Saturday, December 10, 2016
Photo of Nouriel Roubini

The world economy in 2016 will continue to be characterized by a New Abnormal in terms of output, economic policies, inflation, and the behavior of key asset prices and financial markets.

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The Global Economy’s New Abnormal

NEW YORK Since the beginning of the year, the world economy has faced a new bout of severe financial market volatility, marked by sharply falling prices for equities and other risky assets. A variety of factors are at work: concerns about a hard landing for the Chinese economy; worries that growth in the United States is faltering at a time when the Fed has begun raising interest rates; fears of escalating Saudi-Iranian conflict; and signs – most notably plummeting oil and commodity prices – of severe weakness in global demand.

And there’s more. The fall in oil prices – together with market illiquidity, the rise in the leverage of US energy firms and that of energy firms and fragile sovereigns in oil-exporting economies – is stoking fears of serious credit events (defaults) and systemic crisis in credit markets. And then there are the seemingly never-ending worries about Europe, with a British exit (Brexit) from the European Union becoming more likely, while populist parties of the right and the left gain ground across the continent.

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These risks are being magnified by some grim medium-term trends implying pervasive mediocre growth. Indeed, the world economy in 2016 will continue to be characterized by a New Abnormal in terms of output, economic policies, inflation, and the behavior of key asset prices and financial markets.

So what, exactly, is it that makes today’s global economy abnormal?

First, potential growth in developed and emerging countries has fallen because of the burden of high private and public debts, rapid aging (which implies higher savings and lower investment), and a variety of uncertainties holding back capital spending. Moreover, many technological innovations have not translated into higher productivity growth, the pace of structural reforms remains slow, and protracted cyclical stagnation has eroded the skills base and that of physical capital.

Second, actual growth has been anemic and below its potential trend, owing to the painful process of deleveraging underway, first in the US, then in Europe, and now in highly leveraged emerging markets.

Third, economic policies – especially monetary policies – have become increasingly unconventional. Indeed, the distinction between monetary and fiscal policy has become increasingly blurred. Ten years ago, who had heard of terms such as ZIRP (zero-interest-rate policy), QE (quantitative easing), CE (credit easing), FG (forward guidance), NDR (negative deposit rates), or UFXInt (unsterilized FX intervention)? No one, because they didn’t exist.

But now these unconventional monetary-policy tools are the norm in most advanced economies – and even in some emerging-market ones. And recent actions and signals from the European Central Bank and the Bank of Japan reinforce the view that more unconventional policies are to come.

Some alleged that these unconventional monetary policies – and the accompanying ballooning of central banks’ balance sheets – were a form of debasement of fiat currencies. The result, they argued, would be runaway inflation (if not hyperinflation), a sharp rise in long-term interest rates, a collapse in the value of the US dollar, a spike in the price of gold and other commodities, and the replacement of debased fiat currencies with cryptocurrencies such as bitcoin.

Instead – and this is the fourth aberration – inflation is still too low and falling in advanced economies, despite central banks’ unconventional policies and surging balance sheets. The challenge for central banks is to try to boost inflation, if not avoid outright deflation. At the same time, long-term interest rates have continued to come down in recent years; the value of the dollar has surged; gold and commodity prices have fallen sharply; and bitcoin was the worst performing currency of 2014-2015.

The reason ultra-low inflation remains a problem is that the traditional causal link between the money supply and prices has been broken. One reason for this is that banks are hoarding the additional money supply in the form of excess reserves, rather than lending it (in economic terms, the velocity of money has collapsed). Moreover, unemployment rates remain high, giving workers little bargaining power. And a large amount of slack remains in many countries’ product markets, with large output gaps and low pricing power for firms (an excess-capacity problem exacerbated by Chinese overinvestment).

And now, following a massive decline in housing prices in countries that experienced a boom and bust, oil, energy and other commodity prices have collapsed. Call this the fifth anomaly – the result of China’s slowdown, the surge in supplies of energy and industrial metals (following successful exploration and overinvestment in new capacity), and the strong dollar, which weakens commodity prices.

The recent market turmoil has started the deflation of the global asset bubble wrought by QE, though the expansion of unconventional monetary policies may feed it for a while longer. The real economy in most advanced and emerging economies is seriously ill, and yet, until recently, financial markets soared to greater highs, supported by central banks’ additional easing. The question is how long Wall Street and Main Street can diverge.

