Column: Strong headwinds

The real risk is that GDP growth rate may fall back from the levels of the 2.5% it has reached in the US and the UK

Paris was a surprise success. After the long saga of failures since Kyoto (via Copenhagen and Durban), many did not expect a climate treaty to be agreed upon. Now, we have a treaty which has provided different flight paths for developed and developing countries. There is an act of  faith that we shall all converge on the same trajectory. The poor of today will be rich tomorrow and have similar preferences to the rich of today. Their trade off between pollution and prosperity will be similar. Their flight will be monitored and subsidised.

So far, so good. But there was another decision in the past week which has a bearing, though very indirect, on Paris. This was the least surprising decision by the US Fed to increase interest rates by 25 basis points. Fed chair Janet Yellen managed tor wrest a unanimous outcome, despite differences among her colleagues. There is also an indication that there are more such steps to come which will take rates into the almost normal levels of 2.5-3%.

The Fed took its time and, in my view, should have done it sooner. Low, almost-zero rates lead to financial risk taking such as we have seen in the M&A activities, shares buy-back and the proliferation of shadow banks which are just hedge funds which have attracted a lot of money seeking higher returns. The best way is to wean the markets away from the zero-rate syndrome and get it back to a less volatile path without a crunch along the way.
Most people, even the Fed itself, are more concerned about the effects of  the move on the income and employment fronts as well as inflation. The Fed sticks to its target of 2% and is waiting to see if the recovery in the labour markets can boost inflation from the current low up towards the target . (I have to confess. Having lived through the Keynesian/monetarist battles, I never thought a day would come when central bankers would struggle to increase inflation rates.)

The danger, of course, is that inflation may stay low. We are in a downward phase of the long Kondratieff cycle. After the upswing of  1991-2008, we could be in a low growth, low inflation phase for the next 15 years. One indicator of this is the collapse in the rate of inflation ( India excepted, of course). Oil and primary commodity prices sustained inflation during the latter part of the upswing. Manufacturing prices had stopped being a source of inflation, thanks to Asian manufacturing nations being competitive. Now, there are no strong inflationary forces except what each country may have in the non- traded sectors.

If, however, inflation remains stubbornly low but financial stability requires rates of interest of 2.5-3%, then the world will have to cope with positive real rates after a long time of being used to negative ones. The real risk is that the growth rate of GDP may fall back from the levels of the 2.5% it has reached in the US and the UK. The Eurozone countries may gain some traction if the ECB does not follow the Fed  (as is expected ) and the Euro may depreciate relative to the dollar. Even so, the Eurozone is unlikely to be a growth engine.

There has been a slowly growing sea-change in expectations about future prosperity. While income levels are high, few Westerners expect their children to have the rising standards that they themselves experienced. To add to this, there has been a problem of movement of labour from the less affluent and less stable regions of the world to EU and US. Terrorism has compounded the problem but we can see in the electoral performance of Marine Le Pen in France and the lead position of Donald Trump and Ted Cruz in the US Republican  primaries that the low growth prospects has created a backlash in the rich countries.

Of course, in the US, the crucial issue is income distribution.  The  deflating of the middle and fattening of the tails at either end of  the income distribution explains some of the anger fuelling the Trump/ Cruz appeal. Bernie Sanders is the Left alternative, but he is unlikely to get real traction in the  Democratic Party.  The risks of the backlash are as much to the Paris accord as to the sustainability of the Fed’s policy of stiffening interest rates.

The Republicans are not expected to win with either Trump or Cruz. But the policy options with the Congress may move distinctly against the Fed stance and Paris accords if pessimism about future growth becomes widespread. It is, as yet, an open bet and may not become a highly likely outcome. It is, however, necessary to bear in mind that the assumption of global convergence of preferences as to the trade-off between income and environment  is just that—an assumption such as the many which we have seen falsified by events.

The author is a prominent economist and Labour peer

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