances from spiraling out of control. In such a climate, business has little incentives to expand production capacity as the mirror image of a world savings glut is excess production capacity.
When all categories of demand are turning negative, not only will corporate profits, and hence the markets, ultimately suffer but the danger of a self-reinforcing vicious cycle are becoming all too real. Mix in the euro-crisis, the bad state of the housing market and the still large levels of debt and there is the possibility of several negative feedback loops.
The most notorious one set out by Irving Fisher in the 1930s about deflationary-debt spirals (deflation leading to higher debt burdens in real-terms, leading to forced asset selling and even more depressed asset prices, you know, stuff like that..).
In today's automatic trading trading world, there are entirely new negative feedback loops possible. For instance, when trading computers get their feed from from computers scanning news and even twitter for sentiment, there is a danger of a self-reinforcing loop here, where negative 'news and twitter' sentiment leads to a market sell-off, which further depresses sentiment.
Emergency Plan B
Fiscal stimulus would probably be the correct answer in this environment but budgets are very much stretched as it is. It would be having to chose between two bad options, but the choice isn't really there because there is no (or at least too little) political will to go this route. This, despite quite a number of rather intimidating examples of the dangers of early fiscal retrenchment.
This leaves rather massive scale central bank involvement as the most obvious alternative. A massive quantitative easing (QE) type of program should be tried to reflate the economy in the developed economies. For the US, the onus is on those who argue for immediate austerity how they would deal with the consequences of an inevitable decrease in demand in an already weak economy. They should at least consider some offsetting monetary stimulus. This is exactly what's happening in the UK, under a largely conservative government.
They're doing it in the UK
The coalition led by David Cameron governing Britain has embarked on large scale austerity to reign in the public deficit and stabilize the debt/GDP ratio. To mitigate the risks that this pro-cyclical (business cycle reinforcing) policy does not weaken an already weak economy further, the Bank of England has just announced it will embark on bond buying ('QE') once again.
Britain does issue its own currency. Apart from leading to much lower interest rates compared to countries with comparable public finance situation (like Italy and Spain) because Britain can ultimately always pay its bondholders back, this has another advantage.
On the news, the pound immediately decreased in value, making British exports cheaper and imports more expensive, thereby improving Britain's competitiveness.
Sterling declined against all of its 16 major peers and gilts rose as Britain’s monetary policy makers boosted the central bank’s quantitative-easing program by 75 billion pounds ($115 billion) to 275 billion pounds. [Bloomberg]
This is what the BoE gave as rationalization:
The central bank, which expects to complete the new round of purchases in four months, said in a statement that slowing global growth and the turmoil in Europe “threaten the U.K. recovery.” It also said it is now “more likely” that inflation will undershoot its 2 percent goal in the medium term. [Bloomberg]
Still, the best place for doing this would actually not be the US or Britain, it would be elsewhere...
It works in Europe..
While a lot can, and has been said about the two earlier QE operations by the Fed, we mainly look elsewhere for getting the most traction, which is Europe. It certainly looks like politicians so far are unable to come up with any kind of solution to the euro-crisis.
Since countries like Italy and Spain (or the euro area as a whole) have no worse public finances compared to the likes of Britain and the US but pay three times their interest rates on 10 year bonds, it can be argued that the euro crisis has a considerable systemic component.
For those reasons, one could plausibly argue that Italy and Spain are solvent. They would be if they were able to issue their own currency and profit from countries with similar public finance situation (arguably worse) like the US and Britain. There is, therefore, a good case to be made for the ECB to keep these financing costs low (or better, to try to lower them), especially in a situation in which there doesn't seem to be any other viable alternative.
Just think of what will happen if the cost of Italian and Spanish debt would continue to rise. Sooner or later, both countries would not have access to the markets anymore and their public finance situation will have spiraled out of control. This still isn't unavoidable.
If an ECB QE program actually manages to keep Italian and Spanish debt financiable a lot would already be won. We find it extraordinary that two German officials resigned over the bond buying program of the ECB whilst offering no credible and immediate alternative. It seems to us they rather keep their monetary virginity than work at actually solving the enormous problems in front of us.
Maintaining Italian and Spanish debt is absolutely crucial for keeping the world economy from falling over. But an ECB QE program would actually achieve more. It would relieve European banks of this debt, thereby adding significantly to their solvability and survival chances.
In short, we think that Europe is the first place to look for QE, because politicians are not delivering, because Italian and Spanish public finances are suffering tremendously from the euro and earlier policy mistakes, and because we really don't see any other alternative with anywhere near the same traction in sight.
Will it happen? Well we are keenly aware of the obstacles, but really, what's the alternative? What one has to realize though is that it will work. There is no doubt about it.
The space available in a single article rather limits us here, so we can only scratch the surface here. The main objectives of the previous two QE programs of the Fed where that it created inflation (or at least increased risk) and wasn't effective.
We can start with the latter. Not everybody has woken up to the circumstance that we're in a liquidity trap. In the diagnosis of the situation we described low credit demand, both from households (repairing balance sheets) and firms (little incentive to expand production capacity). So there really isn't much of a transmission mechanism for the extra created bank reserves to work their way into the economy. And extra bank reserves have been created in large quantities:
These bank reserves (monetary base is just that plus currency in circulation) just sits there (the Fed could stop paying interest on them, but that would probably not make much of a difference). As long as credit demand doesn't come back, which will be as balance sheets get repaired and/or sustainable economic growth returns, they will stay there.
This is also why those that have warned for any kind of 'hyperinflation' are mistaken. They've done so for a number of years now.
The mirror image of large and growing excess savings in the world economy is excess productive capacity. Any uptick in the world economy as a result of any QE will disproportionally go to output, rather than prices. Much business is of the high-fixed cost, low variable cost nature that really suffers from idle plant. These type of companies will have every incentive to keep prices low in order to benefit from increased capacity utilization.
All over the Western world labour is in no condition to bargain for wage rises. The world economy is by no means capacity constrained, exactly the contrary.
Yes, perhaps some of Fed QE2 in particular leaked to emerging markets and did have an effect on commodity prices. But capital has been flowing out of emerging markets lately and commodity prices are tanking, so that's much less of a danger right now.
One could even argue that even if some inflation materializes, this also has benign effects as it reduces the real value of outstanding debt. This is how countries like Britain and the US got rid of much of their (considerably higher) debt levels after WOII, after all. No lesser figures than Oliver Blanchard (chief economist of the IMF) and Greg Mankiw (former advisor to George Bush) have argued for moderate inflation targets. Here is what the latter wrote:
Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.
With fiscal policy in a bind, monetary policy seems the main alternative. It's certainly no miracle cure, but rather than the US, we think firstly of Europe, where it really seems to be able to take a whole lot of risks off the table, like keeping Italy, Spain, and the banking system from falling over.
Yes, these risks would be substituted for other risks, like inflation, like moral hazard. But we believe the inflation risk is quite low under the present economic conditions. And yes, it would once again underline the moral hazard problem and indulge speculative behaviour. We think regulatory changes are better suited to this. Don't let the perfect be the enemy of the good.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.