In fact, this divergence is one aspect of the final abnormality. The other is that financial markets haven’t reacted very much, at least so far, to growing geopolitical risks either, including those stemming from the Middle East, Europe’s identity crisis, rising tensions in Asia, and the lingering risks of a more aggressive Russia. Again, how long can this state of affairs – in which markets not only ignore the real economy, but also discount political risk – be sustained?

Welcome to the New Abnormal for growth, inflation, monetary policies, and asset prices, and make yourself at home. It looks like we’ll be here for a while.

 

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Photo of Mohamed A. El-Erian

Just when the notion that Western economies are settling into a “new normal” of low growth gained mainstream acceptance, doubts about its continued relevance have begun to emerge.

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The End of the New Normal?

WASHINGTON, DC – Just when the notion that Western economies are settling into a “new normal” of low growth gained mainstream acceptance, doubts about its continued relevance have begun to emerge. Instead, the world may be headed toward an economic and financial crossroads, with the direction taken depending on key policy decisions.

In the early days of 2009, the “new normal” was on virtually no one’s radar. Of course, the global financial crisis that had erupted a few months earlier threw the world economy into turmoil, causing output to contract, unemployment to surge, and trade to collapse. Dysfunction was evident in even the most stable and sophisticated segments of financial markets.

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Yet most people’s instinct was to characterize the shock as temporary and reversible – a V-shape disruption, featuring a sharp downturn and a rapid recovery. After all, the crisis had originated in the advanced economies, which are accustomed to managing business cycles, rather than in the emerging-market countries, where structural and secular forces dominate.

But some observers already saw signs that this shock would prove more consequential, with the advanced economies finding themselves locked into a frustrating and unusual long-term low-growth trajectory. In May 2009, my PIMCO colleagues and I went public with this hypothesis, calling it the “new normal.”

The concept received a rather frosty reception in academic and policy circles – an understandable response, given strong conditioning to think and act cyclically. Few were ready to admit that the advanced economies had bet the farm on the wrong growth model, much less that they should look to the emerging economies for insight into structural impediments to growth, including debt overhangs and excessive inequalities.

But the economy was not bouncing back. On the contrary, not only did slow growth and high unemployment persist for years, but the inequality trifecta (income, wealth, and opportunity) worsened as well. The consequences extended beyond economics and finance, straining regional political arrangements, amplifying national political dysfunction, and fueling the rise of anti-establishment parties and movements.

With the expectation of a V-shape recovery increasingly difficult to justify, the “new normal” finally gained widespread acceptance. In the process, it acquired some new labels. International Monetary Fund Managing Director Christine Lagarde warned in October 2014 that the advanced economies were facing a “new mediocre.” Former US Secretary of the Treasury Larry Summers foresaw an era of “secular stagnation.”

Today, it is no longer unusual to suggest that the West could linger in a low-level growth equilibrium for an unusually prolonged period. Yet, as I explain in my new book The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse, growing internal tensions and contradictions, together with over-reliance on monetary policy, are destabilizing that equilibrium.

Indeed, with financial bubbles growing, the nature of financial risk morphing, inequality worsening, and non-traditional – and in some cases extreme – political forces continuing to gain traction, the calming influence of unconventional monetary policies is being stretched to its limits. The prospect that such policies will be able to keep the economic engines humming, even at low levels, looks increasingly dim. Instead, the world economy seems to be headed for another crossroads, which I expect it to reach within the next three years.

This may not be a bad thing. If policymakers implement a more comprehensive response, they can put their economies on a more stable and prosperous path – one of high inclusive growth, declining inequality, and genuine financial stability. Such a policy response would have to include pro-growth structural reforms (such as higher infrastructure investment, a tax overhaul, and labor retooling), more responsive fiscal policy, relief for pockets of excessive indebtedness, and improved global coordination. This, together with technological innovations and the deployment of sidelined corporate cash, would unleash productive capacity, producing faster and more inclusive growth, while validating asset prices, which are now artificially elevated.

The alternate path, onto which continued political dysfunction would push the world, leads through a thicket of parochial and uncoordinated policies to economic recession, greater inequality, and severe financial instability. Beyond harming the economic wellbeing of current and future generations, this outcome would undermine social and political cohesion.

There is nothing pre-destined about which of these two paths will be taken. Indeed, as it stands, the choice is frustratingly impossible to predict. But in the coming months, as policymakers face intensifying financial volatility, we will see some clues concerning how things will play out.

The hope is that they point to a more systematic – and thus effective – policy approach. The fear is that policies will fail to pivot away from excessive reliance on central banks, and end up looking back to the new normal, with all of its limitations and frustrations, as a period of relative calm and wellbeing.