Bill Jamieson: Between burnt toast and the bubble busting

Chinese stocks begin to plunge on a display in Beijing. Picture: Nicolas Asfouri/Getty
Chinese stocks begin to plunge on a display in Beijing. Picture: Nicolas Asfouri/Getty
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Here are two views on where the world is headed.

Scenario one: from China to America, Asia to Europe, the growth story continues. Inflation has not erupted as many feared. Even in the UK, GDP has performed better than predicted. Overseas investment in the UK continues to confound the pessimists and fears of a Brexit stagnation and investment slump have given way to more optimism across business.

Scenario two: we are heading towards a global recession. The great asset price boom of the past nine years is coming to an end, and it will prove no gentle glide downwards. Central banks are moving to rein in quantitative easing and push interest rates higher. There are mounting threats of a trade war between America and China. Meanwhile, sabre rattling between the super powers points to a marked darkening in the world of geopolitics. And far from easing, the debt mountain of the western economies continues to grow, with attendant risks to government finances and bond markets.

Both views are plausible, but which will prevail? For now, the consensus is that while we may be due a correction in financial markets, the more chilling outcomes will be avoided. The world economy will continue to show decent growth. It has momentum behind it, aided and abetted by international co-operation and policy co-ordination. An all-out trade war will be avoided. Tax cuts will continue to spur the US economy while China pushes ahead with its colossal infrastructure spending plans. And that smouldering volcano of government debt? It’s been known and written about for years. What is new or different that would cause it to erupt now?

But it is precisely this comforting view that troubles markets. Yes, the world economy looks to be firing on all cylinders, with almost every region showing reasonable growth. Yet this has been made possible only by unprecedented monetary easing to stave off a slump after the 2007-09 banking crash. This has been a long boom by any standard, with the US stock market enjoying its second longest ever rally. And it is not just its length but its artifice, the availability of emergency money and the lowest interest rates across developed country economies since records began, that is causing growing unease.

This can only go on for so long. We do not know yet whether we are destined for a slow fizzle or an almighty bang. But the news flow of recent months has not been good, and much is riding on two of the biggest worry points – military conflagration and a global trade war – being resolved with little damage to the world order.

As for monetary policy, don’t central banks now have matters in hand? But here, arguably, is where the greatest risk is to be found. John Wyn-Evans, head of investment strategy at wealth manager Investec, likened the management of interest rate policy to those revolving toaster machines in hotels. The emerging toast is either barely browned or is burnt to a frazzle. Mis-timed reaction through resort to the machine’s buttons can worsen the risk.

Over the next 12 months short-term interest rates may be pushed higher or faster than markets expect. This could be because of a surge in inflation, the impact of tax cuts in the US, and an increase in government borrowing in the UK. An early casualty would be the government bond market. And a widespread bond market fall would have serious consequential effects around the world.

And it is here that over co-ordination of economic and monetary policies could work to turn a localised forest fire into a conflagration. If countries push synchronisation too closely, business cycles became overly co-ordinated, with the result that booms and busts become global in scale and intensity.

Back in the 1990s, financial globalisation helped turn subprime mortgage lending problems in the US into a global crisis. Today it seems that monetary policy is not aligned to any dangerous degree: the US central bank is pushing ahead with rate rises while Japan and Europe have been keeping theirs low or negative. But with long-term US rates still falling, international divergence in monetary policy is more apparent than real. The risk here is that as national economies become more interrelated, the failure of one presents greater risks to all – and mistakes in one area could move more quickly to others.

And how disconnected is China? The big story of the past 20 years is how influential it has become on the world economic stage. 2017 marked the second year in succession that it surpassed the US as Germany’s biggest trading partner, with the value of its trade with Germany rocketing 35 per cent on the previous year. A slowdown in China – potentially triggered by an overheating caused by its massive “One Belt, One Road” (OBOR) infrastructure programme – could hit the US hard through inflation and higher than expected interest rate rises.

On another perspective, Desmond Lachman, resident fellow at the American Enterprise Institute, argues that the US economy is in danger of soon overheating, bringing inflation in its wake. “That in turn is all too likely to lead to rising interest rates, which could very well be the trigger that bursts the all too many asset price bubbles around the world… On that score, today’s financial market situation would appear to be very much more concerning than that on the eve of the September 2008 Lehman bankruptcy.”

According to IMF estimates, today the global debt-to-GDP level is significantly higher than it was in 2008. Today’s asset price bubbles are dependent on interest rates remaining indefinitely at today’s ultra-low levels. And as matters stand, the US economy is now experiencing an extraordinary degree of monetary and fiscal policy stimulus at a very late stage of the cycle. America’s budget borrowing is set to hit five per cent of GDP in the near future, with debt rising to 96 per cent of GDP in the next decade.

Too big to tackle? Then an age-old dilemma in economic policy kicks in: the longer you leave the problem unaddressed, the greater the damage when the bubble bursts.