Monday’s big drop on Wall Street sent markets into frenzy as panic briefly swept across the world with each passing time zone. With an apparent return to normal, it’s time to look at what it meant.
Following Wall Street’s lead, this week has seen dramatic plunges across share markets the world over. Seemingly paradoxically, the fall was sparked by good economic news: US wages, and consequently inflation, were finally growing after years in the doldrums. Interest rate rises are likely on the way. Speculation is now rampant as to what is really going on: is this merely a correction amid record stock price highs? Or are we witnessing the beginning of the next big financial crash?
The birth of the bubble
Recent growth predictions certainly belie the more pessimistic outlook. The International Monetary Fund (IMF) began the year by announcing it was revising global growth figures upwards. Although the forecasted economic improvement was predicated on a Republican tax bill that the IMF deems damaging to the US economy in the long-run, it nevertheless predicted the tax bill would have a positive immediate impact. In the short run, it was deemed likely to galvanise an already promising global economy experiencing “the broadest synchronised global growth upsurge since 2010”.
At face value, such a proclamation does indeed seem justified. Europe is witnessing its best economic conditions in a decade, with GDP growth hitting 2.5 per cent in 2017. The American economy is also proving to be robust and is facing its lowest level of unemployment in 17 years. China, meanwhile, has continued to confound predictions of economic slowdown by increasing its GDP growth in 2017. Taken together, such news seems to indicate a global economy finally strengthening after years of weak growth following the Global Financial Crisis (GFC).
Unfortunately, as the recent share selloff hints at, a latent crisis lies beneath all the good news. While the return to growth represents the beginning of a long-awaited recovery, it is also a harbinger of the end to an extraordinary era of monetary policy. To understand why, it is necessary to understand what this policy entailed. When financial markets froze and the global economy tanked during the GFC, central banks embraced a little-tested, controversial measure known as quantitative easing to stimulate moribund economies.
Quantitative easing involves the mass purchase of safe assets (mostly government bonds) by central banks to inject liquidity into financial markets and lower the cost of lending. When banks effectively ceased lending and economic activity collapsed during the GFC, quantitative easing functioned to restore confidence and boost demand. It was used in Europe, the US and Japan and did indeed prove effective; combined with massive government spending programs, the world economy halted its tailspin faster than it did during the most recent comparable financial collapse, the Great Depression.
The problem, however, is that quantitative easing was supposed to be a short-term measure; instead, it has persisted for a decade. The post-GFC era has been one of tepid growth and low inflation. Fearing that withdrawing their exceptional support might undermine already feeble growth, central banks have continued massive bond-buying programs to prop up shaky financial markets. This is most clearly seen via the balance sheets of the American, Japanese and European central banks: their assets grew from just over USD$3 trillion (AUD$3.8 trillion) in 2007 to around USD$15 trillion today.
The consequences of this have been profound. Although it has largely taken until 2018 for a real recovery to get underway, recent years have seen asset and equity prices skyrocket to record highs. This has been most apparent throughout global stock markets, but can also be seen in the booming housing prices of the West and unwaveringly high bond prices. The surge in prices can be explained via economics 101: demand has massively increased as cheap money has sloshed throughout financial systems, while the supply of assets has remained constrained.
A dangerous addiction
The reason for this constraint? Look to a phenomenon known as secular stagnation. Recently popularised by former US Treasury Secretary Larry Summers, secular stagnation posits that the long-term growth potential for developed countries shifts permanently lower due to a variety of limiting factors. Chief among these today are ageing populations and stagnant productivity. Importantly, lower growth means diminished prospects for profitable investments. This, combined with endless money-printing, has created the dangerous asset price inflation that we see today. More money has gone after less opportunities, leading to what Summers’ predicted would be “a prolonged period in which satisfactory growth can only be achieved by unsustainable financial conditions”.
Such unsustainable financial conditions were pressingly highlighted by Professor William White, a chief economist at the OECD, during the recent World Economic Forum in Davos. Professor White painted a dangerous picture of global finance. He pointed out that global debt levels have vaulted well beyond the levels seen prior to the GFC, with debt fuelled by quantitative easing in the West flowing into risky investments in developing markets. Furthermore, he asserts that Western credit markets are showing signs of deterioration daily, as repayment problems begin to emerge across a variety of unsustainable debt instruments issued in markets desperate for decent returns. Most disturbingly, he declared that market indicators appeared strikingly similar to just before the collapse of Lehman Brothers during the GFC.
It is not surprising that financial markets caught serious jitters when faced with the prospect of the end to quantitative easing and a rise in interest rates. But while the story of stock market falls is undoubtedly ominous, the more daunting concern pertains to what might happen next. The world’s weak recovery from the GFC has seen government debt levels rise almost universally. Central banks have kept interest rates near zero while feverishly propping up financial markets. If a financial crisis were to emerge, the traditional tools of fiscal stimulus and expansionary monetary policy would be largely unavailable to much of the developed world. Despite good news to start the year, dark clouds loom over the global economy in 2018.
Adam Bell works as a researcher at the AIIA National Office. He has completed a Bachelor of Economics at the University of Queensland and is currently writing his thesis as part of the Master of International Relations program at the Australian National University.
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