Many equity market bulls, economists and politicians have been puzzled by the global economy and stock markets failing to respond to increasingly radical central bank monetary policies such as quantitative easing and negative interest rates. But they shouldn’t be.
High school students studying calculus start learning to solve for the second derivative — also known as the rate-of-change; convexity, in financial derivatives markets and acceleration, in physics applications — yet the implications of a rate-of-change in economics is still deeply misunderstood and ignorantly dismissed, even among high-profile economists.
China’s growth rate is the prime example as it has decelerated from more than 10 percent in the 2000s to sub-7 per cent now while the other is the sharp deceleration in global money supply growth since 2009. But they are both linked.
“The financial crisis raises a potentially existential crisis for macroeconomics. Practical macro (economics) is based on the assumption that there are fairly stable aggregate relations, so we do not need to keep track of each individual, firm, or financial institution—that we do not need to understand the details of the micro plumbing. We have learned that the plumbing, especially the financial plumbing, matters: the same aggregates can hide serious macro problems.” former IMF chief economist Olivier Blanchard, August 2015.
Undeterred from missing the global financial crisis in 2008, macroeconomic optimists have long fobbed off any negativity over China’s slowing growth rate, claiming GDP growth of 7 per cent was still fantastic and would still have a positive effect on the rest of the world for many years, especially in commodity-exporting countries like Australia, Brazil, Russia and South Africa.
From a money-flow perspective, however, China’s slowdown is like a big truck cruising along on a straight, busy freeway. If it brakes because of a bend ahead, or worse, suddenly brakes hard to avoid someone drifting out of their lane, the traffic behind the truck is forced to brake too — think miners and raw commodity suppliers. The more traffic there is — a lot, because China’s economy is so big — and the lower the expectations for any change in speed — low, because China is “different”, it’s so big — the greater the risk of a multi-car pile-up as traffic compresses behind it. Even though Chinese officials told the world its growth rate would slow, commodity producers and speculators never thought sub-7 percent GDP growth would have any impact on overall demand for their production. They have all been forced to swerve to avoid a collision, refusing to stomp on the production brakes, hoping their rivals will crash instead, easing the chronic oversupply.
The commodity carnage in China’s wake was reflected in the 67 percent collapse since 2013 in the Bloomberg commodity index to a 17-year low in January 2016, as well as billions of dollars of asset write-downs for mining companies like BHP Billiton and Rio Tinto. Russia, Brazil, Saudi Arabia and South Africa all face chronic fiscal and balance of payments problems from plunging export revenues.
The Chinese “growth miracle” has ended and the developed world is in a state of economic stasis because they have reached a “Minsky moment”. It is the tipping point described by economist Hyman Minsky where the credit cycle has swung from having a positive rate-of-change effect on productive GDP growth to one where new debt is being issued simply to rollover old debt.
In other words, debt-default problems are being pushed out into the future with considerable help from governments and central banks. The new debt simply replaces stale or rotten debt. Most of the “new” debt extended during Minsky’s tipping point is not economically productive because it is not adding to the money pool. GDP “growth” appears in sectors like finance and services that offer minimal net benefits to the broad economy. The effect of the debt on growth is like “pushing on a string”.
Writing in Forbes magazine in February 2016, Professor Steve Keen noted that US money supply grew at an average of 8.5 percent from 1975 to 2008, but since then it had plummeted to a growth rate of just 1.5 percent, with the same pattern repeated across OECD countries.
In other words, the flow of new money to pay for goods and services, and chase asset prices higher has decelerated. Bankers around the world with their fingers close to the economic pulse have slammed on the money-creation brakes because they can feel the financial stress. They can see it in their customer accounts — the late payments, the diminished balances, the rising bad-debt level and most importantly, the money destroying defaults.
The financial stress has occurred because global debt has soared to more than 290 percent of global GDP, which means total debt is approaching three times the underlying economic cash-flow. Since 2008, there has been debt deleveraging in the US and Europe, despite all the US Federal Reserve and European Central Bank (ECB) policies designed to increase new lending, so China and emerging markets account for almost all the increase in global debt.
The reason why about $12 trillion of so-called central bank “stimulus” since 2008 — primarily quantitive easing by the Fed, the ECB and the Bank of Japan (BOJ) — hasn’t worked is because it did not actually create “new” money in the private sector. QE, as it is known, is merely an asset swap where the central bank buys an asset, usually a government bond, and pays for it with cash. The only change from a private sector perspective is that the bond seller holds a zero percent yielding “asset” as opposed to the higher yielding bond sold to the central bank, and there is consequently no new money in the banking system.
QE had an impact on asset prices because it prompted front-running of central bank bond purchases and it reduced the availability of safe, higher-yielding assets, forcing conservative investors up the “risk curve” — into corporate bonds and stocks — in order to achieve an inflation-beating return.
For those looking for a more technical dissection of QE, Alhambra Investment Partners strategist Jeffrey Snider has an in-depth look at the effect of QE and the growth in central bank balance sheets here or here.