An economic crisis is not certain, but we’re vulnerable to one

An economic crisis is not certain, but we’re vulnerable to one

Prediction is folly, but protectionism, political dysfunction, stretched central bank assets, and misguided monetary policy do not reassure, says Stephen Roach

PREDICTING the next crisis — financial or economic — is a fool’s game. Yes, every crisis has a ‘hero’ who warned of what was to come, but was ignored.

But the record of modern forecasting contains a note of caution: Those who correctly predict a crisis rarely get it right again.

The best that economists can do is to assess vulnerability. Looking at imbalances in the real economy or financial markets gives a sense of the potential consequences of a major shock. It doesn’t take much to spark corrections in vulnerable economies and markets. But a garden-variety correction is far different from a crisis.

The severity of the shock and the degree of vulnerability matter: big shocks to highly vulnerable systems are a recipe for crisis.

In this vein, the vulnerability that I worry about the most is the overextended central-bank balance sheet. I have concern for three reasons.

First, central banks’ balance sheets are stretched. Assets of major central banks — the US Federal Reserve, the European Central Bank, and the Bank of Japan (BOJ) — collectively stood at €12.6trn in November 2019, which is down only slightly from the peak of €13.5trn, in early 2018, and is more than 3.5 times the pre-crisis level, of €3.6trn. A similar conclusion comes from scaling assets by the size of their respective economies: Japan leads the way, at 102% of nominal GDP, followed by the ECB, at 39%, and the Fed, at a mere 17%.

Second, central banks’ balance-sheet expansion is a failed policy experiment. Yes, it was successful in putting a floor under collapsing markets, over a decade ago, in the depths of the crisis in late 2008 and early 2009. But it failed to achieve traction in sparking vigorous economic recovery.

Central banks believed that what worked during the crisis would work during the recovery. That didn’t happen.

The combined nominal GDP of the US, eurozone, and Japan increased by €4.8trn, from 2008 to 2018, or only about half their central banks’ combined balance-sheet expansion of €9trn in the same period.

The remaining €4.2tn is the functional equivalent of a massive liquidity injection that has been propping up asset markets over most of the post- crisis era.

Third, steeped in denial, central banks are again upping the ante on balance-sheet expansion to stimulate flagging economic recoveries. The Fed’s late-2018 pivot led the way, first reversing the planned normalisation of its benchmark policy rate and then allowing its balance sheet to grow again (allegedly for reserve management purposes), following steady reductions from mid-2017 through August 2019. Asset purchases remain at elevated levels for the BOJ, as a critical element of the ‘Abenomics’ reflation campaign. And the recently installed ECB president, Christine Lagarde, the world’s newest central banker, was quick to go on the record stressing that European monetary authorities will “turn [over] each and every stone”.

This, presumably, includes the balance sheet.

So why is all this problematic? After all, in a low-inflation era, inflation-targeting central banks seemingly have nothing to fear about continuing to err on the side of extraordinary monetary accommodation, whether conventional (near zero-bound benchmark policy rates) or unconventional (balance-sheet expansion).

The problem lies, in part, with the price-stability mandate itself — a longstanding, but now inappropriate, anchor for monetary policy. The mandate is woefully out of sync with chronically below-target inflation and growing risks to financial stability.

The potential instability of the US equity market is a case in point. According to the widely cited metrics of Nobel laureate economist Robert Shiller, equity prices, relative to cyclically adjusted long-term earnings, currently are 53% above their post-1950 average and 21% above the post-crisis average since March 2009.

Barring a major reacceleration of economic and earnings growth, or a new round of Fed balance-sheet expansion, further sharp increases in US equity markets are unlikely. Conversely, another idiosyncratic shock — or a surprising reacceleration of inflation and a related hike in interest rates — would raise the distinct possibility of a sharp correction in an overvalued US equity market.

The problem also lies in weak real economies that are far too close to their stall speed. The International Monetary Fund recently lowered its estimate for world GDP growth in 2019 to 3% — midway between the 40-year trend of 3.5% and the 2.5% threshold commonly associated with global recessions. As the year comes to a close, real GDP growth in the US is tracking below 2%, and the 2020 growth forecasts for the eurozone and Japan are less than 1%. In other words, the major developed economies are not only flirting with overvalued financial markets and still relying on a failed monetary-policy strategy, but they are also lacking a growth cushion, just when they may need it most.

In such a vulnerable world, it would not take much to spark the crisis of 2020. Notwithstanding the risks of playing the fool’s game, three ‘Ps’ are at the top of my list of concerns — protectionism, populism, and political dysfunction.

An enduring tilt toward protectionism is particularly troubling, especially in the aftermath of a vacuous ‘phase one’ trade accord between the US and China.

Indian prime minister Narendra Modi’s ‘Hindu nation’ crusade could well be the most disturbing development in a global swing toward populism. And the great American impeachment saga takes Washington’s political dysfunction further into uncharted territory.

Quite possibly, the spark will be something else — or maybe there won’t be any shock at all. But the diagnosis of vulnerability needs to be taken seriously, especially because it can be validated from three perspectives: real economies, financial asset prices, and misguided monetary policy. Throw a shock into that mix and the crisis of 2020 will quickly be at hand.

Stephen S Roach is a faculty member at Yale University and former chairman of Morgan Stanley Asia

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