Sustained global economic expansion continues to be expected, with a real GDP growth rate of about four per cent in both 2010 and 2011, writes DICK HOEY, chief economist at BNY Mellon
The strongest economies in 2010 and 2011 should be those with three characteristics:
- public policy that places the highest priority on economic growth relative to other objectives
- No significant debt overhang
- Rising productivity among the workforce due to the diffusion of modern technology and business practices. This would include some of the largest emerging market countries.
The US should have the strongest recovery among the major industrial countries. Relative to a normal recovery in the first four quarters after a severe recession, US economic growth should be “sub-par” at a real GDP growth rate of three to four per cent, well below the growth rate of eight per cent or more, which would be normal after such a severe recession. However, US economic growth should also be “above trend,” with growth higher than longterm trend growth near 2.5 per cent. The US economy bottomed in mid-2009, but US employment has just bottomed and should now show sustainable positive growth, even excluding the coming surge of temporary jobs.
In Europe, the recession has surfaced underlying vulnerabilities. In the early years of the euro, countries in the periphery benefited from low interest rates due to a form of “borrowed credibility” from their association with core Europe, especially Germany. Also, periphery countries have tended to have somewhat higher inflation rates than Germany, so the real policy rate (short-term interest rate minus inflation) was lower in these countries. This temporarily stimulated their growth, but there was a cumulative loss of competitiveness.
While other countries within the euro benefited from German policy credibility, they often did not fully share favourable German fundamentals. Germany has its own economic issues but it does have a long history of monetary discipline, export competitiveness, favourable cost control, a sedate housing market and some degree of fiscal discipline.
If the periphery countries had not been part of the euro, serious weakness in their economies might have fostered a decision to devalue their national currencies substantially to shift the mix of their economy towards exports at a time of weak domestic demand.
However, in recent years, these countries have been sovereign borrowers in the euro, not in their own currencies. As a result, devaluing out of the euro would now be a very disruptive path, both for them and for those countries whose banks own a great deal of their debt. We believe that the most likely case is that no countries within the euro will default or leave the euro any time soon, but the odds are high that the weaker countries will be forced to pursue a restrained fiscal policy in order to be eligible for implicit or explicit financial support, most likely within Europe but, possibly, from the IMF.
It is still uncertain, though, how much support stressed countries such as Greece will need and receive; how severe the contagion of financial stresses in Europe will be; and how much recent events will weaken the economic growth prospects for Europe.
Greece represents a small percentage of European GDP while the export competitiveness of the large German economy has just been improved by the weakness of the euro. If financial contagion within Europe is not too severe, the benefits of euro weakness to revenues and profits from exports to the rest of the world could offer some offset to the growth-dampening impact of financial stresses on the European economies.
However, European fiscal policy is likely to be hamstrung for some years, with Germany having just tightened its long-term fiscal targets and peripheral countries struggling to restrain the path of their future deficits.
Our most likely view is that worstcase scenarios for financial contagion in Europe will not occur, that stresses will gradually ease over the coming year and that Europe will have slower growth than most other industrial countries for an extended period of time.
We believe that slow growth is more likely than a double-dip recession. Europe was expected to be a laggard in the global economic recovery in any case, even before the recent strains, so the negative impact on the global expansion should be limited if financial contagion does not worsen.
We expect strong growth to persist in such large emerging market countries as China, India, Brazil and Indonesia. China adopted a hyperstimulative policy in late 2008. It worked and policy is now shifting towards neutral. We expect Chinese economic real growth to run at or near 10 per cent in the near term.
Chinese economic policy was appropriately hyperstimulative at the worst of the global recession and is now undergoing an appropriate shift to neutral. The provision of excess liquidity is no longer cyclically appropriate. At some point over the next year, the policy shift may include the onset of gradual revaluation of the RMB against the US dollar as such a policy shift is likely to become increasingly appropriate in response to Chinese economic fundamentals.
We are optimistic about the prospects for the US to have a sustained economic expansion at a three per cent to four per cent rate. However, sceptics point to three main negative theses on the US economy: there is so much vulnerability in the consumer and housing sectors that the US is likely to have a double-dip recession the excess liquidity provided by the Fed is likely to trigger a major inflation upsurge over the next year or two there will be a deficit-triggered rate spike in response to high budget deficits.
We strongly disagree with the first two scenarios (double-dip recession and inflation surge) and believe that the third (a deficit-triggered rate spike) is substantially premature.
We do believe that the drag of the long-term hangover in the housing and consumer sectors does help explain why the economic expansion is likely to run closer to a threefour per cent growth rate than the growth rate of eight per cent or more that might be expected if the normal cyclical pattern after severe recessions was repeated.
However, we believe that the odds of a double-dip recession are quite low, given the substantial easing of financial conditions and the likely persistence of stimulative monetary policy. We believe that employment has bottomed and we reject the idea that consumer spending growth and deleveraging cannot occur at the same time, although it depends on the circumstances. Consumer spending growth and deleveraging can easily occur together if wage and salary income is growing, house prices stabilise and the stock market recovery persists. The passive deleveraging via a combination of low credit usage for new spending and amortisation of existing debt should not prevent an expansion of consumer spending.
Double-dip recessions are rare. The main precedent was that the brief 1980 recession was followed by a severe recession in 1981-1982. However, the intervening recovery did not die a natural death. The economic recovery in late 1980 and early 1981 was halted by aggressive monetary tightening, which was designed to generate a renewed recession and a slowing of inflation.
