Eight years on from the global financial crisis, economists are wondering when the next downturn will arrive – and how debt-laden governments and their central banks can possibly fight it.
It was an economic rescue effort like no other in world history. In the immediate aftermath of the Lehman Brothers collapse in September 2008, the major economies’ national governments and central banks took remarkable and concerted efforts to stop the Great Recession turning into another Great Depression.
Central banks slashed official interest rates to extraordinarily low levels, bought up debt to push rates down (quantitative easing) and even, in some cases, set negative rates – measures that previously were barely thinkable. Governments guaranteed large amounts of private debt and pushed up their spending to encourage economic activity.
Though debate still rages, those actions may well have succeeded in preventing the economic downturn turning into something far worse.
Almost eight years later, however, the recovery is still struggling to find traction; the World Bank recently downgraded its 2016 global growth forecast to just 2.4 per cent. Meanwhile, sluggish growth has strangled the flow of tax revenue, making it harder for many governments to wean themselves off deficits and debt.
In the US, public debt as a proportion of GDP is almost 105 per cent, compared with a figure of 120 per cent at the end of World War II. In the UK and France, debt-to-GDP is touching 100 per cent, and in Japan it has topped 250 per cent.
At the same time, central banks are grappling with the legacy of ultra-low interest rates and ballooning balance sheets. The official interest rates of most developed nations are close to (and in Japan’s case, below) zero, and total assets held (excluding the People’s Bank of China) have reached US$11.8 trillion.
It is little wonder that the International Monetary Fund (IMF) recently warned that if there is another severe global downturn, “the needs could exceed the collective resources available”.
And the risks are not small.
A febrile world
The US economy hit bottom more than seven years ago. That in itself is cause enough for concern in an economy whose average expansion lasts less than 60 months. The World Bank warns that the global economy is facing “mounting risks” from slow growth in advanced economies, low commodity prices, weak global trade and diminishing capital flows. IMF managing director Christine Lagarde is echoing those fears.
Even US Federal Reserve chair Janet Yellen, who has generally adopted an optimistic tone about the outlook for the US and global economies, sees risks aplenty, including Europe or China “taking a turn for the worse”, a spike in oil prices, a resumption of the slide in commodity prices or a non-economic shock.
“In the current environment of sluggish growth, low inflation and already very accommodative monetary policy in many advanced economies, investor perception of – and appetite for – risk can change abruptly,” says Yellen.
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Former US Treasury secretary Larry Summers has put the odds of a US recession in the next year at one in three and believes it is a better-than-even bet in the next two years. The UK’s exit from the European Union has only deepened Summers’ and Yellen’s concerns.
What to do?
Given how much central banks are already doing to support activity, worried policymakers are now thinking hardabout what else they could do to halt a new downturn.
One answer is to do more of what they are already doing – holding interest rates very low, expanding their quantitative easing programs and providing forward guidance on the direction of interest rates.
Despite these measures, observers such as former US Federal Reserve chair Ben Bernanke warn of limits to how low interest rates can be pushed. They expect the impact of such a policy to diminish over time, while the risks it brings, such as property bubbles, are likely to increase.
There has been discussion of whether inflation-targeting central banks should raise their aim, lifting their goals from around 2 per cent to create additional rate-setting room. Some argue that such action could cut loose inflation expectations and undermine the hard-won credibility of central banks, while others fear it might not even lift demand anyway.
Another idea, “helicopter money”, was first articulated in 1969 by the legendary US economist Milton Friedman and has been championed by Bernanke, but is only now being talked about seriously in wider policy circles. It suggests authorities can fund tax cuts and spending increases from the balance sheet of the central bank, rather than through their normal strategy of issuing interest-bearing bonds.
Bernanke likes the idea, because it lets stimulus flow without adding to the future tax burden. Politicians might also enjoy being able to fund pet policies without driving up taxes. Many analysts, though, worry about this approach, fearing governments might not want to turn the money tap off once it starts flowing. In any event, it would require an unusual degree of coordination between governments and central banks.
Missing in action
Other analysts believe that central bank action has gone as far as it can and say governments will need to fight the next downturn. Allianz chief economic adviser Mohamed El-Erian says central banks “can’t go it alone anymore”. The IMF’s Lagarde says monetary policy needs support.
Concerned at swelling levels of public debt, governments in the US, Europe, Australia, Canada and elsewhere have been trying to hold spending down and cut budget deficits rather than loosening the purse strings to help stimulate demand.
In more normal times, bodies such as the IMF and the Organisation for Economic Co-operation and Development (OECD) would laud such restraint, but years of slow growth have shifted the economic consensus away from austerity.
The change in mood has been reflected in moves such as the acceptance by European creditors that Greece needs debt relief, Germany’s warning against an over-reliance on central banks, and policy prescriptions from the IMF and the OECD that urge governments to take on much more of the burden of supporting economic activity.
Yet with debt now at elevated levels, few nations can easily contemplate simply shoving money out the door. Come the next downturn, governments will be forced to seek more bang for their stimulus buck.
