It's hard to see ahead when there is dense fog. Similarly, forecasting about the world economy when it's clouded by multiple uncertainties is impossible. But deeply uncertain times also bring in a sense of gloom and excessive pessimism, just as good times spawn irrational exuberance on the positive side.
While there are enough discussions about doom and gloom, pointing to several indicators and patterns with historical parallels, this post will try to provide a different perspective. It is not an argument that we'll continue to have the stable and high economic growth of the period of Great Moderation era, which we should recognise was a historically one-off period. Instead, it's an argument that we could revert to the more commonly observed period of reasonable economic growth amidst episodes of geopolitical uncertainty.
In other words, instead of pessimism and optimism, I feel that the world economy and world in general could revert back to its normal state of affairs - moderate growth and geo-political uncertainties.
The three decades of Great Moderation was supported by the tailwinds of globalisation and globalised value chains, trade liberalisation and financial market integration, flush of countries embracing capitalism and liberalising their economies, emergence of China, growth in immigration, rapid and breakthrough advances in digital and communications technologies, other trade promoting factors, and ultra-low interest rate policies. Underpinning all this was a politically stable world order, with its overwhelmingly western dominated institutional architecture.
On a broad historical sweep, there is nothing normal about forces like global integration, low interest rates, geopolitical stability etc. There is also nothing to suggest that global economic prospects will be weaker just because these forces are retreating. The world economy experienced remarkable growth in the three decades after the War, without any of these factors.
In fact, we may be entering an age of deglobalisation (or at least slowbalisation), protectionism or at least attenuated trade flows, re-shoring, rise of anti-immigration policies, and restoration of normalcy in the credit markets. The big drivers of global growth like China may have lost their steam. And most importantly, the geo-political stability may have given way to a new Cold War involving two blocs. This is in some ways similar to the situation after the World War II.
What are the possible drivers of economic growth this time?
The re-shoring and diversification of supply chains is likely to result in a spike in investments. It'll reallocate spending and jobs away from their earlier concentrated locations (read China) towards other developing countries and the west. In particular, the risks arising from the concentration in supply of energy, and critical commodities and industrial inputs, which have become disturbingly evident during the twin shocks of the Covid 19 pandemic and the Ukraine crisis, have generated a very strong imperative for diversification. Investments in LNG terminals and other transportation infrastructure, computer chip manufacturing facilities, health care diagnostics and other critical inputs are already on the train.
The green energy transformation is likely to be the major investment driver in the next couple of decades. If anything, its importance and urgency will only increase in the years ahead. Besides, it'll be an important contributor to innovation and productivity enhancement. The full possibilities from digital technologies like IoT, AI and ML, data analytics, robotics etc lie in the years ahead. Their productivity improvement potential could be large and likely. The shock provided by the Russian invasion will also boost military spending in the years ahead.
Finally, the recent rise in wages signal a possible recalibration in capital-labour bargaining power. Any inflation due to higher growth in labour wages, which have either crawled up or been almost stagnant over the Great Moderation, should be welcome feature. This coupled with the gathering momentum and regime shift on anti-trust issues, should create the foundations for more equitable and broad-based economic growth. Yes, these forces could reverse and remain still-born. More likely, they'll play out with far less intensity than expected. That would still be progress and creates conditions for sustainable economic growth.
This is a good article.
On the debt side, corporate and bank balance sheets in the US and Europe remain fairly strong and, unlike a few years back, does not look alarming on the debt side. For sure, governments have become massively leveraged, and this is an issue which will constrain fiscal policy response in case of recession. However, deleveraging of the kind required without engendering instability is not not without precedent, as the post-war years show. As to the argument that recessions are inevitable with any monetary tightening to cool an overheated economy, as Jerome Powell himself indicated, there have been instances in 1965, 1984 and 1994 when such reversals did not lead to recessions.
In my views the more serious concern about global economic prospects should arise from the leverage-driven asset market distortions that have emerged over the last decade. What will be the spill-over effects on the real economy from the inevitable bursting of the asset bubbles? Here too there is a case that nearly three-fourths of the bubble valuations come from a handful of very solid technology companies of a new economy, which would anyways command very high valuations, though arguably not as inflated as now. This is not anything like the vapourware of the technology stock bubble at the turn of the millennium.
Even the possibility of elevated energy prices does not make the case for a recession. A large part of the era of Great Moderation was co-terminus with the commodities Super Cycle. In fact, oil prices have risen above $100 in multiple occasions from 2008-14, even briefly crossing $140 once. High commodity prices can perfectly co-exist with high growth rates, and that too for long periods of time.
Even if recession strikes, it's not as though all will be bad. As the graphic below shows, unlike the Great Depression and Great Recession, modern US recessions have been short durations (for a few months) and far less frequent.
On the inflation side too, there are important overlooked factors. For one, it's reasonable to assume that the current supply chain disruptions and commodity shortages are likely to ease, at least in a couple of years. Further, even in the most dire predictions, we're talking about inflation staying elevated at levels like 4-6%. While this is high by the current standards, these are not alarming normals in any historic sweep. Finally, there is the structural view of inflation, about which I have blogged here earlier, which makes the strong case for low inflation over the coming decades. In any case, if the new normal in inflation is 4% and not 2%, it hardly spells doom.
One cannot but help feel that there are two psychological factors at work here among commentators assessing the world economy. One, there is the pall of gloom associated with any envelope of uncertainty, which geo-politics currently presents. Second, there is also the representativeness bias of looking at the future with the anchor of an immediate past which was characterised by an unprecedented long period of low inflation, high employment, and high growth.
In other words, there is enough basis to assume the foundations for reasonable growth in the foreseeable future of a decade or so. At the least, there's no more evidence for an extended period of stagflation than there is on the likelihood of a period with a slightly lower economic growth rate compared to the Great Moderation era.
Given all these, it's fair to argue that the western economies will not remain stuck in stagnation for long. For sure, a slow-down, or even a short recession, will most likely happen to wring out the excesses of the credit bubble, the excessive Covid spending (in the US), and also due to the twin shocks of the last two years. But instead of an era of stagflation, we are more likely to have a short period of recession and elevated inflation compared to our immediate history. There is also a non-trivial possibility of a financial cycle induced stagnation or recession, and its impacts could be uncertain.
Update 1 (07.04.2022)
From the Times on the economic prospects,
A majority of forecasters say a recession remains unlikely in the next year. High oil prices, rising interest rates and waning government aid will all drag down growth this year, said Aneta Markowska, chief economist for Jefferies, an investment bank. But corporate profits are strong, households have trillions in savings, and debt loads are low — all of which should provide a cushion against any slowdown. “It’s easy to construct a very negative narrative, but when you actually look at the magnitude of all those impacts, I don’t think they’re significant enough to push us into a recession in the next 12 months,” she said. Recessions, almost by definition, involve job losses and unemployment; right now, companies are doing practically anything they can to retain workers. “I just don’t see what would cause businesses to do a complete 180 and go from ‘We need to hire all these people and we can’t find them’ to ‘We have to lay people off,’” Ms. Markowska said.
In general, there are too many signatures of economic strength that an outright recession in the immediate future appears less likely. A slowdown looks possible, even most likely.
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