Since early 2009 there has been a battle between structural headwinds, some of which pre-date the Great Recession but all of which were at least accelerated by it, and cyclical tailwinds.
The primary headwind has been the world has too much debt. Consequently there is a need for the household and financial sectors to de-leverage. Recently the government sector has also joined in with its own need to de-leverage. The relative importance of these trends varies for individual countries across the developed world. In the UK and US we are seeing all three in action. In Germany and northern Europe it is arguably just the financial sector that needs to participate. But the problems in the euro area as a whole are symptoms of this underlying headwind.
Until this summer, there had been enough cyclical tailwinds to at least partially offset the debt problem. The best way to deal with a debt problem is to generate enough growth to ensure the debt is repaid and still increase aggregate output. This was happening. There had been an economic recovery, with emerging markets and northern Europe in particular growing reasonably robustly. Corporate profits recovered dramatically and were at record levels in nominal terms and expressed as a percentage of GDP. Monetary policy stayed supportive, at least in the US and UK, to facilitate the cyclical recovery.
But in recent weeks a number of things have imperilled that cyclical recovery. In the US at least, it turns out the recession was worse than originally forecast and the recovery weaker. On the revised figures, US output is still below its pre-recession peak, implying that although officially the US economy is in a growth cycle, in reality the downturn engendered by the Great Recession has not ended. We have also had policy confusion over the summer and the postponement of difficult decisions on both sides of the Atlantic. The US Congress has set up a committee to work out how to make the spending and revenue changes it finally promised at the end of the tortuous negotiations on raising the debt ceiling. But it will be November at the earliest before we see what these changes will be.
Meanwhile European policymakers have dithered about how to deal with the ongoing existential crisis in the single currency area. The relatively small scale fiscal transfer involved in the bailouts of Greece and the setting up of the European Financial Stability Facility and European Stability Mechanism have failed to calm markets. The ECB buying Italian and Spanish sovereign bonds had bought some time but the eurozone is already back on the front pages.
In short, there is too much debt and not enough growth in the world. The only good news is there is little evidence of inflationary pressure.
If inflation is not a hindrance then monetary policy can do more to fight the cyclical slowdown that is apparent. Given the structural backdrop it is critical that monetary policy acts swiftly before the slowdown becomes a renewed recession.
We can legitimately argue about the efficacy of renewed QE on the economy but it would be foolhardy to think it will not be tried. In our estimation, governments and central banks in the US, UK and eurozone have printed, spent, lent or guaranteed over $17 trillion since 2008, over 50% of the combined GDP of the three. It would be staggeringly irresponsible to watch a new recession unfold, potentially creating a situation where the result will be a messy default of a European sovereign or another global financial company, and waste that $17 trillion.
But QE in the US and UK can’t do more than offset some of the fallout from ongoing eurozone turmoil. It should provide some respite from the recent mayhem in markets, and to buy time for the eurozone to sort it self out. So let’s get on our knees and pray, that we do get fooled again.