Money well spent
Research by Princeton University economist Alan Blinder, a former Federal Reserve board member and presidential economic adviser, suggests providing money promptly to lower-income households is the best way to combat any new downturn. That could include child tax credits, payroll tax holidays for employees and earned income tax credits. The US’s temporary boost in food stamps for the poor during the global financial crisis (GFC) was even more effective, Blinder argues.
His findings echo those made even before the GFC by US economists Doug Elmendorf and Jason Furman – that governments should react to downturns with spending that is “timely, temporary and targeted”, with low-income households the best targets.
This was the formula that Australia’s Rudd government applied in its earliest 2008 stimulus. Between October 2008 and May 2009, the Australian Government directed almost A$21 billion in welfare payments and tax bonuses to low- and middle-income households.
It’s estimated that about 40 per cent of households spent the money, and Australia’s Treasury says the handouts added more than 0.3 percentage point to GDP in the last three months of 2008 and 0.8 percentage point to growth in the first three months of 2009.
This measure’s biggest problem is that governments in most economies have found it difficult to follow. Instead, they have often kept spending up long after the immediate danger was past – partly to provide that continued stimulus to demand.
Another option is to change the mix of government taxes and spending, with more spent to make economies more productive. This formula is being urged as a fix for today’s sluggish growth: Lagarde says that even those governments with tight finances could aim for a more “growth-friendly” mix of taxes and spending, including more funds for infrastructure.
Blinder agrees that infrastructure investment is an attractive long-term measure. It’s less attractive as a short-term fix, though, because most infrastructure projects spend years in the planning.
Breaking the chains
Governments have more weapons than just their credit cards. In downturns, the instinct of politicians is often to try to save jobs by putting up tariffs, manipulating the national currency or erecting other barriers to international competition.
Economists, however, warn that the benefits of such policies are illusory. Trade and investment barriers, in particular, push up the cost of imports and slow the transfer of skills and technology, leaving economies worse off.
Most experts and organisations such as the IMF and OECD see more value in structural reforms that stimulate growth by changing the economy’s rules to foster competition in domestic markets, improve productivity and combat the effects of ageing by boosting workforce participation.
Bank of Queensland chief economist Peter Munckton says European governments, in particular, “should be working very hard in cleaning up their banking system”, which still labours under a huge overhang of debt.
Allianz’s El-Erian warns that the longer politicians prevaricate, the worse the situation becomes. “Every quarter that [governments] wait to enact credible and comprehensive measures adds to the difficulty of removing the impediments to inclusive growth, and makes the political context even more complicated,” he says.
Munckton says that, in the name of prudence, governments should act now: “We should be doing the back-burning before the next firestorm arrives.”
How the next downturn could arrive
Economists are notoriously poor at predicting recessions. A succession of downgrades to global growth forecasts,however, has fuelled the fear that just a little more downward pressure could send things into a recessionary spiral. Here are five ways the next downturn could arrive:
China is negotiating a tricky transition from being an economy driven by exports and investment to consumer-driven growth. As the fallout from sharemarket gyrations early this year showed, it may not be a smooth process.
Many analysts have pointed to China’s corporate debt level as a large and growing issue. Corporate debt has reached 145 per cent of GDP, according to the IMF, and more than half is held by state-owned enterprises, even though they produce only 22 per cent of output. Bank of Queensland chief economist Peter Munckton warns that managing this transition while ensuring enough growth to maintain stability will be “very tricky”. If the Chinese can pull it off, it will go a long way to sustaining global growth. If China splutters, the effects will reverberate across the globe.
Oil prices spike
One factor helping households and businesses across the world has been low oil prices, which have lowered the prices of many goods and services. Though a lift in the cost of oil would be a major development in staving off the deflation threat, it could be destabilising. If it fed a broader lift in prices while wages stayed flat, it could cause jittery consumers to pull back on their spending, undermining recovery. Central banks would face the difficult prospect of raising rates to head off inflation at the risk of suppressing economic activity.
The walls go up
Centrist governments in many parts of the world are coming under pressure from political groups on the right and left campaigning on issues from refugees and immigration to the effects of trade and globalisation on jobs and industry.
US Republican Party presidential nominee Donald Trump has railed against free trade and promises to erect a wall along the Mexican border and ban Muslim immigrants. Similar impulses about the effects of immigration and trade have fed movements in other countries, like the UK’s Brexit debate.
If major markets such as the US and Europe erect or increase trade barriers, China and other exporters would be hit hard.
Financial system risks
The IMF has warned that as the international financial system has become more interconnected, financial ups and downs are “growing in amplitude and duration, capital flows have become more volatile, and non-banks [which sit outside many regulatory structures around banking] have gained importance”.
Growth in emerging economies means the global economy is less likely to just reflect events in the US. However, the financial cycles of many countries remain closely linked to the US cycle, and the global financial system is still highly dependent on the US dollar as a reserve currency.
A consistent feature of recessions is that they begin suddenly and are a surprise, notes Yale University economist Robert Shiller.
While events such as a spike in oil prices can fuel a recession, Shiller argues that the importance of psychology is often overlooked. Consumers shape their behaviour in response to what he calls “social stories”, such as the shift to more austere cultural values following the 1929 stock market crash.
“History tells us that human imagination can spontaneously transform discrete events into world-shaking narratives of unexpected colour and force," he says.
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