CAMBRIDGE – Perhaps we should call 2013 the year of Winehouse economics. As the late English chanteuse Amy Winehouse sang: “They tried to make me go to rehab, but I said ‘No, no, no.’” In 2013, the singers were the world’s most important central banks, led by the Federal Reserve.
In the summer, both the Fed and the People’s Bank of China signaled their intention to normalize monetary policy. Fed Chairman Ben Bernanke talked openly of “tapering” the Fed’s policy of open-ended bond purchases, also known as quantitative easing (QE). PBOC Governor Zhou Xiaochuan actually did try to rein in his country’s runaway credit growth. But when markets in both countries reacted more violently than expected – with bond yields soaring in the United States and inter-bank lending rates spiking in China – the monetary authorities backed off.
It is a problem many a pop singer has encountered: After years of stimulus, rehab is just not that easy.
True, there remain strong intellectual justifications for continued economic stimulus of one sort or another. In November, the man who once seemed poised to succeed Bernanke, Larry Summers, suggested that the US economy might be in the grip of “secular stagnation.” Other economists continue to fret that in Europe, if not in America, the benign disinflation of recent decades could yet turn into malign deflation.
And yet there are indications that the world economy as a whole is perking up. The International Monetary Fund forecasts that annual global growth will accelerate from 2.9% this year to 3.6% in 2014, and will be 4% or higher for the next four years – above the average growth rates recorded in the 1980’s, 1990’s, and 2000’s.
The mismatch between advanced-economy under-performance and resurgent growth in the rest of the world raises (at least) seven questions, especially for the major central banks themselves. Each of these institutions has some kind of national mandate. Yet, in our interconnected world, their decisions inevitably have global consequences.
Question 1: What exactly will the Fed do under its new boss, Janet Yellen? She certainly sounds as if she favors ongoing medication over cold turkey. The tapering of QE has to happen sooner or later, but Yellen’s genuine concern about the state of the US labor market suggests that she will promise lower interest rates for longer than might seem warranted by other indicators. The challenge will be to make this new regime of “forward guidance” work if other indicators suggest that recovery is underway (just ask Mark Carney, Governor of the Bank of England).
The US is on the mend in more ways than one. Shale gas and oil have brought an energy bonanza. Silicon Valley is thriving. The stock market is hitting record highs. And, amazingly, a deeply polarized US Congress has just struck a two-year fiscal deal that will boost spending slightly in the short run, while reducing the deficit in the long run.
There is a strong possibility that markets will react to this and other good news by ignoring forward guidance, focusing on the tapering of QE and nudging up long-term rates. And one short-run consequence of this might be the kind of sharp stock-market correction that we saw in 1980 and 1987. Wall Street likes to test a new Fed chairman.
Question 2: How will other central banks react to a changing monetary policy regime in Washington? In Frankfurt, the European Central Bank knows that the eurozone periphery is not ready for higher interest rates yet, even if Spain, Ireland, and Greece are showing signs of economic life. Unemployment on the eurozone periphery remains appallingly high. Moreover, the biggest political risk in Europe is still populism – and next year’s European parliamentary elections will give the likes of France’s far-right leader, Marine Le Pen, a golden opportunity.
Question 3: Will the populists do well enough to disrupt the complex process of establishing a banking union, a prerequisite for the sustainable recovery of Europe’s financial system? Probably not. Indeed, populist success may even encourage Social Democrats and Christian Democrats to form a “grand coalition” in the European Parliament – which would represent another step in the European Union’s quiet Germanization.
Meanwhile, in Japan, there is even less enthusiasm for monetary rehab: the Abe government clearly expects more, not less, stimulus from the Bank of Japan. Without it, hopes that “Abenomics” will get Japan’s annual inflation rate up to 2% will surely be dashed.
Question 4: Will Japan be able to maintain QE while the US tapers? Probably, but the extent to which it serves the cause of sustained growth and higher inflation depends on the so-called “third arrow” of structural reform, which has yet to hit real targets.
The contrast with Japan’s neighbor and strategic rival, China, is striking. There is at least some evidence that the PBOC has already resumed monetary tightening in an effort to impose a controlled credit crunch on the country’s shadow banking sector. That brings me to the final three questions:
Question 5: Can China really sustain growth while simultaneously deflating a credit bubble and implementing the structural reforms announced after the Communist Party Central Committee’s Third Plenum?
Question 6: How will China’s vast new middle class react if the answer to question 5 is “No”?
Question 7: Will the leadership in Beijing respond to domestic discontent with more of the foreign-policy saber rattling that we have seen this year?
I do not pretend to know the answers to these last questions. But they may prove to be the key to how well – or badly – a “Rehab World” turns out.