George Kerevan: Not time for economic cold turkey

The monetary stimulus drug is working for the US, but turning the supply off too soon would deflate global markets, argues George Kerevan. Picture: Rob McDougall
The monetary stimulus drug is working for the US, but turning the supply off too soon would deflate global markets, argues George Kerevan. Picture: Rob McDougall
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YOU read it here first: the economic downturn is over.

Well, at least in some parts of the world. In America, in particular, the economy has started to power ahead – leaving the rest of us in its wake. Bizarrely, this good news is unsettling the world’s financial markets and sending stock prices into a tizzy. How come?

Let’s start with America’s economic renaissance. After the crisis of 2008, the Yanks did what they do best: rolled up their entrepreneurial sleeves and rebuilt their economy. American industry used low interest rates and government handouts to invest in new technology, boosting US productivity, though shedding jobs in the process. Better still, America is in the middle of an energy revolution. Domestic production of shale gas and petroleum has surged, dramatically lowering costs in heavy industry. As a result, the US economy has already recovered the level of output it had at the peak of the 2005-08 boom. Forget China, the 21st century belongs to America.

At first these positive developments were obscured by the infighting in Congress. America’s politicians seemed incapable of agreeing on how to cut the mushrooming budget deficit, which was piling up at $1 trillion a year. That made the financial markets very nervous. However, on Tuesday, America’s private sector economy suddenly came to the rescue. New official figures indicate that the growing US economy is filling the taxman’s empty coffers. This year’s deficit will be $200 billion lower than estimated only three months ago. At this rate, borrowing should be down to a minimal 2.1 per cent of GDP by 2015.

Meanwhile, in Europe the economic dawn could also be breaking – just. On Wednesday, the EU at last woke up to the fact that austerity is leading it nowhere. The European Commission suddenly reversed gears and announced – as if French butter would melt in its bureaucratic mouth – that it was giving eurozone member states permission to break the so-far stringent rule not to borrow over 3 per cent of their GDP. Of course, France, Spain and basket-case Belgium were never in danger of getting below the sacred 3 per cent, so you could say the commission was just accepting the inevitable. However, the change in tone in Brussels is highly significant.

What about the UK? True, the OECD think tank has just cut its growth forecast for Britain, for next year, from 1.6 per cent to 1.4 per cent. Frankly, that’s just statistical tinkering, even if the Tory media used it as another excuse to bash David Cameron, their current favourite bloodsport. Much more important is yesterday’s news that UK house prices have started to rise again, boosted by Chancellor Osborne’s “Help to Buy” scheme which effectively uses taxpayers’ cash to subsidise the property market. Who says socialism is dead? Also, inflation seems to be abating in the UK, boosting real incomes. A combination of rising property values and more money in peoples’ pockets should have the cash registers ringing on the high street by Christmas.

So why are the world’s stock markets having the jitters this week? The London FTSE lost 3.5 per cent in five days. Things were even worse in Japan where share prices have been plummeting. The same nervous volatility is apparent in global currency values and commodity prices. Do investors know something we don’t?

The root of the problem lies with central banks, where governments print (electronically) the world’s money. Over the past two years, led by the US Federal Reserve, the key central banks have been conducting an unprecedented experiment. Essentially, they decided to print money on an unlimited scale and pump it into the global economy, in the hope of stimulating growth. Note: this is different from the monetary injections that followed the credit crunch of 2008, which were more limited and aimed at stopping a general collapse of the American and European banking systems. Instead, today, we are talking about turning on the monetary taps and letting the cash flood out until the recessionary fire is put out.

And it has worked after a fashion – but for a very odd reason. Most of this new cash has been used by those central banks to buy up government bonds, not to lend to you or me. That, in turn, has funded the gargantuan government budget deficits which every country has been running, and also calmed the euro crisis. All that has restored a degree of confidence and let economies start to recover on their own. Also, by buying government bonds, central banks have lowered the interest yield paid on public debt. So to earn a crust, private investors have had to look elsewhere: to shares. Result: share prices have reached record levels over the past 12 months.

But now comes the reckoning. If the global economy has turned the corner, central banks will stop printing money. Earlier in May, the US Federal Reserve began hinting that time had come. Unfortunately, that could have catastrophic consequences. Without the central bank prop, government bonds will fall in price while the real interest yield payable on them will soar. That will trigger higher interest rates throughout the industrial economies and send share prices plummeting. Hence this week’s nervous market reaction.

The global economy is like an addict hooked on heroin. The trick is how to get off the drug – in this case, relying on central banks printing money. One solution, already being hinted at in dark corners, is not to stop. Or at least not to withdraw all those extra trillions that have been printed from circulating in the banking system. But mishandled such a course could be hyper-inflationary. Equally, withdrawing the monetary stimulus too soon will deflate the markets and take rising business confidence with it. There are no free lunches in economics.

Dr Kerevan’s remedy: keep the monetary stimulus in place for the next few years until recovery is certain. But the UK and Europe need to use the breathing space to emulate America’s latest productivity miracle.