In London last week, I had the pleasure of being interviewed by Gerard Lyons, Economic Adviser to the Mayor of London Boris Johnson, at a special breakfast event hosted by the London campus of The University of Chicago Booth School of Business. We used our time to delve into some of the broad economic topics of the day.
The World Economy is increasingly becoming more divided and disconnected as the post-financial crisis economic recovery proceeds at varying paces around the world. Geographical divisions have been very apparent. The northern sector of Europe is in much better shape than the periphery and southern sector. Older, mature industrial economies are doing nearly as well as younger, more dynamic emerging market economies. The U.S. is an interesting exception, as its energy supply revolution and robust competitive culture are leading that economy out of the post-recession doldrums much faster than in Europe or Japan. In the currency sector, there is a divide between the zero-rate countries, from the U.S. to the U.K., Europe, and Japan, relative to the higher rate emerging market economies. All of these divisions make for volatile market conditions.
China: A long perspective
We addressed the challenges of an aging Chinese population. In spite of the one-child policy and the resultant lack of population growth, the urban labor force continues to grow due of the rural to urban migration. The current population mix is about 50 percent urban to rural, however, as the urban population reaches 70 percent, we may see the China naturally decelerate toward 4% annual real GDP growth rates. At present, I estimate about half of China’s expected GDP growth of 7% or so for 2013 to be coming from the construction and infrastructure spending associated with the urban migration of around 12-15 million people per year. In this way we can see how the migration from the countryside masks, the inherent growth challenges of an aging population.
Whatever the case, China will still be the world’s fastest growing major economy in the coming years. It is just not going to be as fast as it was. Regarding turbulence in the Chinese economy in the near future, however, it is important not to underestimate the ability of the state capitalism model to smooth over difficulties that policy-makers in the U.S. and U.K. would not be able to do.
US: The inflation variable
The relationship between CME Group and The University of Chicago goes back to the creation of the financial futures market place and it is a partnership that continues to prosper. I grew up as a student of international monetarism where my heroes were University of Chicago faculty members Harry Johnson and Bob Mundell. In contrast with the more celebrated Milton Friedman – they built international (open) economic models as opposed to closed ones. The importance of this being that the closed models assumed the velocity of money to be constant and if this was so, then inflation was a domestic monetary phenomenon that could be predicted by domestic monetary policy. Open economy theories look to additional impacts from the international sector on the path of inflation.
In the U.S. now, we find ourselves in a position where we have not had significant inflation for four years, despite highly accommodative monetary policy. The post-recession period has seen substantial deleveraging which temporarily, at least from 2009-2011, seems to have broken the link between monetary policy and inflation pressures. When companies and consumers are deleveraging, they are not sensitive to interest rates, until they get their debts in line with their now lower income expectations.
Another issue for monetarists to consider is the role of foreign exchange rates in the inflation process. When one country has an accommodative monetary policy you can get a declining exchange rate and this may feedback to more inflation happening faster – which is what we may see occur in Japan now. But when the U.S., the U.K., Europe and Japan all have zero interest rates and all have monetary accommodation together, you do not get the same exchange rate feedback loop in the West. And this lack of a feedback loop from the international sector in U.S. allows the economy to go for a longer time without seeing the inflation pressure from monetary stimulation.
Milton Friedman was famous for noting that there were long and variable lags between monetary stimulation and inflation. He seemed to focus on about an average two-year lag. This time around, with a deleveraging recession and simultaneous global easing with little exchange rate feedback loops, the lags are much longer, and we may not inflation pressure develop until 2014 or 2015.
Europe: Where is the growth?
The European Central Bank has pulled Europe back from the brink in two ways: they have prevented the single currency from splitting up, and they took fear out of the market of another financial disaster. These actions were important, yet largely defensive. That is, avoiding disaster is a necessary condition for economic growth, but not a sufficient condition. The E.U. itself has to decide what degree of austerity to take. The U.K. went down the path of extreme austerity right away and correspondingly has not had any growth. Austerity will not deliver growth in the short-term and politicians that promise that are playing with fire. Of course, austerity is necessary if you have too much debt and you cannot afford it down the line – so again the action is a preventative measure. What Europe has to come to grips with is the fact that it is going to be an area of slow growth for a long time.