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Global
The world
economys titanic
problem
Coping with the next recession
without policy lifeboats
13 May 2015
Stephen King
Chief Economist
HSBC Bank plc
+44 20 7991 6700
stephen.king@hsbcib.com
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13 May 2015
Federal funds target rate (horizontal lines show ECRI business cycle troughs)
20
20
16
16
12
12
0
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
13
15
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Yield
Yield
Lehman Brothers
collapse
7
6
-2
-2
-4
-4
-6
-6
-8
-8
-10
4
3
2
-10
-12
-12
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 14
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
Other regions offer a similar narrative. True, the European Central Bank tried to raise interest rates in
2011, but its attempts ended in ignominious failure: having reversed its rate increases, the ECB is today
committed to quantitative easing that, on current plans, is likely to extend all the way through to
September 2016. The Bank of Japan is in a similar position. The Bank of England is no longer
increasing its balance sheet via quantitative easing but, despite having had the urge, it has so far been
unable to find an opportunity to raise interest rates. Fiscal positions, meanwhile, are mostly poor at
least when compared with those pre-crisis.
4. The ECB raised rates and ended up with egg on its face
Index
600
500
500
400
400
300
300
200
200
100
100
%
5
-1
-1
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
ECB repo rate
ECB deposit rate
Index
600
0
07
08
09
10
BoE
11
12
ECB
13
Fed
14
15
BoJ
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13 May 2015
6. The recovery since the last trough has been very weak in the US
%
5
%
5
0
Mar-75
Jul-80
Nov-82
Mar-91
Nov-01
Jun-09
A second reason for a lack of action reflects at least in part the very weak starting point. The US
economic collapse during the global financial crisis was far worse than experienced during all previous
post-war downswings. From peak to trough, US GDP fell 4.2% (see table 7).
In the past, however, deep recessions were typically followed by strong recoveries. This time around, a
deep recession has been followed by an insipid recovery: more L-shaped than V-shaped. Chart 8 shows
the average annual growth rate for the US economy from equivalent peaks in economic activity since the
1970s: this time around, performance has been hugely disappointing.
7. The overall decline in US GDP through the financial crisis was huge compared with earlier recessions
Cycle
Peak date
Trough date
1953-1954
1957-1958
1960-1961
1969-1970
1973-1975
1980
1981-1982
1990-1991
2001
2007-2009
July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
March 2001
December 2007
May 1954
May 1958
February 1961
November 1970
February 1975
August 1980
November 1982
February 1991
November 2001
May 2009
Annualised average
% change
Total % change
-2.5
-4.0
-0.4
-0.2
-2.5
-4.4
-2.1
-2.7
0.7
-2.9
-1.9
-3.0
-0.3
-0.2
-3.1
-2.2
-2.5
-1.3
0.5
-4.2
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8. The growth rate of the US since the last peak in economic activity has been pitiful
%
5
%
5
0
Nov-73
Jan-80
Jul-81
Jul-90
Mar-01
Dec-07
This, in turn, might imply that the US economy still has a significant shortfall in demand: activity has yet
to return to the path that might have been predicted before the onset of the financial crisis. Put another
way, perhaps the US still has a sizeable output gap. Some have argued that this persistent weakness
reflects a premature decision to tighten fiscal policy when what was needed was continuous fiscal stimulus.
However, other measures of slack in the economy dont fully support for this view. Charts 9 and 10 show
the unemployment rate and the manufacturing capacity utilisation rate for the US economy going back to
the mid-1970s. In each case, the first increase in Fed funds in each tightening cycle is marked with a
vertical line. On both measures, the amount of slack in the US economy is no greater than in earlier
economic cycles: indeed, it could be argued that the Federal Reserve is behind the curve.
9. Back to normal on the unemployment rate.
%
12
US unemployment rate
11
11
10
10
3
75 78 81 84 87 90 93 96 99 02 05 08 11 14
%
90
%
90
85
85
80
80
75
75
70
70
65
65
60
60
75 78 81 84 87 90 93 96 99 02 05 08 11 14
That view, in turn, might reflect the impact on supply performance of the financial crisis either in terms of
a drying-up of credit to start-up companies and otherwise rapidly-expanding smaller enterprises or,
instead, as a result of the creation of exceptionally easy financial conditions for large inefficient
companies, thereby limiting the impact of Schumpetarian creative destruction. Either way, a lower
long-term growth rate and associated weak productivity growth would imply a structurally lower level
of real interest rates, exactly what weve witnessed in the post-crisis world.
