In the past, policy makers could always produce new rabbits from their hats to trigger asset reflation and economic recovery, but now the hat is nearly empty.
We are seeing rising income and wealth inequality, poverty, unemployment and hopelessness in both developed and emerging markets (EMs), and the U.S. has entered a new “Gilded Age,” with income and wealth inequality as high as at the onset of the Great Depression.
Unregulated capitalism is in crisis and we need to find a third way between the twin broken poles of Anglo-Saxon laissez faire and the traditional continental European model of a deficit-driven welfare state, returning to the correct balance between markets and the public provision of public goods.
The recent massive volatility in global financial markets and sharp equity market correction—bordering on a bear market in some countries—signal that most advanced economies are on the verge of a double-dip recession. The financial and economic crisis of 2008-09 (caused by too much debt and leverage in the private sector) was followed by a massive re-leveraging of the public sector—via automatic stabilizers, counter-cyclical fiscal stimulus and the backstopping and bailout of banks and financial institutions to prevent the Great Recession becoming a Great Depression 2.0. The subsequent recovery in most advanced economies was anemic and sub-par as a painful process of deleveraging—spend less in the private and public sectors, save more to reduce debts—led to weak demand and employment growth. But now, a combination of tail risks and black swan events—rising oil and commodity prices, turmoil in the Middle East, Japan’s earthquake, the eurozone (EZ) debt crisis, and the U.S. fiscal impasse and rating downgrade—have led to a massive increase in risk aversion and worse-than-expected data. Rising fear, equity market volatility and lousy macro data have led to a stall speed in the U.S. economy and the periphery of the EZ, the UK and Japan. Even fast-growing emerging markets (EMs)—China and emerging Asia and Latin America—and economies relying on EM growth—exporters such as Germany and resource-rich economies such as Australia—are now slowing sharply.
But as with an airplane reaching stall speed, you either accelerate to escape velocity or you start to free fall; and the fuel that would allow economies to return to escape velocity—policy bullets—is low in the tank given we have used most of it in the past three years. Mixing metaphors, policy makers could, until last year, always produce a new rabbit from their hats to trigger asset reflation and economic recovery. Zero policy rates, QE1, QE2, credit easing, fiscal stimulus, ring-fencing, liquidity provision to the tune of trillions of dollars, and bailing out banks and financial institutions; they tried them all. But now the hat is nearly empty.
Fiscal policy is now in fiscal drag in both the EZ and the UK and soon the U.S. Even in the U.S., the issue is merely the amount of drag, as state and local governments, and now the federal government, cut spending, reduce transfer payments and (soon enough) raise taxes. Another round of bank bailouts is politically unacceptable and unfeasible: Most sovereigns, especially in Europe, are so distressed that not only are bailouts unaffordable, their sovereign risk is actually leading to banking risk as most government paper is held by their banks.
Could monetary policy help? Not really. Quantitative easing (QE) is constrained by rates of inflation that are well above target levels in the EZ and the UK. The Fed will likely start QE3, but it will be too little too late. Last year’s US$600 billion QE2 and US$1 trillion of tax cuts and transfers gave us a growth handle of barely 3% for one quarter (in Q4) and then growth slumped to below 1% in H1 2011. QE3 will be much smaller, and will do much less to reflate assets and restore growth.
It is not possible for all advanced economies to have weaker currencies: They need to depreciate and improve their trade balances to restore growth, but they cannot do this concomitantly—logically if one is weaker, another has to be stronger; and if one trade balance is improved another is worsened. This is a zero-sum game. Currency wars are thus on the horizon with battles now beginning as Japan and Switzerland try to weaken their exchange rates. Others will soon follow with lower policy rates, more QE and more FX intervention.
In the EZ, the pot of rescue money is not big enough. Italy and Spain are at risk of losing market access (following Greece, Ireland and Portugal), while financial pressures are mounting in France too. But Italy and Spain are too big to fail and also too big to be bailed out or to be saved. For now, the ECB will provide some purchases of their bonds to bridge the gap to the EZ governments voting to allow more flexible use of the European Financial Stability Facility (EFSF) to purchase Italian and Spanish bonds. But by year-end or early 2012, the €440 billion of EFSF resources could be depleted if Italy and/or Spain were to lose market access. Then, unless the EFSF pot is doubled or tripled—which would be seriously resisted by Germany as it would lead to a quasi fiscal union that would eventually threaten Germany’s triple-A rating—the only option left would be an orderly but coercive restructuring of Italian and Spanish debt, as happened in Greece. Coercive restructuring of the senior and junior debts of insolvent banks would be next.
The only sector with a sound balance sheet is low-levered high-grade corporates. But tail risks have led to cautionary behavior by firms that are on an investment and job-hiring strike given the fog of uncertainty and the option value of waiting in times of risk. But here is a Catch 22: Firms are not hiring—and are actually shedding more jobs—as there is not enough final demand. But if firms hire less and/or fire more there are not enough jobs and labor income and thus consumption and final demand are weaker, making the double dip self-fulfilling. Worse, in the past few years, the secular worsening in the distribution of income has gotten worse since, during and after the financial crisis, income has shifted from labor to capital and from wages to profits as firms have slashed costs and jobs to survive and thrive. But what is individually rational—slash jobs to survive and profit—is in aggregate destructive of labor income and aggregate demand. Indeed, the marginal propensity to spend of workers/households is larger than that of the corporate sector, which has a greater propensity to save than households (even more so when the fog of uncertainty from tail risk leads to the option value of waiting). Thus, this redistribution of income is reducing aggregate demand when there is already a glut of capacity given the excess capacity in anemically growing advanced economies and the massive overcapacity in China (given over-investment), and there is a lack of aggregate demand given the deleveraging of households and governments.
So, the painful process of the deleveraging of households, banks, financial institutions, highly leveraged corporates, local and central governments has barely started and debt reductions will become necessary if countries cannot grow or save or inflate themselves out of unsustainable debt problems.
In this sense, Karl Marx was partially right in arguing that globalization and financial intermediation run amok and the redistribution of income and wealth from labor to capital could lead to capitalism self-destructing (he was only partially right as his view that socialism would be a better economic system than capitalism turned out to be utterly wrong). Indeed, if there is not enough labor income given rising income/wealth inequality, there is a structural lack of aggregate demand especially when debt burdens don’t allow households to borrow to bridge the gap between anemic incomes and spending goals. And recent riots from the Middle East to the UK and massive popular demonstrations in Israel (and rising popular anger in China) and soon enough in other advanced economies and EMs (if advanced economies were to double dip) are all driven by the same issues and tensions: Rising income and wealth inequality, poverty and unemployment and hopelessness in both the working class and even the middle class, which are feeling the squeeze of falling incomes and opportunities. In the U.S., we are now back to a second Gilded Age as income and wealth inequality is as high as in 1929 at the onset of the Great Depression after the Gilded Age of the 1920s. And after five rounds of unsustainable tax cuts in 2001-10, federal tax revenues are now at a 60-year historical low of 14% of GDP, when the U.S. historical average is 19%.
For capitalism and market-oriented economies to survive and thrive as they should—rather than ending up in a Great Depression 2.0—we need to move away from laissez faire and return to the correct balance between markets and the public provision of public goods. The Anglo-Saxon model of laissez faire and voodoo/supply-side economics and the traditional continental European model of a deficit-driven welfare state are both bust and broken. We need a third way between the two, by:
The alternative is more double-dip recessions, stagnation, depression, currency and trade wars, capital controls, financial crises, sovereign insolvencies and massive social and political instability.