The paradox of rising wage growth and falling inflation

• ? Strong labour markets and rising wages in advanced economies stand in sharp contrast to recent declines in economists’ inflation forecasts and market expectations. In our view, though, these developments are not necessarily contradictory. Even if wage growth edges higher, we think demand factors will limit any pick‐up in prices. Instead, we expect firms’ margins will be squeezed.
• ? Although the labour share has risen more sharply than we had expected over the past couple of years, we are sceptical that this will translate into substantially stronger underlying inflation. Not only has the rise been small, it has been employment rather than wages that has surprised to the upside. The strength of employment is probably more about firms’ production preferences than workers’ capitalising on a stronger negotiating position.
• ? True, wages adjusted for productivity now look high by historical standards. But neither theory or empirical evidence suggests that this must inevitably lead to stronger CPI inflation in the short‐term. Our forecast for flat wage growth in 2019 and the absence of strong cost pressures elsewhere are also a comfort.
• ? Inflation tends to be more responsive to demand indicators – and the recent GDP growth soft patch suggests any further pick‐up in underlying inflation pressures will be limited (see Chart below).
• ? More generally, we think that the consensus view on inflation for the key advanced economies is high. Market‐based inflation expectations are typically lower than our own, which may reflect the perception that inflation risks are skewed to the downside. Positive economic surprises could lead downside risks to narrow, but ageing expansions and secular stagnation worries suggest this is unlikely, limiting any future pick‐up in bond yields.

     

Supply surprise is a ‘nice’ reprise

• ? This year advanced economies have enjoyed a rare positive supply surprise: output is higher than expected and inflation is lower. The initial China‐related boost not only proved to be a great antidote to secularly weak global demand, but it has also engendered unexpected global momentum and a benign inflation response. As a result, 2016–17 resembles a mini‐reprise of the “nice” 1990s, a non‐inflationary, consistently expansionary decade.
• ? The global momentum has been propelled by a strong international trade multiplier. This has contributed to strength in several advanced economies, particularly the Eurozone. We expect global growth in 2018 to be bolstered by US fiscal stimulus as the impulse from China fades.
• ? It will remain “nice” in 2018, albeit in the context of weak secular trend growth. We expect the benign output‐inflation trade‐off to continue. Several of the factors that are underpinning low inflation and unemployment as well as weak wage growth are likely to be present for some time.

     

Tighter labour markets to finally lift global wages

• Wage growth has been relatively slow since 2007 in advanced economies, but an upturn may be in sight. Slow productivity growth remains an issue but tighter labour markets make a positive response by wages to rising inflation more likely and there are signs that compositional and crisis‐related effects that dragged wage growth down are fading – though Japan may be an exception.
• Overall, our forecasts are for a moderate improvement in wage growth in the major economies in 2017–18, with the pace of growth rising by 0.5–1% per year relative to its 2016 level by 2018 – enough to keep consumer spending reasonably solid.
• Few countries have maintained their pre‐crisis pace of wage growth since 2007. In part this reflects a mixture of low inflation and weak productivity growth, but other factors have also been in play: in the US and Japan wage growth has run as much as 0.5–1% per year lower than conventional models would suggest.
• The link with productivity seems to have weakened since 2007 and Phillips curves – which relate wages to unemployment – have become flatter. A notable exception is Germany, where the labour market has behaved in a much more ‘normal’ fashion over recent years with wage growth responding to diminishing slack.
• ‘Compositional’ factors related to shifts in the structure of the workforce may have had an important influence in holding down wage growth, cutting it by as much as 2% per year in the US and 1% per year in the UK. There are some signs that the impact of these effects in the UK and US are fading, but not in Japan.
• The forecast rise in inflation over the next year as energy price base effects turn positive is a potential risk to real wages. But the decline in measures of labour market slack in the US, UK and Germany suggests wages are more likely to move up with inflation than was the case in 2010–11 when oil prices spiked and real wages fell.