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A third reason for a lack of action and doubtless a big influence on central bankers tasked with meeting
inflation targets is the persistence of low inflation, measured in terms of both prices and wages.
Charts 11-13 show both headline and core consumer price inflation alongside wage growth in the US
since the mid-1970s, again with vertical lines representing the beginning of each cycle of monetary
tightening. There have been no occasions during which the Fed has raised interest rates when headline
inflation has been as low as it is today. There has been only one occasion when interest rates were raised
when both core inflation and wage growth were as low as they are today and that was at the beginning
of the last tightening cycle. And no one today including members of the FOMC expects interest rates
to rise as quickly or as far as was the case back then (chart 14). So long as inflation stays low and, in
particular, so long as inflation remains below target the case for aggressive monetary action within the
context of current central bank mandates appears to be weak. That message has only been reinforced by
the persistent habit in the post-financial crisis word for forecasters to over-estimate inflationary outcomes:
there is a lot less inflation out there than is commonly supposed (chart 15).
11. US headline inflation is non-existent
% yr
16
% yr
16
14
14
12
12
10
10
-2
-2
70
73
76
79
82
85
88
91
94
97
00
03
06
09
12
15
US core inflation
12
12
10
10
0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
% Yr
US wage growth
% Yr
10
10
0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15
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%
7
0
0
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18
2015 projections
2016 projections
2017 projections
Forward curve
15. Inflation has been lower than expected by the consensus in most major countries and regions
Index
10
Inflation surprise
Index
10
-10
-10
-20
-20
-30
-30
Jan-12
Apr-12
Jul-12
US
Oct-12
Jan-13
Eurozone
Apr-13
Jul-13
Oct-13
Japan
Jan-14
UK
Apr-14
Jul-14
Oct-14
Canada
Jan-15
Apr-15
Asia
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Headline inflation
Core inflation
0.0
1.6
0.0
-0.1
1.8
0.7
1.0
0.6
*National CPI excluding VAT effect. Japanese core CPI is "US style core" (ex food and energy)
Source: National sources Note: Inflation rates for March 2015
Try to avoid it
Higher levels of bank capital, greater liquidity buffers, more aggressive stress tests, macro-prudential
policies: each of these is designed to prevent a repeat of the global financial crisis. In meeting that
relatively narrow aim, they might well work. However, theres more than one crisis, more than one
recession. In the postwar period, recessions have been caused by exogenous shocks (1970s oil price
hikes), inflationary battles (the Volcker monetary tightening in the early 1980s), credit slumps (the early
1990s credit crunch) and the bursting of equity bubbles (2000). While it is tempting to believe that all
recessions have roughly the same causes, in reality they dont one reason why they are so difficult to
predict. A warning comes from the IMF in its latest Global Financial Stability Review: in Europe, the
challenges facing life insurers shouldbe tackled promptly. Regulators need to reassess the viability of
guarantee-based products and work to bring minimum return guarantees.in line with secular trends in
policy rates. Promptactions are needed to mitigate damaging spillovers from potential difficulties of
individual insurers. There is no shortage of systemic risks.
The danger for policymakers is not so much that they havent worked hard to prevent the next crisis but,
rather, they cannot easily know in advance what the next crisis might look like. Admittedly, they can at
least hope to make sure that the financial system itself will be more resilient in coming crises than it was
in the last crisis, but that doesnt alter the fact that all previous crises whatever their cause have been
accompanied by sustained easing of monetary and fiscal policy.
Table 16, for example, shows the extent to which US policy rates have fallen from peak to trough
across all downswings since the 1970s. On average, rates have fallen 6.2 percentage points. At a
minimum, they have fallen 5.0 percentage points. Other than the huge early-1980s decline as Paul
Volckers monetary medicine began to work, the amplitude of interest rate cycles has been remarkably
similar, even if the level of interest rates across cycles has varied: across all cycles, interest rates have
fallen between 5 and 6.25 percentage points. Today, they cant really fall at all unless we end up in a
world of increasingly negative nominal interest rates, a situation that might ultimately prove highly
damaging to the stability of the financial system if people increasingly chose to withdraw funds from
banks to store in the form of cash.
