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Wednesday, July 4, 2007

The Global Economy ... The Topics Which Matter

by Claus Vistesen Copenhagen

I have treated this topic on several occasions both at Alpha.Sources as well as at Global.Economy.Matters(GEM). In many ways, the lingering discourse on the global economy is vested in the separate discourses on five closely interrelated topics. As I demonstrate below, I believe these topics to be; macroeconomic imbalances, excess liquidity, the risk of an impending credit crunch, de-coupling, and demographics. My main tenet is that in order to understand the global economy you not only need to analyse each of these topics individually but crucially you need to look at how and where these topics interact. In the following I try to do just that while simultaneous giving a sort of on to go impression of where the global economy is now and where it is headed.

Bretton Woods 2 and the Global Imbalances ... Regarding first the global macroeconomic proxied by Bretton Woods II there is little sign of change albeit the fact that dim signs are perhaps emerging that the peggers will loosen the band to a higher degree in the future. The US is still getting plenty of financing though from the usual suspects and as such the system lingers. If we take BW2 in a larger perspective some commentators have been talking lately about how China has transisted from a traditionally fixed peg to a crawling peg which essentially also signifies the difficulties facing China with sterilising the inflows. Also regarding the actual remedy of the imbalances has there been much flurry recently about whether in fact the RMB is undervalued or not? Personally, I take the view that we need to look at this in the immediate light of the Dollar peggers as well as in a more structural perspective. As such, it would make little sense in my opinion to apply the same reasoning to Japan's and Brazil's surpluses where the former's, I think, is related to demographics whereas the latter's clearly, to some extent, is related to its policy of pegging to the Dollar. I would also put China and the Petroexporters in this box which means (surprise, surprise) that I actually agree with a lot coming from Brad Setser. I have two main qualifiers though. Firstly, and while I accept the point about RMB undervaluation I do think that there is much more to a rebalancing of the Chinese growth path than aligning the RMB with equilibrium fundamentals. Secondly, and related to the point before I see very little chance of a Dollar crash except in the case where the Dollar pegger themselves took on the task of absorbing the adjustment. In this way, some commentators' notes about how China might diversify into Euros which could crash the Dollar is way off in my opinion. Not even if the Fed lowered interest rate would this happen I think since it would immediately I think prompt the ECB to hold or perhaps even follow the Fed down and if it did not ... well, brace yourselves for the slide of Italy and Portugal out of the Eurozone then. Consequently, as I also noted in the inaugural post at GEM there are some divergence in terms of what drives these imbalances and consequently also whether they can and will unwind with a great crash. As a result, the imbalance discourse also mirrors discussion on what seems to be the main concern in the global economy at the moment. Is it reserve accumulation by major emerging markets in Asia and the Middle East (Bretton Woods II), is it the excess liquidity and complexity of financial markets which has deprived central banks the control of the supply of credit, or is the ongoing global demographic transition which is presenting the global economy with a new and historically unique challenge? Or perhaps, it is even something else? At the end of the day we need all the explanations I think in order to get it right. However, amongst these differing perspectives I tend to play, as many others, the role of a 'one-trick pony' in my continuous emphasis on demographics as an important explanatory variable in terms of explaining the structural nature of the imbalances.

