The Global Economy Lives in Wonderland Now

There was a period not so long ago when it looked as though the world’s central banks were on course to normalize. We were nearing a significant milestone on the long road back from 2008, when, in response to the implosion of the global financial system, central banks around the world had adopted a suite of unconventional policy measures. They had dropped interest rates to zero. Under the sign of quantitative easing, they purchased mountains of bonds.

Janet Yellen, then-chair of the U.S. Federal Reserve, ended its quantitative easing program in October 2014. By that point, America’s central bank had piled up $4.5 trillion in assets. Since then, the balance sheet has been run down, and interest rates have nudged up. The European Central Bank (ECB) didn’t get into the quantitative easing game until March 2015, but it ended its purchases in December 2018. Meanwhile, the Bank of Japan never eased up. But it was the exception that proved the rule.

The consensus nine months ago was that, with the world economy picking up steam, it was time to tighten monetary policy. That would allow financial markets to recover something like their normal balance. And it would give central bankers some room for maneuver in the event of an eventual downturn.

That was then. Now the question is whether the Bank of Japan may actually be the new normal. With global manufacturing slowing sharply and investors surging into the safe haven of government bonds, financial markets are flashing warning signals. The Fed’s decision on Wednesday to cut rates by a quarter percentage point and end the drawdown of its bond holdings two months early is an indication of the altered mood.

Fed Chairman Jerome Powell in the subsequent press conference did his best to deflate expectations of a sustained series of interest rate cuts. But there was no denying the significance of the moment. This was the Fed’s first rate cut since 2008. And the markets wanted more. The spread between short and narrow bond yields tightened, signaling that the markets are now more concerned than ever about a recession, and equities closed down. That was enough to trigger angry tweets from President Donald Trump about the Fed failing to keep pace with either China or Europe.

Trump is right about one thing. The Fed is not alone in taking action. The People’s Bank of China has made clear that it will provide as much stimulus as it can without endangering the threshold exchange rate of 7 yuan to the dollar. The last thing the world economy needs right now is for currency movements to provoke further belligerence from Trump.

While the Fed is cautiously cutting rates, the ECB is discussing more radical options. It is already charging European banks negative interest to hold their deposits. If it cuts deeper into negative territory, it is sure to spark protests from banks and savers. As an alternative, the ECB may have to consider restarting quantitative easing, which will require it to find ways around its own self-imposed rules that cap the percentage of a member state sovereign debt it may purchase. The ECB is haunted by the fear that if it goes further, it could find itself accused of printing money to finance borrowing by member states. The question of ECB bond buying is being litigated in front of the German supreme court this week.

Alternatively, the ECB might follow the Bank of Japan and buy equities rather than sovereign bonds. The Bank of Japan already owns 4.7 percent of the Japanese stock market. This is the path that no lesser authority than BlackRock is urging the ECB to go down. Apparently, the world’s largest asset manager sees nothing wrong in arguing the case for open-ended official support for one of the world’s most undervalued equity markets.

What has happened to change the outlook so drastically? How have we ended up sliding back in the financial twilight zone? And what are the implications for the future?

The darkening mood has both immediate and deeper causes.

The immediate trigger was the deepening realization of the damage done by Trump’s trade war. It turns out that the increase in tension unleashed by the belligerence of the Trump administration is bad not just for the countries that the White House is trying to bully but for globalized business generally. It is so bad that despite the Fed’s mandated focus on the U.S. economy, it cannot ignore the blowback from the wider world. The impact goes beyond the immediate effect of the trade wars on the balance sheets of General Motors or American chipmakers. The prospect of a retreat into economic nationalism has the potential to really spook the markets.

In Europe, the impact is direct. Its export-dependent manufacturing sector is sliding into recession. Expectations of future inflation, a good measure of the broader economic outlook, have collapsed. Trump may chortle about the slump in the Shanghai stock exchange, but if China sneezes, Germany’s carmakers catch cold. And when Germany’s carmakers suffer, so too do their supply chains across Eastern Europe. Already Prime Minister Viktor Orban is lashing out because Hungary’s car factories are under threat.

Faced with a global slowdown, the authorities in Beijing show a capacity and willingness to mobilize every available policy tool. They complement monetary policy and bank regulation with government spending and tax cuts. The problem for Europe’s central bankers is that fiscal policy is frozen by the corset of eurozone discipline. Italy, which desperately needs stimulus, has narrowly avoided a showdown with Brussels. Germany, the only country that really has the room to deliver a major fiscal stimulus, shows no willingness to use it. That puts the entire onus on the ECB—hence the resort to desperate measures.