     

Global wages: we don't (yet) have lift‐off

• ? Policymakers, most notably in the US, have been expecting wage growth to pick up for some time as job markets tighten. But the data over the last six months have shown few indications of wage lift‐off. Our review of the latest evidence suggests that although labour markets are, on the whole, still tightening, we see increased downside risks to our forecasts for faster global wage growth in 2018–19.
• ? Rates of “churn” in labour markets – a possible precursor to faster wage growth – have continued to rise in the US and parts of Europe.
• ? But other structural factors may still be holding wages down. A recovery in prime‐age participation in the US may be helping to cap wage rises, as may a pool of “underemployed” workers in the US and UK (though this pool is shrinking fast).
• ? Productivity growth also remains weak, running at a 0.5%–1% annual pace in Q1 2017 across the US, UK, Germany and Japan. This compares with a G7 average pace of 1.5% per year in 1985–2006.
• ? Overall, the risks to our baseline forecast of faster wage growth in the major economies in 2018 look skewed to the downside. We expect wage growth to firm in 2018 by 0.5–1 percentage points in the US, UK, Germany and Japan. We would give this modal forecast a probability of around 60%, but with a 25% chance that wage growth is somewhat slower than this and only a 15% chance that it is higher.

     

How low can U go?

• ? Although there is growing evidence that wage growth is building in response to low and falling unemployment in the advanced economies, there is scope for unemployment rates to fall further without triggering a pay surge.
• ? For a start, current unemployment rates in comparison to past cyclical troughs overstate the tightness of labour markets. Demographic trends associated with the ageing ‘baby boomer’ bulge have pushed down the headline unemployment rate – unemployment rates among older workers are lower than those of younger cohorts. And in a historical context, Europe still has a large pool of involuntary part‐timers.
• ? In addition, rising participation rates mean that demographics are less of a constraint on employment growth than widely assumed. In both 2017 and 2018, had it not been for increased activity rates (mainly for older cohorts), unemployment would have had to fall more sharply to accommodate the same employment increase. We expect rising participation rates to continue to act as a pressure valve for the labour market.
• ? Finally, unemployment rates were generally far lower during the 1950s and 1960s than now. If wages stay low relative to productivity, as was the case during that prior era, employment growth may remain strong, with unemployment falling further. In the post‐war era, low wages were partly a function of a grand bargain in which policy‐makers provided full employment in return for low wage growth.
• ? There is evidence to suggest that many post‐crisis workers have opted for the security of their existing full‐time job and its associated benefits despite lower wage growth, rather than change job and potentially earn more; the rise of the ‘gig economy’ has led some workers to value what they already have more. Put another way, the non‐accelerating inflation rate of unemployment (NAIRU) has fallen. So, the role of labour market tightness in pushing wage growth higher may continue to surprise to the downside.

     

Secular stagnation ‐ are we stuck in Summers' long winter?

• Stunningly low global long‐term bond yields provide some credence to a secular stagnation view of the world. We present an analytical framework – culminating in a simple scorecard – for assessing the extent to which purported drivers and manifestations of secular stagnation match global economic and financial developments and we compare with a complementary narrative focusing on balance sheet boom and bust. We find some support for each, but think global rates will not stay as low for as long as markets price in.
• Larry Summers has used the term to refer to a situation where demand and supply for savings deliver very low equilibrium real interest rates. The bulge in middle‐aged savers, falling prices of investment goods, and flows of savings ‘uphill’ from emerging markets may have all led to real rates trending much lower in recent decades.
• Another version of the story is that slow technical progress depresses demand for borrowing, and pushes down on real rates. This is less compelling, and based more on anecdote than anything else. There are as many reasons to be optimistic, as pessimistic, about the supply side.
• There are holes in the secular stagnation narrative. Until very recently, G7 savings rates have trended down rather than up, partly because of another decades‐long trend of financial innovation. Furthermore, few economists, nor the Fed or the BoE, expect policy rates in the US or UK to stay low for as long as is priced in to markets.
• A complementary narrative would stress the role of the credit‐fuelled mega‐boom and subsequent balance sheet blow out and Great Recession, and then the long road to financial repair. This is more consistent with the path of savings rates over recent decades, and the policy response – including QE – can explain much of the rest.
• We see the two explanations as complementary and reinforcing. In global terms, they appear no better or worse than each other. Comparing across countries, Japan comes closest to resembling secular stagnation, followed by EZ, US and UK, according to our scorecard.
• We think ultra‐low long rates will not be borne out by the future path of short rates, but acknowledge a significant risk they might, for example, if monetary policy remains too tight on average because of zero bound effects on interest rates and limited scope for fiscal accommodation.

