2016 is nothing like 2008, but there’s trouble ahead for the world economy

In my New Year post I did not write much about finance, but made some rather throwaway comments that the economy could take a turn for the worse in 2016.  Having just read Martin Wolf’s rather sanguine piece in the FT, I hadn’t quite understood that my views were in line with conventional wisdom in the financial markets – and this not at all a position I like to be in. But pessimism is in, and reflected by lower share prices worldwide. This has filtered through to left wing commentators, like Will Hutton, who gleefully want to show that “austerity” or “neoliberalism” is leading to a repeat of the 2008 crash (though Mr Hutton is too good a writer to use those particular totems). This is definitely company I don’t want to keep. Time to dig a bit deeper.

It helps to think back to what happened in the last turndown, the crash of 2008 – as this is foremost on people’s minds. At the start of 2008 the banking system was in deep trouble, although on the surface things were quite calm, if gently sinking. “Holed below the waterline” was the description that I used at the time – alas I was not publicly blogging until three years later, or my reputation might have been made. Trust was breaking down because the banks were dealing a lot with each other, or off-balance sheet offshoots, rather than with the public or businesses. And things were starting to go wrong, beginning with US sub-prime mortgages. The huge tangle of interbank transactions and derivatives meant that nobody knew how the losses would play out or where – so everybody was tainted. Things kept superficially calm until quite late in 2008, when Lehman Brothers collapsed, threatening a chain reaction that would have brought much of the world’s banking system to a screeching halt. Since the banking system is at the centre of everyday life in developed economies the result could have been catastrophic.

That catastrophe was largely avoided, but only because governments bailed banks out to keep the whole system afloat. Even then the damage to the non-banking economy was severe, and government finances, especially here in the UK, were ruined. What was so alarming about the whole episode was that a fairly routine downturn in the business cycle infected part of the US mortgage market, which then completely disproportionately went on threaten the whole system. Defenders of Britain’s Labour government still can’t believe it was anything to do with them – though in fact ten years of complacent economic management had left the country highly vulnerable to such a chain reaction.

Why are people worried now? Well one thing that helped the ameliorate the disaster in 2008 was that emerging markets, especially China, were less badly affected, and in China’s case, government stimulus helped keep things afloat. Now that side of things is unravelling. The Chinese economy is slowing, and in the process it is undermining world markets for commodities such as oil, which presents the threat of widespread damage in the developing world. The Chinese situation arises partly because the country has hit an awkward point in the evolution of its development, and partly because their stimulus package after 2008 was largely wasted and bad debts are threatening its banking system. Indeed the whole soundness of China’s growth strategy is coming into question (its second, state-directed phase , rather than Deng Xiaoping’s original liberalisation from 1978).

This is serious, and no mistake. The role China has played in the world economy in the last quarter century is hard to exaggerate. What is happening there is much bigger than the US subprime crisis that was at the heart of the 2008 debacle. But it doesn’t have the same destabilising features that caused such a fierce chain reaction – which were in plain view as 2008 started. China is not at the heart of a cat’s cradle of complex derivatives sitting in off-balance sheet funds, with almost every international bank taking part. And the huge power of the Chinese state, and the depth of its financial reserves, means that the country’s financial system will collapse slowly rather than suddenly. The western banking system is a much soberer thing than it was in 2008 too, even if many left wing commentators would have you believe that nothing has changed. For these reasons 2016 does not look like 2008. A meltdown, or near meltdown, does not look likely.

But there could be a slower moving form of trouble. Secular stagnation, the affliction of the world economy I referred to recently, is here to stay. Western economies will slow. Worse things may be in store in the developing world. Share prices may well fall badly – many markets have been overpriced for some time.

