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October 28, 2009 4:04 pm
Following a powerful financial market recovery, it is tempting to assume that we have seen the best of the rally. A popular school of thought holds that the expiry of the extraordinary stimulus programmes will see economic growth and asset prices flop lower once again.
Such concerns are misplaced, tending to confuse a financial panic with a structural economic problem.
To illustrate this point, let us consider the financial aspects of the crisis. A significant portion of the problem was caused by a flight from risk, sparked by fears over the dimensions of losses from bad lending.
From 2007 through to January 2009, $1,500bn flowed into US money market funds out of more risky assets.
This retreat from risk severely compounded the natural reduction in credit due to bank loan losses.
The government response has effectively counterbalanced these effects.
The reduction in short-term interest rates to zero has reversed around a third of the 2007-09 flight to safety, with flows out of money market funds into the broader credit market accelerating to a quarterly annualised $1,140bn in October.
Quantitative easing has directly or indirectly financed this year’s government borrowing and helped depress long term real interest rates to exceptionally low levels.
Meanwhile, the government’s fiscal expansion has offset the impact on final demand from the collapse in animal spirits in the real economy.
Since the start of 2008, the combination of higher household savings and lower income from employment should have seen annualised consumer spending flows fall by $351bn.
But this has been more than offset by an annualised flow of $449bn in tax rebates and a reduction in the household interest bill of $35bn.
The net result has been an increase of $126bn in the flow of consumer spending since the start of 2008, after accounting for small variations in transfer payments.
This stability in final demand invalidated the pessimistic expectations of businesses formed during the post-Lehman panic. Inventories are now far too low in relation to demand.
This point is confirmed by the fact that supplier delivery times have lengthened proportionally more than at any comparable stage in every previous cycle of the past 58 years. Output will therefore continue to rise in the quarters ahead, as companies re-stock, returning the labour market to positive growth. To forecast otherwise would be to assume a miraculous growth in labour productivity from already very high levels, an outcome strikingly at odds with the past decline in capital equipment investment, which has fallen to its lowest share of GDP for 35 years.
With employment some 1.5-2 per cent below levels compatible with the current level of output, the probability of a sustained revival in employment is very high.
As such, the revival in household income and spending will make the fiscal stimuli redundant over the next few quarters, an elevated savings rate notwithstanding.
Currently, risk appetites in the markets have revived faster than animal spirits in the real economy, just as they declined sooner in the run-up to the recession. With equity and credit market valuations back at fair value and government bond valuations bordering on a bubble, the zero interest rate and quantitative easing policies are no longer entirely warranted from a purely financial market perspective.
However, since policy makers tend to target the real economy, there is a clear risk that very easy policy settings will persist long enough to inflate a broader market bubble.
This possibility is compounded by the effects of business and household de-leveraging, which drastically reduces the supply of – and increases the demand for – financial assets.
In many of the economically healthier developing and commodity economies, the practice of exchange rate targeting imports US monetary settings that are inappropriate in the local context. Over-exuberance in the financial markets might spill over into broader real asset and consumer price inflation in these economies.
Policy makers will therefore soon need to decide whether the objective of a sustained economic expansion is best served by curtailing the dimensions of any putative bubble, or by underwriting a full recovery in employment.
If the recently endemic condition of serial asset bubbles and increasingly wide cyclical swings in GDP is to be interrupted, we should hope that the policy makers will weigh their deliberations somewhat differently to the past.
Tim Bond is head of asset allocation strategy at Barclays Capital
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