Recession round the corner

The danger is that, having used up its arsenal, the rich world will not have the ammunition to fight the next recession.

The struggle has been long and arduous. But gazing across the battered economies of the rich world, it is time to declare that the fight against financial chaos and deflation is won. In 2015, the IMF says, for the first time since 2007, every advanced economy will expand. Rich-world growth should exceed 2 per cent for the first time since 2010 and America’s central bank is likely to raise its rock-bottom interest rates.

However, the global economy still faces all manner of hazards, from the Greek debt saga to China’s shaky markets. Few economies have ever gone as long as a decade without tipping into recession – America’s started growing in 2009. Sod’s law decrees that, sooner or later, policymakers will face another downturn. The danger is that, having used up their arsenal, governments and central banks will not have the ammunition to fight the next recession. Paradoxically, reducing that risk requires a willingness to keep policy looser for longer today.

The good news comes mainly from the United States, which leads the rich-world pack. Its unexpected contraction in the first quarter looks like a blip, owing a lot to factors like the weather. The most recent data, including surging vehicle sales and another round of robust employment figures, show that the pace of growth is rebounding. American firms took on 2,80,000 new workers last month. Bosses are at last having to pay more to find the workers they need.

Inevitably fragilities remain. Europe is deep in debt and dependent on exports. Japan cannot get inflation to take hold. Wage growth could quickly dent corporate earnings and valuations in America. Emerging economies, which accounted for the bulk of growth in the post-crisis years, have seen better days. The economies of both Brazil and Russia are expected to shrink this year. Poor trade data suggest that Chinese growth may be slowing faster than the government wishes.

If any of these worries causes a downturn, the world will be in a rotten position to do much about it. Rarely have so many large economies been so ill-equipped to manage a recession, whatever its provenance, as our “wriggle-room” ranking makes clear. Rich countries’ average debt-to-GDP ratio has risen by about 50 per cent since 2007.

In Britain and Spain debt has more than doubled. Nobody knows where the ceiling is, but governments that want to splurge will have to win over jumpy electorates as well as nervous creditors. Countries with only tenuous access to bond markets, as in the eurozone’s periphery, may be unable to launch a big fiscal stimulus.

Monetary policy is yet more cramped. The last time the Federal Reserve raised interest rates was in 2006. The Bank of England’s base rate sits at 0.5 per cent. Futures prices suggest that in early 2018 it will still be only around 1.5 per cent.
That is healthy compared with the euro area and Japan, where rates in 2018 are expected to remain stuck near zero. When central banks face their next recession, in other words, they risk having almost no room to boost their economies by cutting interest rates. That would make the next downturn even harder to escape.

The logical answer is to get back to normal as fast as possible. The sooner interest rates rise, the sooner central banks will regain the room to cut rates again when trouble comes along. The faster debts are cut, the easier it will be for governments to borrow to ward off disaster. Logical, but wrong.

Raising rates while wages are flat and inflation is well below the central bankers’ target risks pushing economies back to the brink of deflation and precipitating the very recession they seek to avoid.

When central banks have raised rates too early – as the European Central Bank did in 2011 – they have done such harm that they have felt compelled to reverse course. Better to wait until wage growth is entrenched and inflation is at least back to its target level. Inflation that is a little too high is a lot less dangerous for an economy than premature rate rises are.

Return monetary policy
Because the United States’ recovery is strongest, that is where debate about how fast to return monetary policy to normal is fiercest. Hawkish voices at the Fed argue that, with unemployment below 6 per cent and hiring continuing at a torrid pace, it is plainly time to start raising interest rates. In this view, wages and prices are bound to pick up in future.

Meanwhile, excessively low rates are inflating asset prices and creating long-run financial risks. Those risks are real but manageable. Regulators have the ability to let the air out of asset prices by tightening rules on leverage and liquidity. An economy at full employment and with a healthy level of inflation will be better positioned to withstand a bout of financial instability than one that is flirting with deflation.

Governments can also do their bit. There has still been shamefully little growth-boosting investment in infrastructure. The OECD, a club of mostly rich countries, was right to rap George Osborne, Britain’s finance minister, on the knuckles for the scale and pace of his proposed public-spending cuts. Growth is better than austerity as a policy for bringing debts under control.

Governments should instead direct their energies toward overdue reforms to product and labor markets. Open product markets encourage enterprise. The freedom to hire workers under flexible contracts is the best way to keep people out of unemployment. Both reforms make an economy better able to cope with the next shock.

Having fought off the effects of the financial crisis, governments and central banks are understandably eager to get back to normal. The way to achieve their goal is to allow the recovery to gather strength first.