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17. US rates normally fall a long way during downswings now they cant (%)
End of easing
cycle
4.75
11.00
8.00
5.88
3.00
1.25
0.25
-
11.00
16.50
19.00
11.44
8.00
6.50
5.25
-
-6.25
-5.50
-11.00
-5.56
-5.00
-5.25
-5.00
-6.22
July 1977
September 1980
February 1984
November 1986
January 1994
June 2004
December 2008
Average
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2011
2001
1991
1981
45
40
35
30
25
20
15
10
5
0
1971
1961
1951
1941
1921
1911
1901
1891
1881
1931
Shiller PE ratio
45
40
35
30
25
20
15
10
5
0
%GDP
14
US profits as %GDP
%GDP
14
12
12
10
10
6
50 55 60 65 70 75 80 85 90 95 00 05 10 15
This creates a tricky dilemma for central banks. Quantitative easing was adopted originally not only to
push up the value of financial assets but also to encourage higher levels of spending: households would
feel wealthier thanks to rising real estate and equity prices while listed companies would more easily be
able to raise funds for investment thanks to buoyant stock markets. To the extent that QE prevented a
1930s-style meltdown, that ambition might have been met. Policymakers, however, hoped not only to
avoid a depression but also to encourage a return to reasonable economic growth. That has proved more
difficult. Even the better economic performers notably the US have struggled to return to the growth
rates of old.
It may be that QE has merely driven a wedge between financial hope and economic reality. Worse, if the
next recession simply provokes more QE, are investors already beginning to believe that, once again, they
are to be continuous beneficiaries of what was once affectionately known as the Greenspan put? This
was the belief held most strongly during the late-1990s tech bubble that the Fed would stand ready
to offer support in the event of economic weakness, inevitably encouraging even more in the way of
risk-loving behaviour.
Knowing that central banks are potentially hooked on QE for the long term is, at best, likely to lead to the
mis-pricing of financial assets. That, in turn, might lead to a deterioration in the quality of investment
and, hence, lower productivity growth over the medium term. At worst, it may lead to a repeat of the
asset price bubbles that have proved to be so disruptive to economic activity. In the absence of
conventional policy ammunition, an addiction to QE could ultimately mean that the second great
depression was only postponed, not avoided altogether.
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Its not just the financial crisis that demonstrates this problem. In the late-1980s, Japanese inflation was
mostly well-behaved: between 1985 and 1990, the average rate was a mere 1.1%. Judged on inflation
outcomes alone, it appeared that Japanese policymakers were doing a very good job. Indeed, given that
inflation was, on average, below the 2% rate which has become the inflation target du jour, it could be
argued that Japanese monetary policy was, if anything, too tight.
20. Japanese inflation was too low in the late 1980s even though monetary conditions were too loose
%Yr
%Yr
10
10
-2
-2
80
81
82
83
84
85
86
87
88
89
In hindsight, however, its clear that monetary conditions in Japan in the late-1980s were far too loose.
Inflation may have been quiescent, but equity and land prices were soaring, corporate debt was exploding
and monetary growth was through the roof. The absence of inflation merely camouflaged the underlying
imbalances emerging within the Japanese economy. Eventually, of course, the bubble burst, asset prices
collapsed, deleveraging began in earnest, monetary growth shrivelled and Japan succumbed to deflation
and, thereafter, to two lost decades.
Taking the Japanese experience and, indeed, the experience of the US in the years before the onset of
the global financial crisis it could be argued that central banks should stick to their inflation targets less
rigidly. There are times when an inflation rate higher than 2% might be perfectly acceptable. Equally,
there are times when an inflation rate significantly lower than 2% perhaps even a period of deflation
might be acceptable, notably during periods of excessive hot money inflows which boost both asset prices
and the value of the exchange rate (as happened in Japan in the late-1980s and may now be happening in
Sweden). What matters is not the inflation rate alone, but rather the inflation rate in the context of
broader measures of financial and economic instability. In Japans case, monetary policy in the 1980s
should have been tighter than it was, even if the inflation rate would have been even lower as a result.
Tighter monetary policy would have reduced the risk of asset price bubbles and credit booms. Ironically,
it might even have reduced the risk of deflation in the 1990s: a smaller asset price bubble would
presumably have led to a smaller asset price bust.