And in Britain? In my New Year post I suggested that 2016 might be the year the economy here started to turn sour. That comment wasn’t based on any deep thinking. Britain is unusually dependent on the international economy, as is evident from persistent trade and current account deficits, and a value for Sterling that is hard to justify based on its “real” economy. So, with things going awry in the world economy, Britain might be vulnerable. The Pound could come under pressure; foreign investors could desert London’s property market causing a chain reaction; or a downturn in the City’s finance sector could do the same thing. On the other hand, capital flight from the developing world could benefit London in particular, allowing the country to weather the storm. Some left wing commentators have been trying to stoke alarm about the level of personal debt – but that doesn’t stand up to close scrutiny. Neither should we pay much heed to Labour’s economic adviser, David Blanchflower, who on the radio this morning suggested that Britain was less ready to deal with a crisis than in 2008, because interest rates were already rock bottom. That vastly inflates the effects of interest rate policy on crisis management. David Cameron’s and George Osborne’s luck could hold. I struggle to understand the alarmism on the political left – it will merely undermine its already shaky reputation for economic grasp.

it seems to me that 2016 will be the start of a good old-fashioned cyclical downturn for the world economy, with no more than the usual localised financial crises. Personally I think this will morph into a period of more prolonged secular stagnation that will put paid to economists’ lazy assumption that 1-2% rates of growth are a law of nature.

And that should pose some very challenging questions for the art of economics. But that’s a topic for another day. Meanwhile government bonds are a better bet than shares; cash is not a bad bet either; don’t mortgage up to your eyeballs in property; and interest rates aren’t going up.

 

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2 thoughts on “2016 is nothing like 2008, but there’s trouble ahead for the world economy”

  1. Matthew – I think you have a better handle on the situation than I have. My excuse, which I don’t suggest you to take too seriously, is that I am tending to look at more fundamental questions, like: with energy use constrained by the need to tackle climate change and so with much reduced scope for jobs involving production of physical goods and energy-intensive services, how will people occupy their time meaningfully? By the way, it looks as if our incompetence in managing the global economy will bring some early, unplanned but welcome reductions in CO2 emissions.

    But let’s ignore climate change for the moment, or perhaps assume that some as yet unknown technical fixes save us from having to rethink the aims of economic policy. I’m a pretty unreconstructed Keynesian and not much of an economic liberal. It seems to me that with a little (or perhaps a lot) more wisdom we could avert the worst effects of the current downturn and of the “secular stagnation” that appears to lie in the years ahead. If the Eurozone dissolved, promoted parallel currencies or became more like a United States of Europe (with rich parts taking more responsibility for the welfare of poor parts), economic activity could be stimulated in Europe. With a sensible Congress in the USA, the same could happen there. With leaders of most of the major economies co-operating on sensible, expansionary policies, it should be possible substantially to restore global demand. I can’t resist saying that the demand should initially come from massive investment in renewable energy and energy conservation.

    Unfortunately my preconditions don’t apply. We have economic incompetence at the heart of the Eurozone and a US Congress with whom sanity (or perhaps integrity) is not a strong point. So the world may suffer from what looks, to a Keynesian, like human stupidity and perhaps even malevolence. However, because of my age and rather low-consumption lifestyle, I’ll be alright, Jack.

    1. Thanks John. I wish more economists would focus on the big long-term issues rather than being obsessed with keeping the short-term picture on tract. I’m afraid I would have to include myself in that criticism.

      One thing I learnt from my studies of history when at university (the first time) was to be very wary of charges of incompetence. These are made very cheaply through the ages, but in almost every case I have found a more complex situation at its heart. I think that is the situation in the Eurozone, notwithstanding the easy strictures of transatlantic Nobel Laureates. The charge is easier to sustain for the US Congress, because it makes political sense, and their job it to criticise, not take responsibility.

      I’m not sure that pumping up demand in order to deal with the “problem” of secular stagnation is really a no-brainer. I suspect that the path to a more sustainable future passes through a phase of secular stagnation, as we wean ourselves off an addiction to debt-fuelled consumption for its own sake. However, if you put your proposition in a different way, by saying that we have an opportunity to step up our investments in green energy and energy efficiency with relatively little economic pain, then I’m listening!

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