May 12, 2017

Have we passed peak protectionism? And if so, what’s next?

by Fathom Consulting

On Tuesday 9 May, we presented an overview of our Global Economic and Markets Outlook for 2017 Q2 at an event hosted by Thomson Reuters in London. We were joined by former Bank of England policymakers Paul Fisher, Ian Plenderleith and Sushil Wadhwani.

Fathom Director Erik Britton began by setting out what, in our judgment, is the most likely outcome for the global economy. Despite wobbles over his initial failure to replace Obamacare, our central scenario sees US President Donald Trump enact a substantial fiscal stimulus package. There is a material pick-up in growth, with the US economy expanding by 2.7% in 2017 and by 3.5% in 2018. With the labour market already close to full employment, inflation begins to rise. Recognising that it has the tools to deal with a period of above target inflation, while another period of below target inflation would be much harder to address, the Fed moves cautiously. There are two increases in the Fed funds rate this year, and four next year. But this is barely enough to keep pace with rising inflation. Our forecast for the real Fed funds rate – the nominal rate, minus core inflation – is set out in our first chart below. We see the real Fed funds rate essentially on hold for at least the next two years. Moving the nominal Fed funds rate only to keep pace with inflation may appear extreme, but it is precisely what the Fed has delivered to date during the present tightening cycle – it is now 17 months since the Fed funds rate was first raised in December 2015, so we are at M17 on the horizontal axis of our chart. In this environment, inflation moves above target, reaching 3.0% by the end of this year, and 3.5% by the end of next year.

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With the world’s largest economy growing at its fastest pace in more than ten years, and with China continuing to double down, emerging economies do well in our central scenario. Elsewhere the outlook is mixed. With near record levels of consumer confidence, driven in part by falling unemployment, the euro area continues to enjoy a cyclical upturn. Nevertheless, unless and until members of the single currency bloc form a proper fiscal union, we remain long-term euro area bears. In the UK growth continues to slow as the reality of what is likely to be a messy departure from the EU starts to bite.

Our risk scenario has remained largely unchanged in nature over the past year. It sees a series of protectionist policies enacted by populist politicians around the world. Tariffs start to rise, and globalisation goes into reverse, diminishing the size of the global economic ‘pie’ – see chart below. We began the debate by asking Ian Plenderleith whether, with Emmanuel Macron safely installed in the Elysée Palace, we could declare that peak protectionism had passed. Could we at last turn our attention instead to some of the pressing macro-economic questions of the day, such as: ‘Why is the risk-free rate so low?’ and ‘How might we address record levels of debt around the developed world?’.

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Can we stop worrying about the march of populist politics?

Ian Plenderleith felt that M. Macron’s victory in the French elections would do no more than afford the global economy a little breathing space. The fundamental factors that appeared to have underpinned growing support for populist politicians in Europe, such as significant net inward migration, remained in place. Sushil Wadhwani agreed. He described recent political near misses in Europe, including the Dutch legislative and French presidential elections as a “postponement of the inevitable”. Our audience too were far from convinced that the worst was behind us. Asked to consider whether we had passed peak protectionism, only 8% were confident that we had. 41% of our audience felt that we ‘probably’ had, while the remaining 52% felt that we had not.

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Why is the risk-free rate so low?

Mathematician Frank Ramsey demonstrated as long ago as 1928 that, in a world where individuals maximise the present value of expected future happiness, and firms maximise the present value of expected future profits, individuals should save and firms should invest until the real rate of interest is just equal to the sum of economic growth and the rate of time preference, ρ. Frank Ramsey’s theory has, on average, worked well. The following chart compares the real rate of growth of the UK economy since 1870 with the real long-term rate of interest. For all their variability, the means of these two series are very close. GDP growth has averaged 2.11%, while the real long-term rate of interest has averaged 2.90%. That implies that the rate of time preference has averaged 79 basis points. Similar relationships hold in other countries. Looking across all 17 advanced economies in the Jordà-Schularick-Taylor macro-history database, we find that a country’s real long-term rate of interest has, on average, exceeded its real rate of growth since 1870 by 33 basis points.

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The idea that a country’s real rate of interest should, in steady state, be close to its real rate of growth works well on average. But, for now at least, the relationship appears to have broken down. Many would consider that we are pessimistic when it comes to our assessment of the UK’s growth prospects. But even we would accept that trend growth in the UK is some way north of -2%, which is more or less what ten-year index-linked gilts are yielding today.