     

G7 consumption: after the wealth rush

• ? In only one of 12 large advanced economies do we expect consumption to outstrip GDP growth in 2018. As key drivers rotate, the impact of a recovery in real incomes will be dampened by higher oil prices and waning wealth effects .
• ? Policy‐fuelled asset booms sustained the post‐crisis recovery in G7 consumption, though by historical standards the recovery was nothing special. Historically, the G7's average 5‐year recovery from troughs entailed consumption matching GDP growth, but in the five years from 2010 consumption was 0.2 ppt weaker. Its relative strength only picked up from 2015, when boosted by weak oil prices.
• ? Relatively weak G7 consumption growth is likely to continue as key drivers rotate. Strong employment growth and a modest pick‐up in wage inflation will offset waning equity and housing wealth effects.
• ? Near‐term risks are two‐way. An oil‐fuelled inflation surprise could hit consumers, wreck central bank gradualism and reveal balance sheet weaknesses. Currently, however, we see only limited pockets of credit risk and vulnerability to higher rates.
• ? Conversely, there is scope for a credit‐fuelled boost to consumption. G7 household borrowing relative to its trend is arguably close to 40‐year lows, so unless financial deepening has reached a limit, there is scope for increases in borrowing. Furthermore, G7 bank deleveraging could be over, boosting credit supply conditions.
• ? We see two positive longer‐term drivers of the global consumption share: (i) Asian economies will become more consumption‐driven; (ii) Household re‐leveraging offers scope for some debt‐fuelled consumption growth. Offsetting negatives are that demographics, interest rates and asset prices will provide little support

     

China‐commodity nexus at the heart of global upturn

• ? The China‐commodity nexus has been at the heart of the global upturn in trade and industry. It could directly and indirectly account for as much as 70% of the recovery since mid‐2016, based on our analysis. We think this nexus will continue to support world growth in the near term, but the global upturn is vulnerable to moderating Chinese growth and slippage in commodity prices.
• ? China has directly accounted for around a third of the upturn in world trade, similar to the contribution of G7 countries. But adding in indirect effects, China's influence is likely to have been much more significant. Stronger Chinese demand has contributed to an improvement in the trade performance of its Asian trading partners, commodity exporters and other advanced economies.
• ? Using a model simulation that introduces positive shocks to imports in “greater China” and to commodity prices (based on the scale we have seen since mid‐2016), our top‐end estimate for China's contribution to the upturn in world trade is around 70%.
• ? The simulation points to especially strong improvements in output and exports for economies such as South Korea, Japan, Malaysia and some commodity exporters. This broadly matches the pattern of performance seen over recent months, though commodity exporters' performance has been quite mixed.
• ? G7 investment growth is likely to have played only a modest role in the recent global upturn. But Japan is an exception, while upgrades to investment forecasts for South Korea, Taiwan and Hong Kong have also been large.
• ? A 1% rise in commodity prices could raise commodity exporters' investment by 0.3–0.6%, based on our analysis. As a result, there could be additional improvement in commodity exporters' investment this year, supporting world growth. However, with our forecasts suggesting that commodity prices are set to slip further over the coming quarters, this boost could prove short‐lived.

     

An investment‐led expansion is no pipe dream

• Contrary to some perceptions, the UK's economic recovery has not been a disproportionately consumer‐led one. In fact, business investment has punched well above its weight in supporting growth. And the conditions look good for this outsized contribution to continue.
• Consequently, we think that the threat of ‘secular stagnation’, reflecting a lack of appetite to spend on the part of firms, is one that the UK should avoid. Moreover, strong investment growth should have desirable by‐products in the form of more accommodative monetary and fiscal policy.

     

Global growth to 2024: reversion to which mean?

