Longer-term Prospects for US, Europe

Yılmaz Akyüz

23/10/2013

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Below is an analysis of the prospects for the US and European economies. It is part of the analysis of the policies of these two major economies, which were already carried in SouthViews. The larger paper on which this is based also examines the spillover effects of these policies on the developing countries. (See the note at the end of this article on accessing this paper).

Five years into the crisis, growth in the US is still below potential, Europe is struggling to get out of recession and major emerging economies are slowing rapidly after an initial resilience during 2010-11. Longer-term prospects are not much brighter largely because the key problems that gave rise to the most serious post-war crisis, income inequalities, external imbalances and financial fragilities, remain unabated and have indeed been aggravated.

The world economy suffers from an underconsumption bias because of low and declining share of wages in GDP in all major advanced economies (AEs) including the US, Germany and Japan, as well as China (Chart 4). Still, until 2008-09 the threat of global deflation was avoided thanks to consumption binges and property booms driven by credit and asset bubbles particularly in the US and the European periphery. Several Asian developing countries (DCs), notably China, also experienced investment and property bubbles while private consumption grew strongly in many DCs elsewhere, often supported by the surge in capital inflows and asset and credit bubbles. This process of debt-driven expansion created mounting financial fragility in the US and the EU and growing trade imbalances and culminating in the Great Recession.

The crisis has not removed but reallocated global trade imbalances. Before the crisis the US acted as a locomotive to three major underconsumption-cum-surplus economies, China, Germany and Japan, running growing current account deficits, due to a surge in private spending driven by the sub-prime bubble. During 2004-07 GDP growth exceeded growth of domestic demand in all three surplus economies. After 2007 the US deficit fell sharply and the Eurozone (EZ) moved from a $100 billion deficit to a $300 billion surplus. Germany has continued to rely on exports and its current account surplus reached 7 per cent of GDP while both Japan and China have increasingly relied on domestic demand and their current account surpluses have dropped drastically. With the cut in current account deficits in the EZ periphery, a higher proportion of this growing German surplus is now running with the rest of the world. In other words, Germany has become a major drag on global growth by maintaining a lid on domestic demand and relying increasingly on exports.

As already noted, the crisis has also widened income and wealth inequalities in both the US and EU and hence aggravated the underconsumption bias. In the EZ, the structural reforms advocated for removing intra-regional imbalances are likely to extend wage suppression further to the periphery and widen the deflationary gap. Furthermore, the crisis has produced new sources of financial fragility, largely because of excessive reliance on ultra-easy monetary policy to fight instability and contraction. Under these conditions the likelihood for the world economy to move to a path of growth that is both stable and strong is slim.

United States: Monetary policy dilemmas

Longer-term global prospects depend a lot on the US due to its central position in the world economy and the international reserves system. It is highly unlikely that the US can move to a wage-led growth in the near future. Nor can it shift to export-led growth. This would require, inter alia, exports to grow faster than domestic demand and the share of private consumption in GDP to fall. This is difficult to achieve since for several decades the US has constantly lived beyond its means thanks to its “exorbitant privilege” as the issuer of the central reserve currency. Besides, there is no other economy that could act as a locomotive to the US.

Thus, a key question is if the US would be inclined to go back to “business as usual” and allow credit and asset bubbles in search for a relatively rapid growth. This is closely connected to its exit from the ultra-easy monetary policy. Clearly, exit implies not just increased policy interest rates but also the normalization of monetary policy - the federal funds rate to become again the main instrument of policy, a significant contraction in the size of the Fed’s balance sheet and the volume of excess reserves that depository institutions hold at the Fed and a large shift of the Fed’s asset composition back to short- and medium-term Treasuries. Monetary tightening would call for raising policy rates, including interest rates on excess reserves, and these would be reflected in long-term rates. The latter would also rise as a result of portfolio rewinding.

A strategy that the Fed should gradually exit from the quantitative easing (QE) 3 but maintain low policy rates for several more years in order to support growth and use macro-prudential regulations to limit systemic risks appears to be enjoying considerable support. However, it may not be easy to engineer such a process without jeopardizing financial and macroeconomic stability. Uncertainty abound because there are not many historical precedents for exit from extended periods of zero-bound interest rates and QE.

Even a gradual return of the Fed balance sheet to “normal” size and composition may result in a considerable hike in long-term rates even if policy rates are kept low for an extended period. The prospects for exit from the QE3 in the coming months have already pushed up the yield on the US 10-year Treasury bond to almost 3 per cent in August 2013 from around 1.60 per cent in May.

Second, macro-prudential policy is uncharted waters; there is considerable ambiguity over what it contains and how it may be operationalized and linked to broader areas of policy that influence systemic risks, including monetary policy. They cannot always be relied on to prevent excessive risk taking and credit and asset bubbles if there is plenty of money available at low interest rates. In all likelihood, monetary instruments may have to be deployed as part of macro-prudential policy if bubbles threaten stability, but this could cut growth. If they are not, then the outcome may well be another boom-bust cycle.