Fathom’s view is that much of the decline in index-linked yields across the developed world, from around 2%-3% at the turn of the century, to less than zero in many countries today, has been driven by the behaviour of the world’s largest emerging economy. Since joining the WTO in 2001, China has become increasingly integrated into global capital markets, which means that its own decisions with regard to saving and investment are able to influence interest rates around the world. Easily the world’s largest saver, China is not following the Ramsey rulebook in our view. It is behaving as if it prefers ‘jam tomorrow’ – its time discount rate, ρ , is effectively negative. It is China’s strong desire to save, rather than consume, that has driven down index-linked yields, in the UK and elsewhere. If our explanation is broadly correct, then the normal relationship between growth and real rates of interest across the developed world might reassert itself in one of two ways. Either China rebalances, and consumes more while saving less, or it is effectively shut out of global capital markets by a collapse in global trade. This, in short, is our risk scenario.

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Our panellists were in broad agreement that the normal relationship between growth and the real rate of interest would reassert itself at some point. But there was little consensus regarding when, and it was unclear whether it would be achieved by an increase in the real rate of interest or a reduction in the rate of economic growth. Sushil Wadhwani drew attention to the fact that, ever since 2010, the consensus each year had been that index-linked yields would rise. And yet in almost every year since 2010 they had fallen. But as he pointed out, that is the nature of mean reversion. Forecasts for mean reversion can be wrong for many years, until suddenly they are right.

Our audience too believed that index-linked gilt yields would normalise, but that it would take a long time. Most believed it would take between 10 and 20 years. However, almost one in five felt that long-term real rates of interest would remain below zero indefinitely.

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Too much debt? A growing problem.

In many advanced economies, the total quantity of debt, relative to GDP, is close to levels last seen in the immediate aftermath of World War II. Having been broadly stable for more than 100 years, rising only in the immediate aftermath of a major global conflict before falling back again, debt began to increase as a share of GDP across the developed world around 1980. Financial innovation undoubtedly facilitated this move. But is the inexorable rise of debt, relative to GDP, a sign of market completion, or market failure? We tend to side with the latter interpretation. The burden of debt has reached such levels, in many advanced economies, but particularly in Japan, that it is scarcely possible to believe it can ever be repaid in full, on the terms envisaged by the lender. That is to say, some form of default whether soft, in the form of higher-than-expected inflation, or hard, through outright non-payment, seems almost inevitable. That is why we have advocated a policy of helicopter money for Japan.

A reduction in the rate of interest typically stimulates an economy through two channels. First, it lowers the repayments required on variable interest loans, boosting the post-interest income of debtors. Second, by reducing the opportunity cost of consuming today rather than tomorrow, it encourages people to bring forward expenditures that would otherwise have occurred in the future. But crucially, there are limits to this second channel. There must come a time when people have borrowed so much against their expected future incomes that they are either unwilling or unable to borrow any more. At that point, monetary policy becomes much less effective. Arguably, that is pretty much the position in which much of the developed world finds itself today. The boost to demand afforded by rising debt over the past 40 years has, in broad terms, come to an end. In support of this view, our own analysis suggests a doubling of a country’s debt-to-GDP ratio, from 100% to 200%, would reduce long-run economic growth by ½ a percentage point.

Among our panel, there was general agreement that debt levels had become problematic. But there was no clear consensus as to the appropriate solution. Ian Plenderleith felt that it could be repaid, more or less in full without the need for persistently high inflation, just as it had been in many countries following World War II. The difficulty with this approach, as Erik Britton pointed out, is that it would take a very long time. It took almost 30 years for the UK’s debt-to-GDP ratio to fall from an all-time high of 288% in 1946, to a more manageable 84% in 1975. Paul Fisher felt that, in an ideal world, the debt would be inflated away, at least in part. This led on to a discussion of whether, in the present circumstances, it would be advantageous for developed economy central banks to target a higher rate of inflation than 2%.

Paul Fisher was strongly of the view that inflation targets should not be raised merely in an attempt to deliver higher growth. He argued that inflation targeting was one of very few policies that had worked. Erik Britton countered that, while a higher inflation target would not boost inflation in and of itself, it is a policy that might benefit an economy, such as the US, that was already close to full employment, and where inflation was rising. Sushil Wadhwani believed that, for many countries, a higher inflation target would be beneficial. Recent experience had taught us that, with debt levels as high as they are, and with inflation intended to average around 2%, an economy can get itself into a position where the real rate of interest cannot be cut sufficiently to stimulate demand. This had caused a number of major central banks to engage in policies, such as quantitative easing and even negative rates on deposits that in his view were harmful to central bank independence.

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