• We expect global GDP growth to average 3.5% per year (at PPP exchange rates) over the next ten years. This is lower than the 3.8% recorded in 2000–14 though not dramatically so. There will be a modest recovery in advanced economy growth ‐ but not to pre‐crisis rates. Emerging market (EM) growth will slow but remain faster than growth in the advanced economies. And with EM's share in world GDP much increased from 10–15 years ago, EMs will continue to provide a large proportion of world growth.
• EM growth is expected to run at around 4.5% per year in 2015–24, well down on the 6% seen in 2000–14. This includes a slowdown from around 10% to 5–6% in China ‐ but China's share in world GDP has risen so much that China's contribution to world growth will remain very substantial.
• Advanced economies are forecast to grow by 1.9% per year in 2015–24, a big improvement from the 1% pace of 2007–14 (which was affected by the global financial crisis) but below the 1990–2014 average. Indeed, the gap between forecast G7 GDP and GDP extrapolated using pre‐crisis trends in potential output will remain large at 10–15% in 2015–24.
• Global growth will remain relatively strong compared to much longer‐term averages: growth from 1870–1950 was only around 2% per year. But a return to such low growth rates looks unlikely; China and India were a major drag on world growth until the 1980s but are now fast growing regions.
• Our forecast is relatively cautious about key growth factors; the contribution of productivity growth is expected to improve slightly, while those from capital accumulation and labour supply fall back. Demographics will be a more severe drag on growth from 2025–40. Overall, risks to our long‐term forecasts look to be skewed to the downside.

     

A Labour win would be a roll of the dice for the economy

• ? “It depends”, the classic economist's answer, is apt in assessing the economic outcome of a Labour government. Looser fiscal policy and shifting income from capital to labour could be GDP positive. But a loss of faith in Labour's commitment to Bank of England independence could offset those gains in a mix of lost confidence, spiking interest rates and currency depreciation .
• ? We attach a 20% probability to a general election being held within the next year. The Government's precarious parliamentary position leaves it vulnerable to rebellions, particularly in passing Brexit‐related legislation. But the Fixed‐term Parliaments Act makes it difficult to force a new election, even if the Government is complicit.
• ? In the event of an election in the near term, Labour would require a significant swing in support to gain a majority. Opinion polls show little evidence of this happening, so we put the chances of a majority Labour government at no more than 10%. But the odds of either a Labour‐led coalition or minority government are around 50%.
• ? The consequences of Labour's plans for sterling are ambiguous. A looser fiscal stance should prompt the MPC to tighten monetary policy more aggressively, boosting the pound. But the Party's approach to the Bank could have the opposite effect. A rise in gilt yields is a safer prediction. But with more than half of the gilt stock held by the public sector and “captive” buyers, the scope for a major sell‐off is limited.
• ? The experience of the EU referendum suggests that a Labour victory is unlikely to cause a sudden collapse in confidence. But the drag on profitability from Labour's policies and an activist approach to foreign takeovers could cut FDI inflows, which may be bad for productivity, though it would imply a more competitive pound.
• ? Our modelling suggests that a looser fiscal stance could boost the level of GDP by 2% above our baseline view after three years, if Labour sustains market confidence. But in a “bad” Labour scenario, with central bank independence compromised, the hit to confidence, market rates and sterling would offset the gains from looser fiscal policy.

     

Japan

Our outlook for domestic demand remains reasonably optimistic, notwithstanding recent financial market turmoil. A tight labour market and a pick‐up in wages will bolster consumption and incentivise investment in labour‐saving technology. Meanwhile, firms continue to expand capacity and raise R&D expenditure for new technologies, boosting investment. While growth in 2018 was set back by weather‐related contractions in Q1 and Q3, we expect demand to have rebounded in Q4 and look for GDP to have grown by 0.8% in 2018 as a whole. We expect growth of 1.0% in 2019 but just 0.3% in 2020, with the key drivers being:

• ? Robust labour market to support consumption: as the labour market continues to tighten, we expect household spending to continue to support growth in 2019. We project consumption to accelerate ahead of the scheduled rise of the consumption tax in Q4 2019, before falling back as the tax hike feeds through. However, given the stimulus measures planned by the government to soften the impact of the tax rise, we then expect consumption to show a faster recovery relative to previous consumption tax increases.
• ? Solid investment intentions despite rising uncertainty: business sentiment and investment intentions remain above historical averages and firms continue to expand capacity and increase R&D for new technologies, despite rising uncertainty over the durability of global economic momentum. And although softening recently, machinery orders remain high. Looking ahead, we expect investment growth to lose some momentum as the investment cycle begins to turn and global trade continues to ease.
• ? Low export growth to carry over into 2019: export volume growth has been weak of late, reflecting the softening in external demand. Import volumes have continued to grow at a robust pace, given solid domestic momentum. We expect export growth to remain weak going into 2019, in line with slowing global trade.
• ? Industrial production to continue growing: industrial output has recovered of late, after weather‐related disruption had weighed on growth earlier in 2018, while the PMI has remained stable at 52–53. We expect industrial production to continue growing in line with domestic demand, but slower than in previous years given less buoyant external prospects.
• ? No fiscal consolidation without economic revitalisation: the government is planning measures to support growth after the consumption tax rise in Q4 2019 including a diverse range of policies to incentivise consumption and an expansion of free childcare and education. It has also signalled that it stands ready to provide additional stimulus if needed.
• ? Monetary policy to stay put amid low inflation and falling bond yields: inflation has remained stagnant while 10‐year government bond yields fell into negative territory for the first time in two years, putting an end to speculation about monetary policy tweaks. With the consumption tax rise drawing closer, we do not expect the BoJ to move again any time soon.
• ? Equity sell‐off to prove temporary, but yen strength will persist: we expect current equity weakness to be temporary, but market volatility and more cautious Fed tightening indicate a stronger yen in 2019. Ongoing trade frictions and political attention on the exchange rate will also support the yen, which we see averaging 107 yen per US dollar in 2019.

     

Brexit adds to gloom over long‐term growth prospects

• The prospect of continued weak productivity growth and less support from rising labour supply means we are relatively gloomy about medium‐term growth prospects. Our forecasts show potential output growth of just 1.6% a year from 2017–2030. This would be well below the average of the decade prior to the financial crisis (2.7%) and in line with our estimate for the 2007 and 2016 period which included the global financial crisis.
• We have become more pessimistic about the extent to which growth in total factor productivity is likely to accelerate. This is partly due to a judgement call that more of the weakness since the financial crisis reflects structural factors. Brexit is also likely to weigh on long‐term prospects, resulting in a degree of trade destruction and lower FDI inflows than would be the case were the UK to remain in the EU. Brexit is also likely to result in less capital deepening.
• Demographic factors also point to weak potential output growth moving forwards. High levels of inward migration have mitigated the impact of an ageing population recently. However, immigration is likely to fall sharply over the next decade, as first an improving European labour market reduces incentives to migrate and then the UK Government adopts more restrictive immigration policy. We are also coming into a period where there will be fewer increases in state pension age than of late.
• Since the mid‐1990s there has been a surge in the number of people going to university, resulting in strong contributions from human capital. But this will be less important moving forwards as university admissions reach a ceiling.
• Stronger growth in potential output would be possible if Brexit results in trading arrangements which are closer to the status quo, or if policy is more ‘liberal’, than our baseline assumptions.

     

And a populist New Year: global hopes and fears framework

• Get ready for more populist governments. There is now sufficiently widespread backing for global populism that at least one further victory in a major economy is very likely in the next year or so, our analysis of populist policies and support in 20 large economies shows.
• While there are no populist electoral front‐runners, many large economies have elections coming up in which populists have a decent chance of capturing sizeable votes. If you roll the dice enough times, the populist number is likely to come up somewhere – there is now around a 50% chance of a populist government in one key Eurozone country; bookmakers' odds suggest an even higher probability.
• Donald Trump's victory showed how market reaction to populism is hard to predict. Our survey provides a framework for assessing the diverse and complex channels.
• We see limited possibilities of Trump‐like, populist‐propelled fiscal expansions elsewhere in the world, which are typically market positive. Even where populist‐leaning politicians have a chance of power, they have shown little appetite for fiscal expansion.
• Globally, populist policies are focussed more on immigration, trade, and governance, which are typically market negative. As such, populist electoral victories would imply modest downward revisions to baseline growth forecasts and risk greater instability.
• Populist electoral victories in Europe would result in unsettling brinksmanship and provide an existential threat to the EU, though compromise is the most likely outcome and subsequent risks are two‐sided. For example, (i) reductions in free movement in labour could make Brexit softer; (ii) populism could challenge unhelpful pro‐cyclicality in the Stability and Growth Pact.