And that in turn puts pressure on the Fed, not because ECB President Mario Draghi is engaged in a currency war but because global investors chasing yield will move out of eurozone assets with negative yields into dollar assets and drive down yields in the United States as well, leaving the Fed little option but to follow suit or risk seeing the dollar surge against the euro.

Certainly, U.S. fiscal policy cannot be accused of inaction. The fiscal policy taps have been full on since the start of the Trump administration. And as the recent exchange of compliments between Powell, Democratic Rep. Alexandria Ocasio-Cortez, and Trump economic advisor Larry Kudlow made clear, there is a strange new political alignment in the United States that favors monetary policy loosening, too.

The basis for that surprising left-right alignment is the dawning realization that behind the turmoil of the trade wars there are deeper changes at work. The basic logic that has governed macroeconomic policymaking since the 1950s no longer seems to apply.

Though the U.S. economy is apparently at or close to full employment, wages have barely budged above the level that would be justified by productivity increases and inflation alone. There is little or no inflationary pressure. The so-called Phillips curve that once mapped the inverse relationship between unemployment and inflation is not serving as a useful guide to policy.

Some think this is due to the pressures of globalization and the weakness of trade unions. Others blame the concentration of power in the hands of huge employers for the lack of worker bargaining power. Or perhaps the United States is not as close to full employment as the official figures suggest. A “reserve army” of discouraged workers may be exerting a dampening pressure particularly on the low-wage, low-skilled end of the labor market. In any case, there is little reason to fear an inflationary surge if the Fed eases.

If not the labor market, is there no other force that will exercise restraint on the policymaker? Where are the bond vigilantes who famously haunted the Clinton administration in the early 1990s? The answer is that they have gone over to the other side. If there is pressure in the financial markets, it is toward demanding even larger cuts than either Draghi or Powell is comfortable with delivering.

It is a topsy-turvy world in which unemployment is at record low levels, but the Fed is worrying not that that the economy is overheating but that inflation is too low. Powell is trying to sell the rate cut as no more than a “mid-cycle correction,” but for the Fed to be cutting rates as “insurance” at the peak of the cycle is hardly conventional. Meanwhile, the U.S. government is set to issue more than $2.5 trillion in new debt in the space of two years, and the markets have not blinked. Investors consider the risk of inflation so low that they will hold $12.5 trillion of European and Japanese bonds at negative yields.

Faced with BlackRock’s shameless demand for public support of equity markets, one Financial Times commentator exclaimed that the proposal amounted to claiming that “the only way to save capitalism is to begin to nationalise it.” True. But why, in light of the measures taken to rescue the banks in 2008, is that surprising? The question today is not whether the state should act to support the feeble rate of economic growth but which policy tools will actually work.

During the crisis, the talk was of “shock and awe” and “big bazookas.” Former Treasury Secretary Timothy Geithner and his colleagues described themselves in martial terms, as fighting wars and putting out fires. Today, with Trump breathing down its neck, the Fed seems more like an anxious hiker shielding the dwindling flame of a campfire, desperate not to let the embers of America’s slow-burning recovery blow out.

Tending that flame is so vital because we are far from confident that if it goes out the monetary fire starters will still work. How will further interest rate cuts help if rates are already at rock bottom? Despite its enormous asset purchases, the Bank of Japan has consistently failed to boost inflation toward its target of 2 percent.

Thankfully, we do not at the present moment face anything like the financial heart attack of 2008. The warning signs of a potential recession in the eurozone are serious, but in the United States the evidence pointing to a hard landing is far from overwhelming. What we do face is a scenario reminiscent of the economist Larry Summers’s vision of secular stagnation. Low interest rates are not a conspiracy of central bankers against savers. They reflect the extraordinary ease of funding on money and capital markets. If low rates don’t stimulate energetic investment, then we need to look to the broader factors—such as demographic and social change, technology, and geopolitics—to understand why opportunities for profit seem so scarce.

What the latest round of desperate central bank action suggests is that we have reached the limit of what monetary policy can be expected to do. The question now is whether governments are willing to match the unconventional measures being taken by the central banks. To the extent that fiscal policy is deadlocked (as in Europe) or captured by a self-serving elite whose only priorities are defense spending and tax cuts for the wealthy (as in the United States), the outlook is depressing. But it’s at least possible to imagine a world in which the public directed the cheap funding that is so readily available toward investments in education and research, global development, and a renewable energy transition that would handsomely pay for themselves.