(Excess) Liquidity ... The sources of liquidity in the global economy represent a topic a bit too large to go into in detail with here. Also, As Brad Setser shows us on a daily basis there is a lingering data issue in terms of tracking reserve growth and thus financing of the US but the story remains intact. In this way, also the story of global liquidity remains much intact. Interestingly, there are many ways to approach this but ultimately we end of up with the same thing I think. As such, there is little difference I think between arguing that the world suffers from asset-shortage to argue that there is a 'wedge' betwee the return and cost of capital. The latter point is often also operationalized in the global K/L (capital labour ratio) which has been skewed towards labour as Asia's massive workforce has been integrated into the global economy. This has indeed boosted the relative return on capital but also further allowed central banks to keep the cost of capital low. In this light it should readily be seen that this potentially could lead to a situation of asset shortage as too much capital chases too little yield implied by the relative lack and thus high price of assets. In a note over at GEM on ageing and financial markets I try to give a bird's eye view of the structural drivers of the asset supply in the future from the point of view of equities and sovereign debt. This is also where I feel that demographics are very important in order to see the big picture since demographics most likely will act further to push up asset prices in the future through three main mechanisms. Firstly, by contributing to the dwindling supply of sovereign debt. The unwind of BW2 could help here in the short to medium term but further afield the ageing of especially China will present an enormous challenge for the global economy. Secondly, by pushing up demand for the structurally depressed shortage of assets proxied by pension funds, retail investors, mutual funds etc in search for yield. And thirdly, by keeping the relative cost of capital down through low real interest rates in domestic economies where ageing is prevalent. In my opinion, we are already seeing this at the moment with the Yen carry trade and as long as globalization in financial markets keeps capital extremely mobile across borders it is difficult to see how this can stop despite warnings from institutional actors such as the BIS and IMF. Of course, if financial markets suddenly took a hit and if risky leveraged positions abruptly unwound (e.g. as a result of the US subprime mortgage mess) it could, I think, lead to some kind of global institutional and behavioral backlash which would dwindle the plays on the highly leveraged 'certain-to-win' liquidity casino.

Yet, the fundamental question regarding liquidity in the global economy still centers on whether there is too much of it? This question, I think, masks another dirty little secret or question as it were; have central banks lost control over liquidity? This is an enticing question I think and I am sure that if you consult the CBs themselves as well as the large global institutional organizations (e.g. the IMF, the BIS, etc) they would to some extent flag this worry. This, I think, is epitomized in the recurring worry about the complexity and depth of financial markets where risk is like dark matter, you know that it is there but where? In this light, we should remember why the current tightening process by global CBs began in the first place, namely to mop up up excess global liquidity. To this date the process (amongst the big three) has been halted in the US on the back of a slumping housing market, in Japan, monetary 'gradualism' has gotten a whole new meaning and only in the Eurozone does Trichet continue, like Don Quixote, to fight the proverbial wind mills epitomized by the illusive M3 gauge. I say this with a bit of tongue in cheek since it is of course a dilemma. Liquidity has scarcely abated and amongst central bankers where the predominant concern is and should be solid anchoring of inflation expectations the alarm bells are still ringing especially given the recent signs that inflation might be picking up due to capacity strains and structural headline inflation. The paradox in all this is however that the very wide global interest rate differential with the BOJ at 0.5% coupled with ample liquidity through deep capital markets actually serves to work like a reinforcing mechanism increasing liquidity in the very economies (i.e. the external deficit countries) who are trying to stem the tide of brisk economic growth. New Zealand and the UK would perhaps be adequate examples here.

Add to this just a couple of the main structural sources of liquidity in global economy and it is clear that if the target is liquidity and the subsequent worry of upward inflation pressure raising rates might not be the best remedy in the current environment. These sources would then divide the external surplus nations into the demographic agers on the one hand (e.g. Japan and Germany) and the Dollar peggers, and their SWFs on the other (e.g. China, the Petroexporters, Brazil etc). More generally, pension funds and other institutional investors where pensions are pooled should also be noted as well as of course those famed Japanese housewives and businessmen who have figured out how to short the Yen and buy, among other things, Kiwis.

In short, liquidity remains the flavor of the day in the global economy powered by strong structural forces and in my opinion only a backlash from financial markets through a credit crunch major risk adjustment can change this.

An impending credit crunch ... This one is more dubious I think but in the context of the global economy I definitely think it is something which has to be entertained. We all know the potential suspect of this in the form of the US subprime market as well as the potential wreckers of havoc of CDOs and CLOs, if ,of course, they are ever downgraded :). The signs are definitely there with widening spreads as well as a declining home equity index in the US. The main question is indeed as put by MS' Richard Berner in a recent note (see previous link) over the GEF ...

While this renormalization of risk spreads represents a tightening of financial conditions, it is so far proceeding in an orderly way. But in my view, it is far from over; indeed, the events of the past two weeks probably mark the beginning of a significant widening of spreads. Both history and fundamentals suggest than when risk spreads begin to widen after a long period of stability — especially when that stability has encouraged investors to take on more risk — they can overshoot or even turn into a rout. The question now: Could this so-far orderly renormalization now morph into an ugly credit crunch that would slam the brakes on the economy and corporate leverage?