     

Brexit and immigration

• Net inward migration from the EU has been running at record levels in recent years, although the steep increase in new National Insurance numbers issued suggests that the official data may be understating the level of immigration. There was a clear step up in inflows after both expansions of the EU into central and eastern Europe, while the relative strength of the UK labour market has been an important driver of the more recent rise in inflows.
• High levels of immigration have helped to offset the impact of an ageing population and ensured that the UK has enjoyed stronger labour supply growth than many of its peers. With migrants typically being better educated than their UK‐born counterparts, the quality of the stock of labour has also improved, and migrants have been found to have a net positive fiscal impact.
• But there have been some downsides, with evidence that high immigration has had a small dampening impact on wages. That migrants tend to head to London and the other southern regions over other destinations has exacerbated the imbalances in regional housing markets.
• Given that a desire to have greater control over immigration is usually one of the key motivations for those favouring Brexit, a vote in favour of leaving the EU is likely to see the UK abandon the policy of free movement of labour. This would probably see the UK extend the points‐based system that it currently uses for non‐EU countries to include EU migrants.
• Our modelling suggests that the adoption of a ‘populist’ immigration policy which lowers net inward migration by 60,000 a year could reduce the level of GDP by 1.1% in 2030 compared with our baseline forecast.

     

The global impact of a sharper US‐China slowdown

• ? We forecast a moderate global slowdown through 2020, but risks are looming of a sharper downturn in China and the US. If these were to materialise, our simulations suggest global GDP growth would hit a post‐crisis low, with the level of GDP dropping by 0.6% and growth slowing by 0.4 ppt in 2019/20.
• ? Economies with strong trade linkages to China and the US – Korea, Taiwan and Mexico – would suffer most. Conversely, a weaker dollar, lower oil prices and relatively smaller trade flows with the US and China would offset the blow in Europe and for some EMs, including Turkey, Argentina and India.
• ? Since 2010, Chinese activity has been a powerful leading indicator of every major economy's exports, proving stronger than similar indicators for US or eurozone activity. This is even the case for non‐Asian economies such as Canada, Mexico, Italy, Germany, France and the UK. This may reflect deepening trading relationships and the relatively high volatility of Chinese cyclical indicators over the period.
• ? Over the past decade, global macro stability has been supported by the US and Chinese cycles moving counter to each other. But this could reverse if the ongoing Chinese policy stimulus fails to gain traction and the weakness gains momentum.

     

World trade recovering but still reasons for caution

• ? World trade has picked up in recent months, expanding at the fastest pace in six years in the first quarter, with the rise fairly evenly split between advanced and emerging markets. Stronger activity in China and a broader upturn in global investment have been key factors. But there are still reasons for caution. Although the ‘cyclical’ element in world trade is improving, the ‘trend’ element is not thanks to changes in supply chains and a lack of trade liberalisation.
• ? World trade growth looks set to reach about a 4% annual rate in Q1 2017, the fastest pace since 2011. Alternative freight‐based indicators confirm the upturn. This suggests some modest near‐term upside risk to our world growth forecasts.
• ? Recent growth has been evenly split between advanced countries and emerging markets (EM). In EM, the end of deep recessions in Russia and Brazil and an upturn in China have been key factors. China directly added 0.5 percentage points to annual world trade growth over recent months and firmer growth there has also pushed up commodity prices and the spending power and imports of commodity exporters.
• ? Another important positive factor is an improvement in investment, which is a trade‐intensive element of world GDP. Rising capital goods imports across a range of countries suggest the drag on world trade from weak investment is fading.
• ? The decline in the ratio of world trade growth to world GDP growth over recent years has both cyclical and structural elements. But while the cyclical component now seems to be improving, there is little evidence that the structural part – responsible for between a half and two‐thirds of the recent decline – is doing likewise.
• ? Key factors behind the structural decline in world trade growth are changes in supply chains and a lack of trade liberalisation/protectionism. Both are likely to remain a drag over the coming years. Meanwhile, a levelling‐off of growth in China and drop back in commodity prices could curb the recent cyclical uptick.