If, on the other hand, concerns about financial instability and the effectiveness of macro-prudential measures come to dominate, the Fed may be obliged to exit rapidly. This would result in a hike in short- and long-term interest rates and give a major shock to the financial system as in 1994. It would result in slower growth and stronger dollar. A too rapid an exit and re-pricing of substantially increased stock of debt could even cause a hard landing in the US by leading to large losses for bond holders and depressing private spending.

These dilemmas arise in large part because of excessive reliance on monetary policy to combat recession and the reluctance to use fiscal expansion and debt restructuring to stimulate aggregate demand. A Goldilocks scenario in which the exit is neither too slow to endanger financial stability nor too rapid to choke off growth is likely to be no more than a fairy tale. The extended period of easy money has sharpened the trade-off between financial stability and growth by allowing considerable build-up of bank liquidity and distortions in the Fed’s balance sheet. If the Fed targets growth and pursues a slow exit, credit and asset bubbles could build up rapidly, threatening to culminate in a bust. If it focuses on avoiding bubbles and exits rapidly, then it could cut recovery short and may even push the economy back into a recession.

The normalization of monetary policy in the US will also cause problems for emerging economies. Despite occasional complaints about the “currency war” entailed by liquidity expansion in several major AEs simultaneously, the policy of ultra-easy money has generally been benign for emerging economies. It has been a major factor in the sharp recovery of capital inflows after the sudden stop caused by the Lehman collapse in September 2008. Many major emerging economies such as India, Brazil, South Africa and Turkey have come to depend on such inflows as their current accounts started to deteriorate. They have invariably welcomed the asset bubbles that such inflows have helped generate and often ignored the financial fragilities caused by increased exposure to interest rate and exchange rate risks by the private borrowers abroad. Such exposures are on the rise since the beginning of 2012; as funds have started to be withdrawn from domestic securities markets, emerging economies have increasingly relied on international debt contracted in reserve currencies, which reached, in net amounts, $600 billion between the beginning of 2012 and mid-2013. As the Fed has got closer to ending the QE3 and the long-term US rates edged up, strong downward pressures have started to build up on the currencies, stocks and bonds of several emerging economies such as Brazil, India, South Africa and Turkey which were widely seen as rising stars only a couple of years ago.

The Eurozone: Bleak growth prospects

The longer-term prospects of the EZ are even less encouraging than the US. Deleveraging and recovery are likely to remain extremely slow in the periphery and many countries cannot expect to recuperate the output losses incurred after 2008 for several years to come. Even if the EZ avoids further turmoil and stabilizes, it would not generate much growth under the current policy approach – something that would also make it difficult to sustain stability. Pre-crisis growth in the EZ was mediocre, barely reaching 2 per cent per annum during 2002-07, and much of that was due to debt-driven expansion in the periphery. Post-crisis growth could even be slower.

The periphery cannot go back to a spending spree and large current account deficits that culminated in the crisis. A growth-oriented adjustment in external debt and deficits in the periphery depends on a fundamental change of policy in Germany and symmetry in adjustment between deficit and surplus EZ countries. Germany needs faster wage growth and higher, albeit moderate, inflation to appreciate its real exchange rate. It should abandon fiscal austerity and create demand to help export-oriented adjustment in the periphery. The latter should try to restore competitiveness not so much by creating unemployment and cutting wages as by investment-led productivity growth.

However, none of these are likely to come by. Recent trends and projections for external balances show a decline in deficits in the periphery without a corresponding decline in the surpluses of the core; that is, an increase in the surplus of the region, notably Germany with the rest of the world. The IMF projects that in 2018 the EZ as whole will run a current account surplus of 2.5 per cent of GDP, up from a deficit of 0.7 per cent in 2008. These imply that the periphery would cut deficits either by keeping growth low, or by joining Germany in wage suppression and competitive disinflation (internal devaluation) and expanding exports to the rest of the world. Either would call for maintaining a high level of unemployment.

Then there is the risk of low-growth hysteresis and growth stalling – weak growth generating its own negative momentum. In its latest report the OECD warned that in some AEs “output growth is now close to or below estimated stall-speed thresholds … with the risk that self-reinforcing endogenous dynamics could push them into outright recession.” When a cyclical upswing is below the stall-speed threshold, growth is likely to weaken and eventually become negative. On all current projections growth in the EZ in coming years is expected to remain below the stall-speed thresholds.

Thus, without a fundamental change of policy, the EZ may be caught in a self-reinforcing deflation. A protracted weakness in economic activity would bring down the potential growth rate so that the region may get trapped in low growth, high-unemployment. Indeed in the absence of redirection of policy, the damage could be long-lasting, permanently impairing growth in the region. Thus, despite improved financial stability in the region, the spectre of exit from the euro may come back with greater force to haunt the guardians of the EZ.

- Yılmaz Akyüz is the Chief Economist of the South Centre. Contact: akyuz@southcentre.int.

This is an extract from the South Centre's Research Paper No. 48, on Waving or Drowning: Developing Countries After the Financial Crisis. The full paper is available at www.southcentre.int.

Source: SouthViews No. 83, 23 October 2013.

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