Economic Outlook

On Thursday, September 6, 2012, the world’s second-largest and cyclically most important central bank finally embraced its role as a lender of last resort for eurozone sovereigns, after European Central Bank (ECB) president Mario Draghi succeeded in building a coalition of support inside and outside the ECB for a shift to unconventional monetary policy.

Faced with material existential risks, which threatened both the financial stability and political cohesion of the eurozone itself, ECB president Draghi boldly committed the central bank’s balance sheet to unlimited, but conditional, purchases of short-dated eurozone government bonds.

This single, inevitable action substantially reduced the probability of depression-like left-tail risks over our cyclical horizon. And, for now, it moved the cyclical economic debate from focusing on the fat tails of a historically unusual bimodal distribution to focusing on the belly of an increasingly rickety, New Normal distribution.

What are the commonly understood objectives of unconventional monetary policy in a New Normal economy at the zero interest rate bound? The first objective is to maintain system-wide financial stability and thus prevent debt deleveraging from becoming disorderly. This can be achieved via the adoption of a lender of last resort function, providing liquidity to both private banks and sovereign states during their time of greatest financial stress and need. The ECB has just arrived at this stage, albeit via a conditional road.

 
The second objective is to ease financial conditions such that diseased balance sheets are given a chance to heal over time. This can be achieved by active and targeted financial asset purchase programs that focus on the normalization of liquidity, interest rate, and credit risk premia from “tight” to “normal” levels. The Bank of Japan has been operating at this stage for over a decade, refusing to go further.

And the third objective is to reduce the real cost of capital to levels well below the expected real return such that animal spirits are kindled and aggregate demand is expanded gradually over time despite deleveraging. This can be achieved via large-scale, aggressive purchases of “risk-free” or near “risk-free” financial assets such that healthy private balance sheets are incentivized to take risk, be it in financial assets or real assets. The Federal Reserve and the Bank of England are here.

At the most simplistic level of supply and demand for savings, unconventional monetary policy tries to reduce the real return on savings to a point at which the incentive to save begins to fall and the incentive to invest or consume begins to increase, all else equal. When large, developed economies like the U.S., Europe and Japan are all concurrently facing private and public balance sheet deleveraging and rising ex ante national savings rates, unconventional monetary policy can be an invaluable tool for protecting aggregate demand from the deflationary clutches of Keynes’ paradox of thrift.

But is this unconventional monetary policy a panacea for all the world’s current economic problems? And are we about to leave the New Normal economy behind once and for all, given the ECB’s actions? Here, we believe, the answer is a clear no.

The global economy remains deeply mired with structural problems of excessive indebtedness, maldistribution, inadequate policy responses, growing inequalities and insufficient global coordination. None of which, we agree, can possibly be addressed by unconventional monetary policy alone. However, monetary policy can provide a nominal bridge to real outcomes, especially if mated with appropriate policies that reduce imbalances and inequalities, enhance investment and production, and become activist with a secular economic vision. Over time, it is necessary that real economic actors make decisions that take advantage of monetary and fiscal policy in a judicious and productive fashion to achieve those outcomes. And here, the jury is still out.

The ECB policy action has provided the eurozone and global economies with much-needed breathing room, and just barely at that. The probability of a deflationary left-tail outcome emanating from the eurozone has declined substantially in the short run, yet outright economic growth in the eurozone will remain elusive in 2013 due to the continuation of games of chicken between policymakers across the eurozone. Fiscal tightening, especially in the less competitive and sociopolitically less stable countries of the eurozone, will deepen the economic recession during 2013 and test the will of both fiscal and monetary policymakers to stay on the policy path they have painstakingly championed. While monetary policy is being eased on the margin to prevent financial instability and to increase political cohesion, little is likely to be done in terms of productively stimulating eurozone growth via coordinated fiscal policy over the cyclical horizon. We expect eurozone growth to decline further between −1% to −1.5% in 2013.

The U.S. faces a less daunting outlook. In comparison to the eurozone, the U.S. economy is much further along the path to real economic healing from the depths of its own debt crisis during 2008–2009. The Federal Reserve has been aggressive in communicating and implementing unconventional monetary policy, which in turn has facilitated the gradual deleveraging of private balance sheets without compromising aggregate demand, profits and employment relative to the eurozone. While the New Normal recovery in aggregate demand, profits and employment has been slower than anticipated by most market participants and policymakers ex ante, it is ex post a far better outcome than that faced by some depressed economies in the eurozone today. We expect the U.S. economy to grow about 1% to 1.5% in 2013, with risks to the downside.