In the late-1980s, virtually all indicators suggested Japan should raise interest rates: money supply, credit
growth, asset prices, unemployment, a rapidly-narrowing balance of payments surplus and rapid
economic growth all suggested interest rates should be higher. Only the inflation rate suggested there was
no need to act. The situation today, however, is rather more ambiguous. The problem is not so much a
11
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disconnect between the inflation rate and all other indicators: it is, instead, a disconnect between growth
and inflation on the one hand and asset prices on the other. There is, if you like, both a real and a virtual
economy, and they are heading in different directions. Tighter monetary policy to deal with potential
asset price bubbles might simply intensify deflationary pressures or throw economies into recession
(as the ECB and Riksbank discovered having raised interest rates in 2011). Continuously loose monetary
policy designed to support growth and prevent inflation from falling too far might simply intensify asset
price bubbles, paving the way for eventual economic collapse.
300%
300%
The Battle of
Waterloo
250%
250%
Income tax
introduced
200%
200%
150%
150%
100%
100%
50%
50%
0%
0%
1700
1725
1750
1775
1800
1825
1850
1875
1900
Source: Bank of England. Number since the global financial crisis include the debts of publically-owned financial institutions
12
1925
1950
1975
2000
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120
World War 1
Civil War
100
%GDP
Projections
World War 2
120
100
80
80
60
60
40
40
20
20
0
0
1790
1830
1870
1910
1950
1990
2030
Those increases are, in effect, a consequence of claims already made on future economic production,
most obviously in areas associated with population ageing: pensions and healthcare. It is the same story
through much of the developed world. Government debt levels are set to rise rapidly as a share of GDP
even in the absence of another recession. Throw a recession into the mix and its a lot more difficult to
see how much cyclical fiscal flexibility there could be unless governments and voters are ultimately
willing to follow Japans path: slow growth thanks to an ageing population accompanied by eyewateringly high levels of government debt.
These future claims suggest the room for fiscal flexibility is a lot smaller than was the case in the 1930s
when Franklin Delano Roosevelt launched his New Deal. Back then, Roosevelt inherited a fiscal position
from Herbert Hoover that was relatively healthy: an insignificant deficit accompanied by government
debt that amounted to only 38% of GDP. Moreover, there were no significant future spending
commitments of the kind we see today. Fiscal stimulus a novel idea at the time may have been
controversial, but the chances of it working to boost economic activity were quite high given the healthy
starting position and an absence of future spending commitments. Today, it is much more difficult to
make the same argument. The best that can be said and this certainly chimes with the Greek experience
is that pursuing aggressive fiscal austerity in the midst of a deep recession is likely to end in tears. That,
however, is not an argument in favour of aggressive fiscal activism.
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not translated fully into decent economic growth and higher inflation which, in turn, suggests it might
not be immediately effective in another downswing.
An alternative approach is simply to accept that debts are too high and that their value needs to be
reduced. There are many explicit ways of doing this ranging from default, public spending cuts and
punitive wealth taxes but there is also one much-used implicit way: the creation of inflation.
Despite huge amounts of monetary stimulus zero interest rates and quantitative easing so far there has
been little evidence that central banks have managed to push inflation higher on a sustained basis. True,
UK inflation was higher than expected in the years following the financial crisis but the rate subsequently
collapsed. Japanese inflation excluding the consumption tax - edged a little higher in the months
following the adoption of QE in 2013 but, more recently, has been heading lower again. If the aim is to
reduce the real debt burden via higher inflation, its clear that the policy has, so far, failed.
There is, however, a way of almost guaranteeing higher inflation. Its called helicopter money. It works only if
the fiscal and monetary authorities work together not only to expand the supply of money but also to guarantee
the extra money is spent rather than saved. The finance ministry announces a large increase in government
borrowing funded by bond sales not to the public but, instead, to the central bank. The newly-issued money is
then used to provide a monetized tax cut or increase in public spending. In other words both the supply of
money and its velocity rise, virtually guaranteeing an acceleration in the growth rate of nominal GDP. The
likelihood in the short term would be a rise in both prices and quantities.
If, however, the benefits of this policy are so blindingly obvious, why has no government or central bank
so far fully gone down this irresponsible path? The answer is simple. Monetized deficit financing can
all too quickly lead to a loss of faith in the integrity of a countrys monetary and financial institutions.
The risk is a mixture of currency collapse on the foreign exchanges and, eventually, a revulsion towards
money that would create a world of hyperinflation. Preserving the integrity of our monetary and financial
institutions is an important public good: risking another 1920s Weimar or modern-day Zimbabwe doesnt
make a whole lot of sense (chart 23).