     

Alternative policy options for combatting a downturn

• ? With limited scope for conventional monetary policy options, central banks and governments may need to turn to alternative approaches to combat slowing global growth and respond to economic shocks.
• ? Our analysis shows that not only do governments in advanced economies have limited room to cut rates but that doing so has proved less effective in boosting growth in recent years. This increases the need to look at alternatives, such as negative interest rates, renewed QE and fiscal stimulus.
• ? While negative interest rates have helped reduce borrowing costs in some economies, the impact on banks has been ambiguous. Also, lowering rates further into negative territory could be hard without incurring significant costs.
• ? QE in the form practised up to now is also likely to be less effective than in the past due to low yields, narrow risk spreads and high asset valuations. So, a deeper downturn might require more radical QE ‐ buying corporate bonds, bank loans and equities ‐ which comes with significant drawbacks.
• ? Some central bankers are starting to acknowledge the limits of monetary action, with the next step being to consider fiscal action as a more effective alternative ‐ as argued recently by the likes of Larry Summers.
• ? In our view, fiscal policy is likely to be especially effective in a climate of weak growth and low rates, with large multiplier effects. Advanced economies have more scope for fiscal stimulus than often recognised and could finance a large public investment programme by issuing ultra‐cheap long‐dated debt

     

The great rotation in global credit risks

• ? The pattern of global credit risks looks very different today than in 2007. Risks are now mostly centred in China and emerging markets. “Excess” private debt in China is as high as $3 trillion compared with $1.7 trillion in the US a decade ago. Yet some pockets of significant risk still exist in advanced economies, which not only implies vulnerability to rising interest rates, but also that the scope for rate rises may be limited.
• ? With policy normalisation underway in the US and the scaling back of asset purchases expected to start soon in the Eurozone, we focus on assessing vulnerabilities across global credit markets. This article explores the topic using a top‐down, cross‐country approach. We find that although private debt and debt service ratios look more benign in advanced economies than a decade ago, they have deteriorated markedly in many emerging markets in recent years.
• ? Based on a measure of excess private debt – comparing private credit‐to‐GDP ratios with their trend – China, Hong Kong and Canada are the riskiest. When comparing debt service ratios relative to their long‐term averages, risks are also mainly concentrated in emerging countries. But Canada, Australia and some smaller European countries also have high debt service ratios that have failed to drop since 2007, despite the slump in global interest rates.
• ? Overall, aggregate private debt indicators look less worrying than in 2007. We would also argue that the concentration of excess private debt levels in China reduces the risk of a sudden financial crisis based on massive credit losses, such as the one in 2007–2010. But with corporate debt levels in the US, Canada and some other G7 countries above their long‐term trend, investors need to be attentive to these considerable pockets of risk.

     

Does Austerity Work? Theory and Evidence

• A number of factors underpin the Coalition's fiscal strategy, the most important being the use of rules (for the structural current deficit and net debt) and the creation of a new “institution”, the OBR, to monitor it. According to the Chancellor, this combination would ensure the government's “credibility and avoid elevated sovereign default premia and foster sustainable recovery.” 1
• It is already clear that the limited degree of independence for the OBR is a major shortcoming but there is another, more serious, problem in the Treasury's belief that the deficit ratio can be reduced by making spending cuts as clear failures by the government to achieve its fiscal targets on the deficit have shown. Such a failure is consistent with the results of research over the last decade which gives strong support to the view that fiscal multipliers are much larger than unity.
• The length of the downturn, the repeated large failures to hit deficit reduction targets and now the source and nature of the recovery show that his plan is failing. The former was predictable from the evidence just noted. In turn, the recovery relies on the surge in consumer demand following the easing of credit conditions for house purchase and points to a switch to a “Plan B”. It also demonstrates that the Chancellor could have brought about recovery very much earlier had he stimulated demand on taking office not reducing it with his self‐imposed austerity measures. He could even have stimulated demand to a much more constructive long‐term effect by increasing public investment.