At the time, the priority of the Federal Reserve was to halt an uptrend in inflation, which had persisted for many years. So the Fed engineered a huge interest rate increase, which helped drive the 90-day Treasury bill rate to 17 per cent, the prime rate to 21.5 per cent, the 10-year Treasury yield to 16 per cent and generated an inverted yield curve. It is hard to believe that anyone at the Fed was surprised when this severe interest rate spike in 1981 caused a second recession.
In contrast, current US monetary policy is anti-deflationary rather than antiinflationary. The 90-day Treasury bill rate is 0.15 per cent, the prime rate is 3.25 per cent, the 10-year Treasury bond yield is 3.7 per cent and the yield curve is very steep.
One of the current objectives of the Federal Reserve is to drive core inflation back up towards two per cent from the one per cent pace likely to be reported for core inflation by the end of 2010.
Our overall conclusion is that the stark difference in monetary policy is likely to result in a stark difference in outcomes. There is a substantial difference between a Treasury bill rate of 0.15 per cent and a Treasury bill rate of 17 per cent. We do not expect a double-dip recession.
We believe that US inflation is likely to remain low for the next several years. One can view the inf lation outlook from a variety of perspectives. From an output gap perspective, the excess supply of labour in the US and competing industrial countries is likely to persist, holding down wage inf lation. In addition, economic policies in emerging markets are tilted towards expanding the capacity to export to the advanced countries.
Emerging market demand for energy continues to increase but we believe that the still depressed level of economic activity in the developed countries and the expanding supply of some energy sources (such as natural gas) should prevent a rapid tightening of the supply/demand balance for total energy beyond what has already occurred.
From the current level of energy prices, we do not expect major upward pressure on the US inflation rate in the near term.
Another perspective on inflation is the currency perspective. Over the past year, we have not shared the expectations by some for a plunge in the dollar since we have believed that US growth and inflation outcomes would be favourable. In addition, the other developed countries with major financial currencies suitable for international reserve allocations (euro, pound sterling, yen) have their own problems.
So what about the emerging market currencies? Due to their currency undervaluation, strong real growth and rising interest rates, some of the emerging market currencies are likely to appreciate against the major financial currencies, including the dollar.
However, the level of emerging country labour costs will still be well below those in the developed countries, even if the difference in labour costs narrows slightly. Thus the most likely result of any weakening of the major financial currencies against some of the major emerging market currencies should be a reduction of disinflationary pressure on the inflation rates of those developed countries, rather than the creation of any major inflation upsurge.
Another negative thesis is that high budget deficits will generate an interest rate spike that will disrupt the economic expansion. On this issue, we have a more confident view on the short-term outlook than on the long-term outlook. While we expect a normal cyclical updrift in interest rates over time, we believe that near term cyclical fundamentals imply that very high budget deficits can be financed in an orderly way over the next year or two.
The very steep yield curve should be helpful in encouraging the purchase of Treasury securities by financial institutions and individuals wishing to restore their liquidity and financial flexibility. Inflation is low and we do not expect the Fed to begin the first rise in the Federal funds rate or the IOR (interest on reserves) rate until late 2010, possibly not until early 2011. We expect a gradual upward drift in interest rates over time rather than any dramatic spike.
Rise in debt
We are less sanguine about the long-term risks of persistently high structural budget deficits in the US. In early March 2010, the Congressional Budget Office (CBO) reviewed the President’s budget proposals and raised its estimate of the national debt for 2020 to $20.3 trillion, substantially above its January 2010 estimate.
According to the CBO, “Under the President’s budget, debt held by the public would grow from $7.5 trillion (53 per cent of GDP) at the end of 2009 to $20.3 trillion (90 per cent of GDP) at the end of 2020. As a result, net interest would more than quadruple between 2010 and 2020 in nominal dollars (without an adjustment for inflation); it would expand from 1.4 per cent of GDP in 2010 to 4.1 per cent in 2020.”
What is needed is a credible path to a balanced budget. We are sceptical whether that will occur without a future crisis. The political left and right fundamentally disagree about the most appropriate Federal spending share of GDP over the coming years and appear quite unlikely to modify their views. Political conditions do not appear favourable for a major compromise to deal with the structural budget deficit prior to a fiscal crisis.
The US may be gradually drifting towards a “future fiscal train wreck,” perhaps four, five or six years down the road. The cyclical conditions under which this might occur would tend to be the opposite of today’s cyclical conditions: high and rising inflation; aggressively restrictive monetary policy; and “crowding out” stress as persistent demand for Treasury financing conflicts with strong corporate credit demand due to a financially illiquid corporate sector stressed by weakening profits. Although, it is somewhat encouraging that public concern about excessive long-term budget deficits is rising, the long-term fiscal outlook remains worrisome.
It is easy to overestimate the inevitability of adverse economic trends and to underestimate how powerful policy decisions can be to create positive or negative outcomes. If the US wants a better economic outlook, Americans need to make better economic decisions. The same is true for other developed countries facing demographic ageing, fiscal stresses and the prospects of slow economic growth.
In the meantime, we have an optimistic view of the cyclical prospects for sustained global economic expansion.
BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation. The statements and opinions expressed in this article are those of the author and do not necessarily represent the views of BNY Mellon or any of its respective affiliates.