So far then the normalization of risk and spreads are muddling along in an orderly fashion but it remains to be seen whether there is a flare out there waiting to ignite the markets and force a major and abrupt correction. For more on this I can recommend two articles from the Economist which treat this subject in more detail. On balance I don't see a credit crunch on the horizon mainly because I don't see the global economic fundamentals changing. But I also think that it is very difficult these days to glance through what are essentially very opaque financial markets and as such it is difficult to say whether there is indeed imminent danger for an abrupt reversal. If it were to happen however the main venue would most likely be the US economy something which would then seriously put the 'de-coupling' thesis, noted below, on trial.

De-coupling ... In many ways I have also dealt extensively with my view on this in a lengthy note over at GEM. As I argued, it is difficult to speak of de-coupling without also talking about global imbalances. As such, it would not be unreasonable to claim I think that the extent to which the world really de-couples from the US economy also hinges on the potential unwind of the global imbalances themselves. Basically, I believe that we need to look at de-coupling in a short-term (the current global economic upswing) as well as more long term. Regarding the imminent synopsis on de-coupling there is indeed evidence that such a process is occurring albeit the fact that US economy has not exactly crashed (yet?). However, I must say that I am duly surprised over the amount of momentum we are seeing at the moment in the Eurozone as well as to some extent in Japan. This reflects two things I think. Firstly, as I noted above, the US economy is still muddling along despite at deeply depressed housing market and secondly the world has already 'decoupled' from the US as it were or at least to some extent with big emerging markets growing very quickly. So even though e.g. China and Brazil might be pegging to the Dollar they are still pulling along their part of the wagons although of course you could reasonably argue that they should be pulling even more. However, this also strikes at the very core of the de-coupling thesis in my opinion because there is a very big difference between de-coupling from the US economy in particular (i.e. the short term perspective) and de-coupling from export driven growth in general (i.e. the long term perspective). In fact, a rudimentary head-count at this point suggests that the deficit nations and surplus nations are very much the same and my guess is that as ageing and BW2 thunders along this will only exacerbate the lock-in mechanism of the imbalances which will pose great challenges for the global economy.

In conclusion, the proponents of de-coupling might feel vindicated at this point but in my opinion we need to go beyond the idea of decoupling from the US to see the complete picture.

Demographics ... Well, it can hardly come as a surprise that I believe this is important. In fact, based on the notes above it should pretty clear that I believe demographics to be a very important component of the global economy at this stage. The first thing which needs to be emphasized relates to the scope of demographic change and its effects. Clearly, as is often the standard answer amongst many economic commentators demographics tend to exerts its influence over the very long run which subsequently makes the magnitude of the effects rather small in the short term. Or does it? After all, as Keynes aptly put it, in the long run we are all dead so perhaps it is time to say the obvious truth. Regarding demographics the long run is very much here today, alive and kicking. Another point which needs to be realized is that contrary to popular belief it is not population growth but rather ageing (measured by median age, dependency ratios, etc) which represents the salient variable.

Regarding the concrete effect of demographics on the global economic environment I have already outlined them in some detail above. First and foremost I believe ageing already represents a strong structural driver for the 'excess' of global liquidity through on the one hand pushing rapidly ageing economies into external surplus and on the other hand increasing the portfolios of institutional investors eager to place their money to earn yield (SWFs is a case in point). From this also follows that the global macroeconomic imbalances cannot entirely be conceptualized without factoring in the fact that ageing acts as one of the important variables. Finally, ageing also relates to the notion of de-coupling in the long run where the real question becomes, as with the global imbalances, who are in fact going to run the deficits in the future? Especially, if you believe that the US at some point will face an abrupt correction it would be interesting to hear your suggestion as to where Chinese, Japanese, and German (Eurozone?) savings are going to flow? India or Brazil perhaps?

There is really not much to summarize and as such it is all noted above. This is basically the global economy as I see it at the moment. One thing which I feel should be included as an addendum before I leave you is the recent talk about capacity strains in key economies around the globe and how this might lead to increased inflation. This I feel is also set to become a somewhat global phenomenon at some point especially if global growth continues to power along as we are currently seeing. I will not go into this in detail here but save it for another day but I do think it is important keep in the back your mind.