HSBC MACRO - Gold prices are a dead giveaway
When can we be sure that economic recovery is in the bag? The world economy seems to be in a much better place today than it was at the beginning of the year. Policymakers haven't repeated the mistakes made during the Great Depression. The banking system seems to be in better shape, thanks in part to a large taxpayer bailout. Asset markets have recovered, suggesting that the earlier collapse in animal spirits may be over. And economists are revising upwards their forecasts for economic activity, concluding that the worst must now be behind us.
For all these reasons, investors are increasingly focused on so-called "exit strategies". How and when should economic life-support policies be removed? After all, interest rates in the developed world are at their lowest levels ever, the gentle hum of the monetary printing press can still just about be heard and budget deficits are huge. Are these policies still necessary, or is it time to expect the world economy to stand up on its own two feet?
It's easy to be seduced by what I might cheekily call "straight-line economics" – the idea that when the worst appears to be over, the best is just around the corner. Straight-line economics assumes that strong economic growth is a "normal" state of affairs, interrupted only occasionally by pesky recessions. If the rules of straight-line economics are applied today, it's obvious that policymakers should be raising interest rates and reducing budget deficits because, with animal spirits now rebounding, we're returning to straight-line predictability.
Sometimes, however, economies end up in a different place, based on the physics of bungee jumping. The economy falls off a cliff. Activity drops a long way. Then there's a rebound. For a while, the rebound looks very good and it's easy enough for economists to stick to their straight-line thinking. But the economy never returns to normal; instead it is left dangling by a thread. The straight line simply doesn't apply.
If we've learnt anything over the last two or three years, it's that straight-line thinking is pretty hopeless. For the economics profession, it's been a bruising experience. At the beginning of 2007, some economists recognised downside risks, but the consensus view was that, if there was to be an economic slowdown, it would be a so-called "soft landing".
For the forecasting community, it was one of the biggest errors ever made.
The economic models that were routinely used to churn out projections for growth and inflation were poorly designed to handle the housing and financial crises which bubbled over on either side of the Atlantic. Even worse, the models fostered the illusion of policymaking invincibility. Most of the models were "self-correcting", assuming that the straight-line approach was appropriate and that recessions were a thing of the past.
This, of course, was rubbish. But the weaknesses of the approach should give us pause for thought today. While it's true that the world economy is now in much better shape than it was last year, is this enough to guarantee that we're getting back to normality?
Central bankers are mostly proud of their efforts to "fix" the global economy. But if the fix is to continue working, the rise in animal spirits since the spring needs to be maintained. That's no easy task, partly because it's not clear what is causing it. The standard claim from policymakers, particularly in the UK, is that equity and corporate bond markets have risen in part because of the benefits of unconventional policies.
If the central bank buys lots of government bonds, the yield on those bond drops, thereby encouraging investors to buy other, riskier, assets. The increase in the value of equities and corporate bonds which follows makes life easier for companies looking to raise funds in the capital markets. It also makes households feel a lot more confident that the worst is over, thereby reducing the desire to hoard cash for a rainy day.
Imagine, however, that the increases in asset prices we've witnessed over past months fail to translate into a lasting recovery in economic activity.
Earlier in the year, investors were beginning to price in a "Great Depression Mark II" – a view which proved to be overly-pessimistic. In a world of bungee economics, it's just as likely that the current hopes of a "Great Recovery" will prove overly-optimistic. Rising asset prices may say something about the success of unconventional policies, but they could just as easily be part of the regular volatility of financial markets and, in fact, say hardly anything about longer-term growth prospects.
Throughout the 1990s, economists following Japan had to cope with similar problems. Every so often, the economic data would show modest signs of improvement. In their haste to declare recovery, investors would pile into Japanese equities, triggering a stock-market rally. The rally gave economists the confidence to revise up their forecasts for future economic growth. These upward revisions led to an even bigger rally. Then came the shocking discovery. The Japanese economy wasn't really recovering at all:
it was the ultimate bungee economy, with occasional signs of rebound followed, as night follows day, by yet another setback. The mistake was to assume that financial markets provided an accurate forecast of future economic developments. As it turned out, the best they could do was to offer an occasional bout of wishful thinking.
The danger for policymakers today is that, again, financial markets are offering not much more than wishful thinking. Indeed, disappointed with the absence of any effect on money-supply growth, the Bank of England is engaged in its own wishful thinking, arguing that the best way of gauging the impact of its quantitative easing programme is via the performance of financial assets – a claim which could easily go wrong given the fickle nature of investors.
The unfortunate reality is that unconventional policies are unconventional because no one really understands how they work. Whisper it quietly, but these policies may be no more than the ultimate economic placebo. Placebos can, of course, work wonders, but their best work is in the mind. Our central bankers are re-inventing themselves for a "new age" economy. They are no longer economic scientists but, instead, mystics who are hoping to persuade the rest of us of their miraculous powers.
If we return to a straight-line economy, central bankers' mystique will be justified. If, however, we're in a bungee world, their mystique will slowly be undermined. I suspect the costs will be seen mostly in increased currency volatility. Those central banks which have engaged in unconventional "funny money" policies need to see sustained results. If those results fail to materialise, we'll be left with weak economies and a broken printing press. The strength of the gold price in recent months suggests that investors still have their doubts about unconventional policies. They're buying insurance in case of failure. They're right to do so.
November 16, 2009
Posted by PROFESSOR 1X2 at 5:42 PM