In January of this year, Adam Posen, External Member of the Monetary Policy Committee, Bank of England, gave a talk titled "What the return of 19th century economics means for 21st century geopolitics." The title caught my interest because what little I know of 19th century economics is now dominated by the parallels drawn between the various panics in the late 19th century and the panic of 2008-2009.
Additionally, last year I learned that the late 19th century and early 20th century featured the world's first experience with globalization and widespread economic integration (see "Nye on the Great Depression, Political Economy, and the Evolution of the State", an interview on EconTalk with Jon Nye of George Mason University). What followed over the next generation or so represented a violent backlash to this experience and a growing distrust in markets. The politics of the time facilitated and abetted the backlash. The rejection of this phase of globalization culminated in World War I.
As it turned out, Posen specifically looks at the years 1870-1910 to find likely lessons for the next 10-20 years. Posen notes that today's relative scale of globalization and cross-border economic integration resembles the 1870-1910 period. Moreover, the apparent shifting of economic dominance and power from the aging (mostly Western) economies to the rapidly growing emerging economies, now accelerated by the current financial crisis and large sovereign debts, has many similarities with the transition in power from the United Kingdom to the U.S. Posen carefully draws one distinction by noting the earlier transition represented a transfer of power from one hegemonic power to another hegemony whereas today's shift is more akin to the establishment of a multipolar economic regime where global incomes converge.
Posen is optimistic that today's transition will not end in a cataclysmic war
…given the lessons of the world wars, the spread of democracy, the development of nuclear deterrence among the major powers, the creation of safety nets and welfare states even in emerging markets, and the strong barriers against outright imperialism.
Here are Posen's main conclusions:
- "Globalization in the form of integration of national economies and markets across borders will continue, with increasing support from important constituencies in emerging markets.
- As US hegemony, that is relative economic dominance, recedes into multipolarity, the international economic system will have less strict rule enforcement and be subject to greater economic volatility.
- The erosion of (intellectual and other) property right enforcement will have significant effects on the global division of labor, which will reinforce this multipolarity and income convergence.
- Price stability will prevail, with sharper fluctuations around low average inflation driven by real (relative price) shocks, and deflation will occur from time to time.
- More than one currency will play a global or reserve role, and the benefits in terms of lower interest rates from having such a role will diminish.
- International diversification of investment will increase, and so will the gross flows of capital, with capital accounts in the major emerging markets moving more towards balance if not deficit."
The last point on balancing capital accounts is a particular flash point for Bank of England (BOE) governor Mervyn King. For many years, King has insisted that until major economic powers improve their capital account balances, the global economy will remain vulnerable to severe shocks. This includes the lack of competitiveness in Europe's lagging economies that has helped to generate out-sized sovereign debts and China's glut of foreign reserves which distorts capital flows and investment.
So I find it interesting that Posen projects that increasingly powerful middle classes (the "important constituencies") in emerging economies will help achieve that balance because they want to unleash the purchasing power that is otherwise suppressed by the currency undervaluation of massive foreign reserves. In the meantime, the Bank of England seems intent on bringing its own economy into balance by bolstering domestic demand and increasing exports partially aided by trying to cap the value of the British pound (FXB).
I am much less convinced about Posen's arguments for general price stability. Unsurprisingly, he is quite confident in the ability of central banks to manage long-term inflation expectations. He suggests that the mandates for price stability essentially translate into the success of accomplishing the mandates and believes that monetary policies have not been too lax (although financial regulations have been too lax). Moreover, Posen insists:
…independent central banks pursue price stability over the medium-term because there is effective opposition to inflation in those societies that have independent central banks. That remains the case. If anything, political opposition to inflation has strengthened among working people and in emerging markets, as revealed in the policies pursued there and the parties elected. While many people are in debt, the ideology of the day is not to forgive debtors, and the interests with the biggest influence on politicians remain those on government fixed incomes and lenders not borrowers.
I remain wary, at least for developed economies. I see every reason to anticipate eventual rationalizations for inflating away debts as sovereign debts in particular prove too onerous to service and/or pay off. The Bank of England and the Federal Reserve have learned from their recent rounds of quantitative easing that money can be printed through the purchase of government bonds without igniting inflation. With economic growth stubbornly sluggish and high unemployment stubbornly persistent, only an explosion of inflation can ween these central banks from the current "free lunch" of this accomodative policy.
I think Posen is also confident in low inflation pressures because, presumably, the erosion of property rights will reduce the prices companies facing international competition can obtain from their products. Also, stagnant wage growth in developed economies will remove another pillar of price pressure.
However, I am left wondering whether Posen has considered or taken into account the fundamental upward pressure placed on the prices of physical assets by the growing wealth and populations in emerging economies. This dynamic continues to motivate me to buy the dips in commodities (for example, see "Profiting from Physical Assets in a Resource-Constrained World - Rules and Picks"). Over the past several years, the Bank of England (and the Federal Reserve) has demonstrated little concern for volatility in commodity prices, assuming increases are shocks, temporary, and transitory…and more importantly unrelated to monetary policy. I can only assume Posen's expectations for price stability confirm the maintenance of this approach to commodity prices.
Regardless of my reservations, I am intrigued by Posen's anticipation of increased price volatility, even around a low base. Certainly, our experience with the S&P 500 (SPY) over the last 12-13 years bears this out. The implication for investors is that the financial environment will continue to deliver numerous buying opportunities for participating in recoveries. If price stability will truly become a norm, then volatility should be embraced, not feared.
The other investing implication in a world of converging incomes is that international diversification will remain an important feature of portfolio planning. Interest rates and dividend yields are likely to remain low in developed economies and the freedom of capital will increase opportunities to invest in attractive international financial instruments. Posen notes that risk aversion will dominate in developed economies, keeping investors wedded to sovereign debt. Given my suspicion that these debts will get inflated away, I am much more interested in scanning the skies beyond the horizon. I am not excited by sovereign debt offered at ultra-low interest rates. Indeed, the ProShares UltraShort 20+ Year Treasury (TBT) looks like it has finally bottomed for now.
Note that the parallels Posen draws between 1870-1910 and the next 10-20 years are not the result of some kind of economic determinism. Instead, I interpret Posen's references as attempts to extract lessons from the prior period that might be applicable for guiding future behavior. I think he has stumbled upon some thought-provoking ideas. As always, time will tell exactly what lessons prove most salient.
Be careful out there!
Additional disclosure: I am also long SSO calls