After a long period of economic expansion, a slowdown has begun. But in an era of high debt and low interest rates, states have little ammunition to deploy.
recession always comes in the end, but the matter of foretelling when is a hazardous exercise at best. Indeed, recessions can remain out of sight to policy-makers even when they have begun. In July 2008 the then president of the European Central Bank (ECB), Jean-Claude Trichet, declared while announcing an increase in interest rates that the eurozone’s fundamentals were sound. In fact, a recession had begun in the first quarter of that year.
The causes of recessions are also sometimes wrongly diagnosed – even in retrospect. For instance, the impact of exceptionally high oil prices and the response of central banks to those prices are still routinely ignored as causes of the US and European recessions in the aftermath of the 2008 crash. In recent months, the spectre of the next recession has begun to take shape. Growth has fallen in several large economies, even while the US, which is much further beyond its last recession than the eurozone, posted growth above 4 per cent in the second quarter of this year. Yet it is also far from clear what is causing the slowdown, especially when there are potential recessionary pressures originating from multiple directions. The prospect of an end to quantitative easing (QE) – electronically created money used to purchase government bonds – for the eurozone, with Italy’s economy deteriorating under this shadow; China’s sky-high corporate debt; the trade war between the US and China; asset bubbles in financial markets; and the sheer length of the present economic cycle all represent substantial dangers to ongoing growth.
Nonetheless, predicting that a new recession is imminent on the basis of past experience is more difficult than usual, because the response to the 2008 crash produced a huge monetary disruption. This new world of ultra-low interest rates has transformed financial markets and investors’ approach to risk.
By any pre-2008 standard there is now a catalogue of asset bubbles which, history would suggest, must eventually burst, possibly spectacularly. Yields on some of these assets bear no relationship whatsoever to discernible risk. Towards the end of last year, yields on European corporate junk bonds fell below 2 per cent, at a time when ten-year US treasury bonds, supposedly the world’s safe-haven investment asset, were averaging above this figure. Prices in financial markets that have historically moved in opposite directions are now often moving together, with almost every asset responding first and foremost to perceptions of what central banks will do next.
The current business cycles also do not look familiar. The present period of growth in the US, which began in the third quarter of 2009, is the second longest on record since the 1850s and will become the longest if a recession is avoided by the middle of next year. But there has not yet been a single year of 3 per cent growth, even though the shale boom has since 2009 increased US oil production by more than 40 per cent and natural gas production by around a third. Quite simply, there has never been an American recovery this long and this shallow.
The US does seem an exception to the downward growth trends in China, Canada and several European economies, including Germany. JP Morgan’s Global Composite PMI, which measures global economic expansion, suggests a significant slowdown since February this year, after a steady climb since early 2016. Crude oil prices have fallen sharply in recent weeks even with the US imposing sanctions on Iranian oil exports from 5 November, while there were sufficient supply worries in late September to produce a sharp price spike.
The eurozone appears most at risk of a recession, although a number of individual economies are performing comparatively well. Growth in the third quarter was the weakest since the second quarter of 2014. Germany’s economy contracted and Italy’s experienced no growth. If the eurozone’s troubles were confined to Italy, there would be less cause for concern. But even Germany’s powerhouse economy is weakening: retail sales and exports have fallen for several successive months.
China’s position, meanwhile, is crucial since the world economy has for nearly a decade lived off the combination of QE and Chinese private credit creation. Economic growth in China has been slowing since the second half of 2017, and even the growth of the first half of that year was an interruption of a downward slope that began in 2013. Predictions of a Chinese financial crisis, owing to the country’s huge accumulation of debt since 2008, are made too readily. But China is now caught between a policy shift towards deleveraging to try to avoid such a debt-induced financial crisis, and another debt-financed push for higher growth amid an economic slowdown and a fierce trade war with the US. The Chinese government is struggling under these conflicting imperatives as the country’s dollar reserves fall.
The picture in the US is also more complex than the headline data might suggest. Provisional figures for September show the largest monthly fall in house prices since the last housing crash, and existing house sales have dropped for six successive months. Car sales, historically a significant predictor of future economic contraction, have also been plummeting. The official US unemployment rate stands at 3.7 per cent, the lowest since 1969. But this masks a notably low participation rate (62.9 per cent), as significant numbers of people have withdrawn from the labour market. Ever-fewer jobs sustain middle-class lifestyles, especially in cities where housing costs have risen over the past decade.
The current US economic cycle appears unprecedented because neither upward nor downward moves have proven robust. The annualised growth rate fell through the first three quarters of 2016, reaching a rate of just above 1 per cent, but then steadily climbed from the fourth quarter of 2016 into 2017. When President Trump proclaimed the era of 3 per cent-plus growth was back, the 2017 economy delivered a relatively poor fourth quarter and the milestone was missed. In the terrain of this new economic world, there could be long stretches of flat land.
The caveat, however, to any assumption that this new world is establishing recognisable patterns is that it has overwhelmingly been shaped by central banks, and central bankers are now openly expressing their desire to find a way out of it. They want to “normalise” monetary policy – raise interest rates and end QE – because they fear that in the next recession they will have insufficient room to act without recourse to negative rates. In the eurozone, this environment has already exacerbated the misallocation of capital and upset German savers. The country’s electorate needs to be convinced that the euro is not a union that condemns Germany to permanently inappropriate interest rates because of others’ debt. Should central banks achieve significant monetary tightening, their own actions may well be the most likely path to the next recession.
Canadian growth has been falling sharply since after the Bank of Canada began a series of interest rate hikes in 2017. Tighter monetary policy will depress consumer demand quite quickly, given high levels of household debt in many countries. The US Federal Reserve Board’s recent hikes will also cause serious problems in China as dollar-exposed corporations struggle for access to dollars, and the rest of the world will not be able to escape the consequences.
