Back in the middle of June we provided an analysis of the likely path of global economic growth over the next eighteen months. Briefly, we argued that there was a growing appetite among policy makers and analysts that a global downturn was required to rectify global trade imbalances, the parabolic growth of housing prices (the property bubble) and to preemptively moderate inflationary pressures. Since then we have been witness to a shift by the major central banks to a policy of hold. To some this would seem to contradict our call that central banks were poised to tighten monetary policy in a bid to cool economic growth.
Such an interpretation would however be remiss because the the Fed has raised interest rates for 17 consecutive quarters making it the longest period of a Fed rate rise in history. Hence, to take the Fed’s call to hold rates as a sign that they are not interested in monetary tightening would be the wrong inference.
This is necessarily so because there is a lag between central bank policy and its effects on the macroeconomy. That is to say, increases/decreases in interest rates take time to work their way through the macroeconomy. Bernake’s constraint was that given the lag he could not be sure that his rate increases had overshot the mark or not. That is, there maybe only a knife edge between a cooling off and severe recession. Hence the Fed’s descision to pause: they needed to know what effect the past rate increases were going to have in the future.
Moroever, when we talk of Fed policy of course we are not talking just about any other central bank (as when we talk about the US dollar we are not talking about just any other currency). The fact is that the Fed has been providing global liquidity by providing dirt cheap terms for borrowing in US dollars and thereby enabling a historically unprecedented current account deficit in the US BoP and on the balance sheet of US households. This deficit in turn has been the source of what can only be described as massive US currency reserves among countries who export to the US. As we remarked back in June, one of the forces potentially driving the appetite for a global slowdown is the increasing intransigence of developing countries. At the time we pointed to the most obvious suspects:
Another explanation for the increasing appetite for a global downturn is the increasing militancy of key developing countries in Latin America and the Middle East. One sure way to break the militancy of developing countries is to undermine the high commodity prices underwriting that militancy. There is no need to bomb Iran, invade Venezuela or unleash the Dogs of War on Morales. A simple correction in the demand for commodities will do the trick.
Yet as Andy Xie at Morgan Stanley has recently pointed out, US concerns about its location within the global hierarchy of states extends well beyond commodity producers to its ability to influence policies amongst developing countries which produce manufactured and semi-manufactured goods, e.g., India and China.
Xie further argues that American influence has traditionally relied on two pillars: the carrot of US dollars for those who play and the stick of military intervention for those who refuse the invitation of empire. Xie sums thus:
While the US may be sincere in its efforts, its position is undermined by the massive US current account deficit. The US’ superpower status is based on dollar or gun diplomacy. The US current account has undermined the former, as developing countries have extensive dollar holdings. The latter is encountering major challenges in Iraq and has lost some credibility.
However, there is another pillar to US hegemony and that is access to its consumer markets (to be fair Xie would argue that this is part of the dollar carrot because all things being equal such access translates into US dollar holdings as most imports into the US are paid for in US dollars). Access to the US as the consumer of last resort has been a crucial tactical arrow in the quiver of the US imperial armoury. The problem is, as Xie alludes to in the above quote, that because the US Fed has pumped so much liquidity into the global economy and as such developing countries have little need for US dollars. Moreover the threat of protectionism has also become less credible. Not only is the US embedded in multilateral and bilateral trade agreements which make the cost of protectionism higher but the US also relies on access to cheap imports to fuel its own domestic economy and underwrite the average American’s standard of living. Add to this that much of the imports into the US are done through US MNCs abroad. So there is a substantial part of US capital that has no truck with protectionism.
We believe that taken together all of these constraints on the US’s capacity to influence other states points in the direction of a global slowdown if not outright recession in the next 12-18 months. For it is only by cooling the global economy to the point where developing countries are indeed once again hungry for US dollars that they will become more pliable to US demands. The up side of this strategy is that such a slowdown would also help to trim the overhang on the US current account, and clean up the froth in housing prices. The downside of course is that it is workers who will ultimately bear the costs of such corrections ion terms of the value of their homes, pensions standard of living and access to gainful employment.
The other interesting thing to note is now that we have seen how the new “leaner and meaner” welfare state works at the top of the cycle, should our call on global growth be right, we are going to get a chance to see how it performs at the bottom of the cycle.
The big question of course is how severe is the downturn going to be: Correction, Recession or Depression? Probability says somewhere between the first two.