23. No one wants a Zimbabwe
Zimbabwe inflation rate
250000000%
250000000%
200000000%
200000000%
150000000%
150000000%
100000000%
100000000%
50000000%
50000000%
0%
0%
99
00
01
14
02
03
04
05
06
07
08
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USDbn
500
400
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
00
Current account
01
02
US
03
04
05
06
China
07
08
USDbn
500
400
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
09
Germany
10
11
12
13
14
Japan
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One possible explanation for the persistence of structurally-low interest rates is that the Eurozone has
replaced China and Japan as the saver of first resort: an ever-larger German current account surplus has,
more recently, been accompanied by smaller deficits and even surpluses in austerity-hit southern Europe.
Even this, however, doesnt quite capture the underlying problem: after all, balance of payments positions
are merely accounting identities which say nothing about the level of interest rates required to make sure
the numbers add up.
A more fruitful explanation which certainly ties in with German savings behaviour is that nations with
ageing populations are full of people keen to postpone expenditure from the present to the future, in the hope
that they will be able to enjoy a long and rich retirement. Each person has an intuitive sense of the required
amount of financial wealth. Yet thanks to peoples collective savings behaviour, their individual wealth
targets remain out of reach: the more they save, the more interest rates fall; the more interest rates fall, the
lower the returns on their wealth; and the lower the returns on their wealth, the more they have to save.
The underlying problem is that countries with ageing populations tend to suffer from slower growth yet to
pay for all the extra retirees the countries need to have faster growth. If returns on investment are simply
not high enough, all the extra saving will simply reduce interest rates to pitifully low levels, leading for
example to remarkably low returns on annuities.
To break out of this vicious circle, the easy answer economically, at least is for the retirement age to rise.
This would, at a stroke, reduce the need for high savings. Faced with a longer period of work and, hence,
of earned income the need to save to meet a retirement nest-egg objective would be greatly reduced.
Lower levels of savings would mean higher levels of consumption, higher levels of demand and, hence
higher levels of investment. Importantly, faster economic growth would also provide higher tax revenues
and higher interest rates. The ammunition needed to repel the next recession would be replenished.
Unfortunately, the chances of such radical reforms emerging are low. Political expediency because
older people tend to be more willing to vote than the young will doubtless trump economic necessity.
As a result, the recession-fighting ammunition will remain in short supply and the risks of a major
economic contraction will be that much greater. We will carry on sailing across the ocean in a ship with a
serious shortage of lifeboats. Many including the owner of the Titanic thought it was unsinkable: its
designer, however, was quick to point out that She is made of iron, sir, I assure you she can.
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Higher US wage costs alongside continued weak productivity growth leading to a falling profit share
within US GDP, triggering a collapse in equity prices, a loss of confidence among both households and
businesses and, thus, another economic contraction. Put another way, another equity bubble bursts.
A series of increasingly-systemic failures within the non-bank financial system as both pension funds
and insurance companies find themselves increasingly unable to meet their future liabilities: those
failures, in turn, trigger a huge increase in demand for liquid assets, leading to panic selling and,
eventually, a collapse in demand that paves the way for a recession.
A recession made abroad, not at home: the Chinese economy weakens so much that the authorities in
Beijing have no choice other than to let the renminbi slide. Collapsing commodity prices lead to
severe weakness elsewhere in the emerging world. The dollar surges, but the Fed is unable to
respond via interest rate cuts. The US is eventually dragged into a recession through forces beyond
its control.
The Federal Reserve raises interest rates too soon, in a bid to normalise monetary policy. The
monetary tightening itself reveals the fragile nature of the recovery and the economy quickly goes
into reverse: in effect, the Fed repeats the mistake of the ECB in 2011 and the BoJ in 2000.
And, to make matters worse, these suspects are not mutually exclusive.
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Disclosure appendix
Analyst Certification
The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the
opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Stephen King
Important Disclosures
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1
2
3
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Disclaimer
* Legal entities as at 30 May 2014
Issuer of report
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abc
daniel.john.smith@hsbc.com.au
Li Jing
+86 10 5999 8240
jing.econ.li@hsbc.com.cn
Karen Ward
Senior Global Economist
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Prithviraj Srinivas
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Murat Ulgen
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Janet Henry
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