Reconciling 3 Narratives About Global Growth

|
Includes: ACWI, DGT, FIGY, GLQ, HACW, IEIL, RGRO, RWV, VT, WBIL
by: Mohamed El-Erian

There are three major competing growth narratives about the global economy, and each has very different implications for markets, policies, and politics. Even though these story lines may seem mutually exclusive in the short term, they could end up being consistent over time. Moreover, combining the three could provide a road map for what likely lies ahead.

Under the first narrative, a growing number of economists who had been resisting increasingly compelling data have been warming to the notion of an even longer period of low growth, or what has been labeled the "new normal," "new mediocre" and "secular stagnation." Driven by advanced economies that consistently fail to reach escape velocity, global growth remains low, which also puts downward pressure on future potential. Meanwhile, active central banks using an expanding menu of unconventional policies continue to successfully repress financial volatility. The result is a low-level equilibrium that is stable and persistent, though disappointing.

The second view involves questions about the continued effectiveness of central banks. Noting that prolonged excessive reliance on unconventional monetary policy has already borrowed significant output and financial returns from the future, this narrative raises doubts about the longer-term sustainability of low but stable growth. Under this scenario, growth becomes increasingly less even and less stable, and financial volatility more pronounced.

The end result - either sustained high growth or lower growth with periodic recessions - depends on whether central banks are able to hand off the burden of shoring up the economy to a more comprehensive set of policy responses from the legislative and executive branches of government.

The third view is derived from financial market action. There will be times of major growth worries, such as last January and February, and there will be times of relative calm and even complacency, as in April. The fluctuations, which will lead to financial market overshoots, will be driven mainly by changing sentiment about China's ability to bring its economy to a soft landing, and evidence that the U.S. continues to heal. Without a timely and more holistic policy response, these fluctuations are likely to become more frequent and more pronounced, increasing financial instability and adverse feedback loops and, with that, the risks of market accidents and policy mistakes.

At first glance, these three narratives appear contradictory, particularly the first and second. This needn't be the case, however, if they unfold in a sequential rather than simultaneous fashion.

Over the shorter term, the low growth equilibrium is likely to hold, and central banks will still have some ability to repress financial volatility.

But as I detailed in my recent book, "The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse," this state of affairs is coming under increasing pressure, and this will be amplified in the period ahead.

The most visible challenges in the short term include the political and governance implications of low growth, including the rise of anti-establishment parties on both sides of the Atlantic and increasingly in emerging economies, as well as the adverse unintended consequences and collateral damage of negative interest rates.

Less visible, but at least equally instrumental in eroding economic and financial stability, is the deeper impact of protracted low and non-inclusive growth. Developments such as alarming high youth unemployment in many parts of Europe and generalized large increases in the inequality trifecta (income, wealth, and opportunity) are accentuating an already notable loss of trust in both the public and private "establishment."

Combined with the transformation and migration of financial risk, including investor overconfidence in the depth of market liquidity, these conditions are making the overall system less stable and unconventional monetary policies less effective. If you add inadequate global policy coordination, there are real questions about whether a low but stable growth equilibrium can be maintained for many more years.

Rather than frame these scenarios as competing narratives, it may be more appropriate and insightful to combine the three into a road map for the future of the global economy and markets.

Absent a major policy mistake and/or a big market accident, the immediate future promises more of the same: low and relatively stable global growth with central banks still engaged in trying to repress financial volatility. But with markets increasingly sensing the extent of underlying tensions and contradictions, financial instability is likely to increase, which could complicate the situation in even the better-managed economies. In those conditions, low but stable growth and financial calm would prove harder to maintain, and market sentiment would fluctuate in a widening band, with more frequent and more violent oscillations.

In such an environment, the volatility-repression policies of central banks would come under increasing pressure, and some could find their involvement becoming ineffective and perhaps even counterproductive. All of which would bring the global economy closer to a T junction within the next three years: The current path of low and stable growth, coupled with repressed financial volatility, would end, leaving a choice of two diverging roads ahead. Which path will be followed - higher more inclusive growth and financial stability, or recession and financial instability - will depend on whether politicians enable a successful transition from overreliance on central banks to a more comprehensive economic policy stance.

This post originally appeared on Bloomberg View.