The past few months have witnessed the global growth engine slowly coming back to life after a prolonged lull. As concerns over an implosion in China have receded, and prospects for the US economy seem to have brightened, trade and investment flows have increased. Stocks and commodities have rallied in anticipation of a sustained global recovery even as bond yields have inched up in anticipation of a firmer recovery that will allow central bankers in the developed world to raise rates.
But will the recovery last, or will this turn into another false hope? The answer from the markets seems to be a clear and unambiguous yes. As the chart below shows, measures of implied volatility have fallen over the past few months even as stock market indices have climbed upwards. Both the CBOE VIX, a globally tracked fear gauge, and the NSE VIX, its Indian counterpart, have trended downwards.
While most economists and economic policymakers agree that the prospects for the global economy appear brighter than what it looked even six months ago, many of them are not as sanguine when it comes to medium-term or even long-term prospects. The dominant view among central bankers and macro-economists is that the growth slowdown since the great financial crash of 2008 represents a new normal, and that even if growth recovers from current levels, global growth will never be what it used to be before 2008. This view is most strongly articulated by proponents of the “secular stagnation” hypothesis which posits that a global deficit in aggregate demand or an excess of savings over investment is holding back growth and pushing prices downwards.
Coined originally by Harvard economist Alvin Hansen in the wake of the Great Depression, the term has gained new currency thanks to another famous Harvard economist Lawrence Summers. The secular stagnation hypothesis has several variants but they all agree that the global economy has been facing a structural demand deficiency for many years, which is likely to persist well into the future, and keep growth sluggish. This long-term stagnation is associated with changing demographics, declining productivity growth, growing income and wealth inequality, and falling tangible investments owing to changes in technology, according to its proponents.
Over the past couple of years, several central bankers across the world have used this hypothesis to justify ultra-loose monetary policies that they have been pursuing. In a speech earlier this year, US Federal Reserve chairperson Janet Yellen referred to some of the familiar tropes associated with the secular stagnation hypothesis to explain why the Fed will continue to be cautious about raising interest rates. The same hypothesis also seems to have influenced the forecasts and analysis of researchers at the International Monetary Fund (IMF).
However, the central bank to the central bankers of the world, the Bank for International Settlements (BIS), remains quite sceptical about this hypothesis. Researchers at the BIS, who were among the few macro-economists to sound a warning ahead of the great global crash of 2008, have for some years developed an alternative explanation of the state of the global economy. In a recent speech, the head of the monetary and economic department at BIS, Claudio Borio, offered a succinct explanation of the alternative hypothesis, rather unimaginatively named as the “financial drag” hypothesis, arguing that this theory explained the world better than the secular stagnation thesis.
According to Borio and his colleagues at the BIS, the financial cycle has a life of its own, quite distinct from the real economy cycle, and it is fluctuations in the financial cycle which cause swings in the real economy. According to this view, financial cycles typically last for 16-20 years and are generally much longer than business cycles which tend to last for two to eight years. According to BIS economists, the inability of the policymakers to understand and deal with financial cycles lie at the root of the woes the global economy has been facing for the past several years.
The financial cycle drag hypothesis posits that credit and property price booms (such as the one leading to the 2008 crash) rather than changes in the overall price level or inflation (to which central banks typically pay most attention) are a more credible indicator of overheating in an economy. Such credit booms typically lead to misallocation of resources, often to the least productive sectors of the economy, such as construction. When the boom turns to bust, high levels of indebtedness and a broken banking system make it difficult to reallocate resources away from bloated sectors. As a result, financial booms tend to severely undermine productivity growth for several years following a crash, making a growth recovery difficult.
In the immediate aftermath of the great financial crash, central bankers were successful in avoiding a depression but they have been less successful in restoring growth because of the neglect of the financial cycle, according to Borio. Too much emphasis on demand management through monetary stimulus, and too little emphasis on balance-sheet repair has proved to be ineffective in raising growth as the private sector has remained over-indebted, and “wishes to retrench rather than spend”, says Borio. BIS research suggests that a monetary policy framework, which ignores the financial cycle, might contain recessions in the short run (say by lowering interest rates), but only at the expense of creating “larger recessions down the road”.
In fact, the financial cycle drag hypothesis suggests that central bankers are sowing the seeds of the next crisis by prolonging the phase of ultra-low interest rates.
“Over long horizons, asymmetrical policies across successive financial cycles – failing to constrain their expansion but easing aggressively and persistently during busts, with monetary and, to some extent, fiscal policy – could lead to a sequence of episodes of serious financial stress, a loss of policy ammunition and a debt trap,” says Borio. “Such a sequence imparts a downward bias to interest rates and an upward bias to (private and public) debt that at some point makes it hard to raise interest rates without damaging the economy. The accumulation of debt and the distortions in production and investment patterns induced by persistently low interest rates hinder the return of those rates to more normal levels. There are some signs that this may be happening: monetary policy has been hitting its limits; fiscal positions in a number of economies look unsustainable, especially if one considers the burden of ageing populations; and at the global level, debt-to-GDP ratios have kept rising post-crisis.”
While BIS economists are critical of the role of central bankers and offer a gloomy prognosis about the medium-term prospects of the global growth engine, they are more optimistic than central bankers when it comes to longer term growth prospects. According to their hypothesis, a “normalisation” of monetary policy in the major economies (whether through deliberate action or because of improvements in the global economy) can become entrenched and sustainable since what caused the crisis in the first place were financial rather than structural factors. Right now, markets around the world may be buying into this narrative but as Borio warns, the road ahead is likely to be bumpy even if it leads to higher growth over the long run.
