As we move into a long hot summer, it’s time to reflect whether we are on the cusp of the slow road to global recovery or another lurch into recession. In late May, the Fed’s warning of "tapering" quantitative easing caused financial markets to react violently. We saw social turmoil in Turkey, Brazil and Egypt, the inter-bank shock in China and a reversal of capital flows to emerging markets.
The reality is quite sobering. Amongst the advanced countries, the US, Japan and Germany have positive but anemic growth at 1.9 per cent, 1.8 per cent and 0.5 per cent respectively. After Abenomics, Japan is feeling more confident, with the stock market rising by more than 35 per cent, but the latest industrial production and inflation numbers are still negative.
The Eurozone is still in shock. The major economies, like France (-0.3 per cent) and Italy (-1.8 per cent) are in negative territory, whereas unemployment remains high at 12.2 per cent. Global stock markets have been a forward predictor of how economies are going to perform. The US and German stock market are up 14.4 per cent and 2.8 per cent respectively, but the emerging market stock markets have been savaged. The biggest drops occurred in South Africa (-14.1 per cent), Turkey (-12.7 per cent), Russia (-17.2 per cent) and China (-10.8 per cent).
This suggests that the financial markets are predicting slower growth in the emerging markets, which explains why the International Institute of Finance forecasted that there will be a slowdown in net capital flows to emerging markets to 2015.
Indicators of slowdown in China have hit commodity prices. The Economist commodity dollar index has declined by 8.7 per cent year-on-year, while gold prices, the supposed hedge against inflation, have declined by 22.8 per cent. The Australian dollar, a good indicator of what is happening in commodity markets, has declined to US$0.90 per Aussie dollar.
There is gradual awareness that central banks may be able to affect the risk-free rate in their domestic economy, but they may no longer be able to influence the upward movement of risk spreads. In other words, despite the large bout of quantitative printing, the market is beginning to price in risks more realistically. Bond prices for the safe haven countries, particularly the US and Germany, have remained low, but risk spreads for sovereign debt in all the other countries, especially emerging markets and periphery European economies, have all widened again.
What does that tell us about quantitative easing going forward?
In the June Bank for International Settlements Annual meeting, the gathering of global central bankers, its Annual Report warned in uncharacteristically blunt language that central banks may have gone beyond their borrowed time. On their own, they cannot repair balance sheets of households and financial institutions; they cannot ensure fiscal sustainability and they cannot promote structural reforms for sustainable recovery. Central banks should realistically expect that monetary policy cannot solve these problems on its own.
In Abenomics terms, the first arrow is monetary policy, the second arrow fiscal policy and the third arrow structural policy. As Genghis Khan told his successors, the three arrows together are strong, but each on their own is easily broken. Firing the first arrow is easy, but firing the fiscal arrow by cutting spending or increasing taxes would be very unpopular. Similarly, everywhere from Eurozone to Japan, making structural reforms face huge resistance from vested interests, which is why no one has seriously fired the third arrow.
Sitting in Amsterdam at a conference trying to figure out the complex Eurozone crisis, we asked whether it is a complex question with a simple solution, or whether we have to use complex solutions to fix complex questions?
For example, the financial crisis is being solved by complex regulations. When I complained that no one seems to be able understand these complex regulations, many of which have not come out yet, I was told by my august friend from Basel that I was being simplistic.
German Chancellor Merkel has the simple explanation for the Eurozone crisis: seven percent of world population, one quarter of world output, and half of world’s social expenditure. This was fiscally unsustainable. The diagnosis was that the Eurozone required more banking union, fiscal union and political union, in that order. But the latter two are much more difficult to achieve. So, the Euro-technocrats are busily writing more and more rules on financial regulation and directives, centralising banking supervision away from national regulators. The basic idea is that countries with trade deficits would not go into deficit if the bank regulators were to tighten up on national bank credit. But if the Greek bank regulator cannot control Greek bank lending, what makes you think that the Eurozone regulator in Brussels will do any better?
The late Apple genius Steve Jobs had the best insight into the issue of complexity versus simplicity: “When you start looking at a problem, and it seems really simple with all these simple solutions, you don’t really understand the complexity of the problem. And your solutions are way too simplified and they don’t work. Then you get into the problem and you see it’s really complicated. And you come up with all these convoluted solutions. That&’s sort of the middle, and it&’s where most people stop, and the solutions tend to work for a while. But the really great person will keep on going and find, sort of, the key underlying principle of the problem. And come up with a beautiful solution.”
It&’s the process, stupid.
His product, the iPhone, is simple to use, but the software and hardware processes are very complex. We don’t need to know how the system works but it does.
The financial markets are sending out a lot of complex and confusing noise, but the smart guys are trying to read the signal – what is the noise telling us?
Basically, the markets will go where four central central bankers are signalling ~ whether to tighten or to continue loosening.
But the markets and social events are beyond the control of central bankers. That&’s where it&’s both simple and complex.
The writer is President of Fung Global Institute.