Something new is happening in the global economy for which few were prepared. We were talking four years ago about de-coupling and how the emerging economies were independent of the developed ones. That theory bit the dust in 2008-09. Emerging economies were hit by the Great Recession but only in terms of a dent in their GDP growth rate, which fell by two to three percentage points. So there was articulation but still a lot of local scope for each region to go its own way.
The efforts to revive the developed economies have been only partially successful. Fiscal policy has reached its limits, though Keynesians would argue that this is out of misguided timidity and fear of the bond markets. But whether in the US, which has been fiscally more active, or Europe where the debt burden has bit more sharply, fiscal policy has been unable to revive the economies from the 5%-plus negative output shock they suffered. The US remains stuck in 9% unemployment and there have been many false dawns promising a return to normalcy. The UK has tied itself to a five year deficit cutting programme (a zero real growth of public spending above its level in 2010-11). Germany has had some export growth but that is now petering out and the Eurozone?s problems, especially of the PIGS, mean that there will not be a resurgence of growth any time soon.
But the more interesting aspect of the reflationary policies has been the QE experiment. Keynes was sceptical about the effectiveness of monetary policy in a recession. He feared a liquidity trap, which would mean that interest rates would not go down below a certain minimum no matter how much money you create. What we have seen instead is that while bond yields can be got down quite low and short-term rates are near zero, there has been no growth in business borrowing. Investment has not picked up. The Post-Keynesians are right; demand for money (credit) is the key, not the supply.
The large amount of liquidity sloshing around has instead gone into commodity markets, causing a strong surge in inflation. Not finding demand at home in developed countries, the money has flooded emerging markets and stiffened their exchange rates, causing resentment. Brazilian finance minister Mantega has been articulate in registering his complaints. It seems that with China pegging the renminbi, it is the other emerging economies that bear an excessive burden.
It is quite clear that the QE via its effect on commodity price inflation is now beginning to hit the growth rate in emerging economies as well. We have downturns in recent months in manufacturing activity not only in the US, UK, Germany but also in China. India has had an erratic growth in industrial production and the early growth estimates for the first quarter are, not surprisingly, a bit down on what was forecast. QE is also making deficit cutting difficult in the UK, for example, where the decline in real income is sharper than anticipated and hence public revenues below forecast, raising the amount of borrowing above target. Thus QE may yet turn out to be counter-productive though it is early days yet. But there is no doubt that emerging economies are being adversely affected by QE.
This is a linkage that had not been anticipated thus far. A monetary stimulus in the developed economies that causes a growth recession in emerging economies while at the same time fails to revive home economies is novel. It illustrates once again that we have a lot to learn yet about how the global economy functions. Most macroeconomic theory, following Keynes?s original theory, assumes a closed economy. Even the little that has been done about open economy macro does not treat the subject truly globally. What we study is exchange rate dynamics of each country and its impact on the domestic macroeconomy. Here, we have effects across the global arena via capital flows and commodity prices whereby one region?s liquidity expansion affects the other region?s growth prospects.
What is worrying is that while there may not be a double-dip recession, the actual recovery will be flat for a while yet. My hunch has always been since the recession began that this is not a Keynesian recession caused by a lack of effective demand but a Hayekian one caused by low interest rates and over-borrowing invested in low yielding projects?mal-investments. Households and governments, which are heavily leveraged cannot spend any money until they have retired their debts. Those to whom they pay back are also not spending since they cannot see any signs of demand reviving.
We are going to be in flat territory for a while yet.
The author is a prominent economist and Labour peer