When, back in the summer of 2013, Ben Bernanke gave evidence before a Congressional Committee about the Fed’s future policy stance, he caused serious turbulence in global, especially emerging economy, markets. I saw it live and sympathised with the Fed Chairman because he seemed to need a blackboard to explain his subtle stance. But the markets were confused and currencies shifted massively.
It was in the wake of that experience that Raghuram Rajan made his argument that in determining its policy stance, the Fed ought to look at the impact on the rest of the world. Some chance, one thought. What John Connally, Nixon’s treasury secretary, said in the early 1970s seemed to remain true: “The Dollar is our currency and your problem.”
But the most recent testimony of Janet Yellen shows that 2016 is different. The year began extremely badly. China shook the global markets. Now, the Fed can no longer ignore the rest of the world. That has been a long journey but well worth making. Chinese stock markets are small in terms of China’s economy and even more so in terms of the global economy. But volatility is a psychological not logical phenomenon. If the Western stock markets are still looking fearfully at China, it is as much because of what it has done to confidence as any real impact.
The problem has been home-grown. Persistent easy money has created it. Asset values have been inflated. People talk about fundamentals being sound only when the markets are falling, not during an asset bubble. China was supposed to be a given, unshakeable constant, going only one way—up. Now, it seems China is like any other economy. The miracle has come to an end. Given a modicum of freedom to export money, the Chinese corporations and richer households have seized the opportunity with both hands. Nearly $100 billion has gone out. The sum is small given the size of China’s reserves and even less significant in terms of where it is heading. But it does signify that the Chinese citizens’ preferences can no longer be ignored either by Chinese policymakers or China watchers. China has suddenly become a complex economy.
Janet Yellen has thus invoked China as one of the variables the Fed has to look at. That much is good news. But the problem is at home. The Fed has been criticised for ending the zero interest rate era. Indeed, its minuscule rise has been blamed for the jitters on the stock market. My view is that exactly opposite is the case. The Fed took too long to raise rates and then raised them by too little. The crisis of inflated asset values has been coming for some time. Its timing may have been hastened by the Fed or perhaps more by Shanghai. But the answer is not to stop or reverse the rate rise as some people are asking for (talking of even negative interest rates). The route-map has to be firmly laid out for a return to normalcy. Investors have to be told that there is no going back to the good old days. Once a clear signal is given and adhered to, there will be sensible revaluations done. Some punters have taken irresponsible long bets. They may go out of business. Many shadow banking entities have taken on unsustainable liabilities against the promise of high returns. But shaking them out is the best thing the market can do; indeed, it is the market’s job to do so.
That said, one has to hope that a full-blown crash can be averted. In the Eurozone, there seems to be a desire for continuing with aggressive monetary expansion. Some Keynesians have cheered that the refugee crisis is loosening the purse strings of governments. But one can hardly rely on the refugees keeping on coming to generate a sustained fiscal expansion. The demographics are bad in Europe and depressing demand. Refugees may add a bit to the population but hardly enough to change either demand or supply sufficiently generate growth.
The impact of new technology is highly deflationary. Whether a full-blown new Industrial Revolution is in the offing with robotics, artificial intelligence and advances in transport is an open question. It will come but may not come all at once like a Schumpetarian gale. But things will get cheaper and more efficient. Whether the impact will be negative on employment creation is hard to judge. Car-driving is the largest single occupation for American men. If driverless cars become normal, they will have to reskill.
The medium-run picture is of a lot of churning. Once the interest rates get back to some sort of normal, say 2-3% real rates, then we can expect the things to settle down. We may be in the early years of the next Schumpetarian wave or merely at the tail-end of the last one. Either way, life will remain precarious.
The author is a prominent economist and Labour peer