Photo Credit: Lending Memo
By Sayantan Ghosal, University of Glasgow
Originally published in
After a relatively benign period, market upheaval has returned. The main stock market indices have been falling across Asia, Europe and the US, while safe-haven assets like gold have been on the rise. This follows a slow drip of bad economic news, not least the sharp fall in German industrial output in August. More recent has been the latest “World Economic Outlook” by the International Monetary Fund (IMF), which makes sober reading.
The agency has downgraded the forecasts for global growth that it made in April and July. Lurking in the background is an underlying global debt problem: the slow, costly process of de-leveraging in the US and Europe and the (arguably unsustainable) accumulation of both public and private debt in emerging market economies, notably China.
IMF economic forecasts for 2014
IMF economic forecasts for 2015
As most people with a passing interest in the financial crisis know by now, our economies got into trouble through debt. Banks over-extended themselves, which forced governments to build up big deficits to bail them out. As we saw in 2007-08, the global nature of the financial system demonstrated that a “local” crisis such as the US sub-prime collapse can have much wider consequences.
In the aftermath of that crisis, financial institutions have had to reduce the amounts that they are lending – but at what cost? New lending has gone down. Weak firms and households have become bankrupt (though not banks, importantly). Firms and banks have hoarded cash and liquid assets. Weak countries have teetered on the edge of default.
Among the knock-on effects, there have been falls in aggregate private investment in new projects and for funding research and innovation. Workers have had to accept cuts in real wages, while unemployment has gone up. Some of the new unemployed have become “self-employed” and a greater proportion of employed have moved into part-time or “zero-hour contract” jobs. All these changes in the labour market have led to lower aggregate consumption. Lower investment has adversely impacted on the productive potential of these economies.
The QE experiment
Quantitative easing (QE) was part of the strategy for preventing these consequences from being even worse, after it became clear that ultra-low interest rates alone were not going to provide enough stimulus. QE consists of central banks temporarily “creating” money with which to buy assets from banks as a way of improving the banks’ balance sheets.
This puts a floor on the money supply and prevents deflation, while propping up share markets and other asset prices (because it essentially gave banks extra money to invest in those assets). It was also supposed to help lower the cost of borrowing for firms and households as a means of stimulating the economy, though this is debatable – some studies suggest that QE can lower the long-term interest rate, and hence the cost of borrowing, but the actual the cost of borrowing from the banks hasn’t fallen.
On its own, QE cannot kick start investment and growth. You still need people and businesses willing to borrow the money and invest it. For this to happen, expectations about the future prospects of the economy have to change. And this does not occur overnight. We have only just begun to see this kind of economy-wide shift in the US and UK after a number of years of QE.
In the absence of private sector investment happening more quickly, public sector investment has played a key role in stimulating growth. Arguably QE in the US and UK has reduced the cost of public-sector borrowing to historical lows. This has made it possible to cut back deficits at a slower pace. It has also strengthened the economic case for ramping up investment in public goods such as infrastructure, higher education, training and skills, basic research and green technology.
QE ends in the US this month, closing six years of money creation worth about US$3.5 trillion (£2.2 trillion). It has already ended in the UK, where the Bank of England’s equivalent injection was £375 billion. Japan has also been in QE mode since last year, printing ¥76tn (£440 billion) in 2013 and targeting ¥60tn-¥70tn (£350bn-£400 billion) each year thereafter. The European Central Bank is now also going down the same route. The hope is that the balance sheets of the eurozone banks improve and that firms and households borrow more, enabling the region’s economies to exit their current stagnation.
Time will tell how much stimulus we see in Europe and Japan, and indeed whether the US/UK cessation endures. If global growth starts to falter and this has a negative effect on US and UK growth and/or leads to more severe volatility in stock markets and asset prices – much of what the IMF is predicting, in other words – we might see the return of QE in these countries.
Indeed there is an argument that ending QE in the US, by lowering available liquidity, has already had an impact on stock and asset prices in emerging markets. Equally, however, this could be being caused by pessimistic expectations about the future prospects for their economies.
Longer outlook better, but also worse
It’s not all doom and gloom, though. Eventually economies will start to grow again. Asset prices will recover as investors with cash and liquidity snap up bargains. We will also eventually see growth from the underlying forces of technological change and innovation, such as new measures to lower the relative cost of energy. It is extremely difficult to say with any certainty when this will happen. I would imagine that we are talking about between five and ten years’ time. But what kind of growth and at what cost? Who will benefit? And will the underlying structural features of the current economic order, which lead to instability and new crises, simply go away?
The stability of our economy might remain the key policy concern in the short-run, but there are plenty of other longstanding issues. To name only a few, there is wealth inequality, the environment, ageing population and the sustainability of the welfare state. Outside the West, the key challenge remains generating and sustaining rates of growth adequate to meet rising aspirations and reduce absolute poverty.
The core test of any economic system must be the extent to which it leads to the satisfaction of human wants from a global and inter-generational perspective. By this test, the current economic order is an abysmal failure. There is a narrow window to seize the opportunity for change but old habits die hard. There is a great hunger and potential for change, for example through grassroots movements, in various shapes and guises, that explore, and seek to mobilise support for, alternatives to the current economic order.
And without a reconfiguration of the institutional foundations of the current economic order, the opportunity to put economies, globally, on a sustainable, equitable, stable footing could be lost.
Sayantan receives funding from ESRC.