Nonetheless, the reasons central banks have pursued historically exceptional monetary policies over the past decade, and the consequences they have had for the allocation of capital and credit, also make this attempted retreat profoundly difficult. The new Federal Reserve chairman, Jay Powell, may have made it clear he does not regard maintaining financial market asset bubbles as any part of his job description, but the upshot has been that share prices have had a number of sharp daily losses this year. Since so many asset prices have become correlated, the potential for financial market carnage if he continues with hikes is considerable.
Corporate debt, for its part, will only withstand a little monetary tightening, and much of it is held by pension and insurance funds for whom the post-2008 monetary world has been largely disastrous. The position of shale companies appears, on the surface at least, particularly vulnerable to the return of higher corporate bond yields, given that many are still struggling, even with higher oil prices for much of this year, to generate a positive cash flow.
Yangshan Port, Shanghai: China’s trade war with the US is a major risk to the global economy
Central banks cannot fix what they set in motion after 2008. There appears to be no way forward that would let this economic cycle play out without risking much more disruption than the typical recession would bring. What is at stake is compounded by the problem of oil: shale production must be sustained by one or more of the following: high prices, extremely cheap credit or investors’ indifference to profitability.
When a recession does come, central banks are unlikely to be able to respond without wading even further into uncharted monetary and political waters. And major economies will have significantly higher levels of debt than in 2008, interest rates will already be low and central banks will have enormous balance sheets. As a consequence, a policy response comparable to that of 2008 is likely to be more dangerous and insufficient to restore sustained growth. In times of fear, high debt ensures that, beyond a certain point, consumers simply cannot be incentivised to spend more. Even if they were to be tempted with “helicopter money” from central banks – new money distributed freely to citizens – there is no guarantee at all that the money would do much for aggregate demand.
If, meanwhile, the response to negative interest rates becomes the withdrawal of savings from banks, then central banks might be drawn towards attempting to abolish physical cash. Such an action would almost certainly induce large-scale resistance and serious unintended social and political consequences.
The superficially less risky alternative would be fiscal stimulus – higher public spending and tax cuts – focused on high-value infrastructure. But owing to existing debt levels in many states this would likely necessitate partial debt write-offs, which would have a profoundly destabilising effect on banks and financial markets. Debt write-offs are also probably unthinkable for the eurozone in view of the German government’s position that monetary union must rest on a disciplined approach towards debt.
There is little reason for optimism that the world’s political leaders are well-equipped to confront the recessionary world when it emerges. This is not necessarily because the cast of characters now in office is diminished in quality compared to a decade ago. The effect of political leaders’ actions in response to the 2008 crash is often overstated. It mattered much more what the central banks, and the Federal Reserve Board in particular, did. It wasn’t Gordon Brown who saved the Royal Bank of Scotland, but Ben Bernanke, chair of the Federal Reserve from 2006 to 2014.
Rather, this time around political leaders will not be able to let central banks make monetary decisions as if they do not have political consequences. Dispersing helicopter money and abolishing physical cash will not look like technocratic judgements and, thanks in part to analysis by some central banks and the rhetoric of the 2016 US presidential election, more citizens may now understand that QE drives up wealth inequality. Nor, in an age of political disruption in which the traditional centre is weak, will governments readily find common ground with each other. This problem will be compounded by the clashes of interest between advanced economy states over oil and gas, in circumstances where energy supply cannot be separated from monetary policy.
Fear at what comes next stalks the world economy even, or perhaps especially, in those markets where investors appear most indifferent to risk. Finding a way beyond it will entail a reckoning with the last recession and the monetary world that central banks made in its aftermath. The 2007-09 recessions exposed the political discontent that had grown in Western democracies over the previous decade. The next recession will begin with that discontent already bringing about substantial political disruption – from Brexit to Trump’s election to the Lega-Five Star coalition in Italy – which in itself has become a source of economic fear. The economic dangers that lurk are only likely to increase political fragmentation, especially when there is little understanding of the structural economic forces that serve to divide people.
The rebellions in democratic politics in the past few years have also primarily focused on immigration, fiscal austerity and, in the United States, trade. Notably, there has been no significant rebellion by savers against such a lengthy period of low interest rates. Even in Germany, the vehicle of a savers’ rebellion through the formation of Alternative für Deutschland was soon bypassed by that party shifting towards a focus on immigration.
If the ECB has, however, to move further into the territory of negative interest rates, savers’ discontent is unlikely to remain suppressed politically. This problem is exacerbated by pensions. QE has left investment-funded pensions extremely vulnerable because of poor bond yields. Their only protection has been the asset bubble in share prices, which at some point will burst. The dynamics of generational politics, then, will change from those to which we have recently become accustomed. There are no policies available that can, even over a whole economic cycle, reconcile the interests of those shut out of becoming mortgage debtors, those presently burdened with large mortgage debt and those needing a meaningful return on savings, even before the possibility arises of central banks effectively compelling consumption.
It has become impossible to confront the economic predicaments in the global economy without contemplating sacrifice, whether that be politicians and central bankers choosing where the heavy costs of the next policy response will fall, or recognising the role that energy sustainability has in maintaining material living standards and a liberal international politics. History is full of grisly episodes, usually in eras of revolution, when the politics of sacrifice have come to the fore. Indeed, in many ways, the whole ideal of Western liberal democracies in the postwar world has been about the importance of avoiding such a politics, even as the policies governments pursued unavoidably created winners and losers.
But the conditions for politics have now become much harder, and the collective and individual question of our times has become how we can confront the inescapable political conflict generated by deep economic dysfunctionality without losing the democratic and liberal foundations of political order as we know it.
Helen Thompson is professor of political economy at the University of Cambridge and a regular on the Talking Politics podcast
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