As matters stand, the next recession will push the Western economic system over the edge into deflation
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Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20pc.
It is a remarkable state of affairs that the G2 monetary superpowers – the US and China – should both be tightening into such a 20pc risk, though no doubt they have concluded that asset bubbles are becoming an even bigger danger.
“We need to be extremely vigilant,” said the IMF’s Christine Lagarde in Davos. “The deflation risk is what would occur if there was a shock to those economies now at low inflation rates, way below target. I don’t think anyone can dispute that in the eurozone, inflation is way below target.”
It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.
The World Bank warns in its latest report – Capital Flows and Risks in Developing Countries – that the withdrawal of stimulus by the US Federal Reserve could throw a “curve ball” at the international system.
“If market reactions to tapering are precipitous, developing countries could see flows decline by as much as 80pc for several months,” it said. A quarter of these economies risk a sudden stop. “While this adjustment might be short-lived, it is likely to inflict serious stresses, potentially heightening crisis risks.”
The report said they may need capital controls to navigate the storm – or technically to overcome the “Impossible Trinity” of monetary autonomy, a stable exchange rate and free flows of funds. William Browder from Hermitage says that is exactly where the crisis is leading, and it will be sobering for investors to learn that their money is locked up – already the case in Cyprus, and starting in Egypt. The chain-reaction becomes self-fulfilling. “People will start asking themselves which country is next,” he said.
Emerging markets are now half the global economy, so we are in uncharted waters. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then “momentum money” late to the party. The IMF says $470bn is directly linked to money printing by the Fed . “We don’t know how much of this is going to come out again, or how quickly,” said an official from the Fund.
One country after another is now having to tighten into weakness. The longer this goes on, and the wider it spreads, the greater the risk that it will metamorphose into a global deflationary shock.
Turkey’s central bank took drastic steps on Tuesday night to halt capital flight, doubling its repurchase rate from 4.5pc to 10pc. This will bring the economy to a standstill in short order, and may ultimately prove as futile as Britain’s ideological defence of the ERM in September 1992.
South Africa raised rates on Wednesday by half a point to 5.5pc to defend the rand, and India raised a quarter-point to 8pc on Tuesday, all forced to grit their teeth as growth fizzles. Brazil and Indonesia have already been through this for months to stem a currency slide that risks turning malign at any moment.
Others are in better shape – mostly because their current accounts are in surplus – but even they are losing room for manoeuvre. Chile and Peru need to cut rates to counter the metals slump, but dare not risk it in this unforgiving climate.
Russia has a foot in recession but cannot take action to kickstart growth as the ruble falls to a record low against the euro. The central bank is burning reserves at a rate of $400m a day to defend the currency, de facto tightening. As for Ukraine, Argentina and Thailand, they are already spinning out of control.
China is marching to its own tune with a closed capital account and reserves of $3.8 trillion, but it too is sending a powerful deflationary impulse worldwide. Last year it added $5 trillion in new plant and fixed investment – as much as the US and Europe combined – flooding the global economy with yet more excess capacity.
Markets have a touching faith that the same Politburo responsible for a spectacular credit bubble worth $24 trillion – one and a half times larger than the US banking system – will now manage to deflate it gently with a skill that eluded the Fed in 1928, the Bank of Japan in 1990 and the Bank of England in 2007.
Manoj Pradhan, from Morgan Stanley, says that China’s central bank is trying to deleverage and raise rates at the same time, which “amplifies risks to growth”. This is a heroic undertaking, like surgery without anaesthetic. It is the exact opposite of what the Fed did after 2008 when QE helped cushion the shock. Morgan Stanley says that 45pc of all private credit in China must be refinanced over the next 12 months, so fasten your seatbelts.
Moreover, China is struggling to keep its industries humming at the current exchange rate. Patrick Artus, from Natixis, says surging wages – and falling productivity – mean that it now costs 10pc more to produce the Airbus A320 in Tianjing than it does in Toulouse.
The implications are obvious. China may at some stage try to steer down the yuan to hold on to market share, whatever they say in the US Congress, partly to stop Japan stealing a march with its 30pc devaluation under Abenomics. Albert Edwards from Societe Generale say this may prove the ultimate deflationary shock, dwarfing the 1998 Asia crisis.
Europe has let its defences collapse behind a Maginot Line of orthodox monetary policy. Eurostat data show that Italy, Spain, Holland, Portugal, Greece, Estonia, Slovenia, Slovakia, Latvia, as well as euro-pegged Denmark, Hungary, Bulgaria and Lithuania have all been in outright deflation since May, once tax rises are stripped out. Underlying prices have been dropping in Poland and the Czech Republic since July, and France since August.
Eurozone M3 money growth has been negative for eight months, contracting at a rate of 1.1pc over the past quarter. Bank credit to the private sector has fallen by €155bn in three months, according to the latest data from the European Central Bank.
The ECB’s Mario Draghi talked up the need for a “safety margin” against deflation before Christmas but now seems strangely passive, as if beaten into submission by the Bundesbank. I heard him twice in Davos repeating – woodenly, without conviction – that core inflation is merely back to where it was in 1999 after the Asian crisis and in 2009 after the Lehman crisis, and therefore benign.
We are not in remotely comparable circumstances. Those two events were at the outset of a new credit cycle. Right now we are nearly five years into an old cycle – already long in the tooth – and 80pc of the global economy is tightening or cutting stimulus. As matters stand, the next recession will push the Western economic system over the edge into deflation.
The US has a slightly bigger buffer, but not much. Growth of M2 money has been slowing even faster than it did in the nine months before the Lehman crash in 2008, but then the Fed no longer pays any attention to such data so it may all too easily repeat the mistake. The Fed is surely courting fate with $10bn of bond tapering each meeting into the teeth of incipient deflation, as Minneapolis Fed chief Narayana Kocherlakota keeps warning.
Those who think deflation is harmless should listen to the Bank of Japan’s Haruhiko Kuroda, who has lived through 15 years of falling prices. Corporate profits dried up. Investment in technology atrophied. Innovation fizzled out. “It created a very negative mindset in Japan,” he said.
Japan had the highest real interest rates in the rich world, leading to a compound interest spiral as the debt burden rose on a base of shrinking nominal GDP.
Any such outcome in Europe would send Club Med debt trajectories through the roof. It would doom all hope of halting Europe’s economic decline or reducing mass unemployment before the democracies of the afflicted countries go into seizure. So why are they letting it happen?