One positive cyclical development for the U.S. economy is the prospect of a real recovery in housing, with the added potential kicker for home price deflation turning to mild inflation over our cyclical horizon. In 2013, we expect real residential investment to grow by some 10% to 12% from a depressed base, thereby contributing at least 0.3 percentage points to real economic growth directly. It is likely, as well, that real growth in housing will come with substantial positive multipliers such that the total positive impact on the U.S. economy could be 0.5 or 0.6 percentage points.

But this is where the good news ends for the U.S. While housing markets have established a nascent recovery, the politics of U.S. fiscal policy are about to establish an unplanned and somewhat untimely exit from unsustainably large stimulus. The much-publicized “fiscal cliff” is set to hit the U.S. economy on January 1, 2013, and, if left unchecked by new policies, will reduce U.S. aggregate demand by an unimaginable sum of roughly $600 billion to $700 billion (about 4% of GDP).

After crunching through a variety of permutations and combinations that tested different election results and all the incentives of various players, we feel confident that the full brunt of the fiscal cliff will be avoided. Our best guess is that in most outcomes of the U.S. election, policymakers will only allow a $200 billion to $250 billion sunset in stimulus, which will create a drag on U.S. economic growth of about 1.5% of GDP in 2013. For an economy that is struggling to grow at 2% per year, this will still be a significant one-time shock, but one that through clear communication and planning can be handled by the private sector.

Then there is China. On the surface, this engine of global growth is undergoing a garden variety cyclical economic slowdown, driven by the dark side of the inventory cycle set into motion via a decline in aggregate demand from both the eurozone and U.S. economies. Simplistically, China is the world’s factory, and it is facing a decline in final sales due to large customers reducing spending overseas. But we asked the question: Is there something more serious going on below the surface in China? Has the streak of 8% to 12% real economic growth in China ended, and is China entering its own New Normal? We think the answer is yes.

China is going through a very important political and economic change in 2012. Economically, China is on the cusp of Michael Spence’s “middle-income” transition. To raise per capita GDP from the level of $6,000 to $12,000, China will need to masterfully execute a reduction in national savings and an increase in economy-wide innovation and productivity all at the same time. This task is complicated immensely by a slowing aggregate demand forecast around the world. Politically, China is facing an unusually uncertain handoff.

In our assessment, China’s easy growth phase is over. But the good news is that China has the balance sheet and the knowledge to continue executing its economic development plan, as long as political stability is maintained, income inequality is addressed, and the external demand environment does not deteriorate substantially further. We expect China to grow between 6.5% and 7% in 2013.

As for other economies, the rest of the world will also grow below consensus expectations in 2013 as detailed in the table. We expect global GDP to grow 1.5% to 2.0% in 2013 vs. 2.2% in 2012, with the weighted sum of developed countries growing 0% to 0.5% and developing economies delivering between 5.0% and 5.5% growth during the same period. This gap between developed and developing, while large, is consistent with the premise that developed economy aggregate demand is the weakest link and developing economy production growth will follow with a lag.

The important question to ask is whether these low growth rates, especially in the highly leveraged developed world, can be sustained without increasing the risk of a stall-speed-driven drop into recession, followed by rising protectionism and capital controls.

The concept of stall speed is a contentious one, but one that we tend to believe does influence economic outcomes over cyclical horizons. In competitive, profit-motive-driven economies, the rate of growth in sales can only slow to a point before it dips below the embedded costs of production and sets into motion an aggregation of cost cutting, labor shedding and inventory reductions that constitute a typical recession.

While we do not expect recessions across all developed countries in 2013, we certainly would caution that the probability of more widespread recessions has increased, given the coordinated slowdown in global aggregate demand we are witnessing across the world. This is where policymakers must focus their attention. While monetary policy is arguably doing all it can to sustain the rickety bridge of nominal growth in the New Normal, fiscal policy coordination and planning has been disappointing on a global basis. Without structural change aided by well-planned fiscal policy, we are afraid the nominal bridges of monetary policy will fail to reach their desired outcomes, whatever and wherever they may be in this uncertain global environment.

The global inflation outlook largely follows the global growth outlook in 2013. We expect a slight moderation in global inflation to 2.0% to 2.5% in 2013 vs. 2.8% in 2012, with developed economies’ inflation slowing to between 1.0% and 1.5% and developing economies’ inflation slowing to 4.0% to 4.5%. This is predicated by a view that oil prices will remain elevated but stable at current levels, treading the middle ground between rising geopolitical risks, global financial repression and slowing economic demand.