Improving the state of the world

What I’ve been following in Australia . . .

What happened:

The RBA Governor gave a speech on inflation targeting and economic welfare.

After acknowledging the current debate around the existing monetary policy framework, the governor argued that inflation targeting was still appropriate for Australia, noting that the current system involved a significant degree of flexibility and stating that ‘In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target. Some alternative frameworks would also be more difficult to implement and/or be harder to explain to the community.’

Lowe also talked about the current stance of monetary policy. Here he noted that ‘if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further . . . Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range . . . It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range.’

Why it matters:

Governor Lowe’s speech offered useful insights into two key areas of the RBA’s thinking.

First, and as flagged a few times here in the Weekly, the prolonged period of inflation below the RBA’s target has inevitably raised questions over the status of the monetary policy framework. Here, Governor Lowe was clear that he judges that the RBA’s version of a flexible inflation targeting regime remains fit for purpose. He also ruled out adjustments to the existing framework such as moving to a lower inflation target, which he dismissed as ‘shifting the goal posts.’

Second, after two consecutive rates cuts left the cash rate at a record low of just one per cent, there has also been some discussion as to whether the central bank would be prepared to continue to ease policy even further, and if doing so would have much economic impact. Again, the message was pretty unambiguous, with Lowe confirming that the RBA is ‘prepared to provide additional support by easing monetary policy further’ should that be required.

There was also a similarly clear statement that the current low interest rate environment is likely be with us for some considerable time. Indeed, the governor’s prediction of an ‘extended period of low interest rates’ prompted a question as to whether this represented a move towards the central bank adopting forward guidance. Lowe said that this was not the case, although keeping in mind previous RBA commentary about the centrality of the labour market and the ambition to get unemployment closer to its natural rate of around 4.5 per cent, as well as these latest remarks about the future trajectory of interest rates, arguably the distinction between that policy and the RBA’s current approach is increasingly a semantic one.

. . . and what I’ve been following in the global economy

What happened:

The IMF has updated its forecasts for the world economy. It now sees global growth this year running at a subdued 3.2 per cent – its weakest rate since 2009 – before accelerating to 3.5 per cent in 2020. Both projections reflect a modest downgrade of 0.1 percentage points relative to the Fund’s April 2019 forecasts.

Real GDP growth 2000 - 2020F

Digging into the forecasts, there is a notable divergence in the expected performance of advanced and emerging economies. In the case of the former, the IMF has actually (slightly) upgraded its growth forecast for this year, from 1.8 per cent in the April World Economic Outlook (WEO) to 1.9 per cent in July’s WEO update. Mostly that reflects a 0.3 percentage point increase in the 2019 growth forecast for the United States, where the Q1 GDP result came in stronger than expected. But there’s also a 0.1 percentage point upgrade for UK growth, once again on the back of a better than expected first quarter outcome. In contrast, the 2019 growth forecast for emerging and developing economies has been cut by 0.3 percentage points, with downgrades in the growth outlook for Russia (a 0.4 percentage point cut), Brazil (down 1.3 percentage points due to weak sentiment triggered by uncertainty around pension and other structural reforms) and Mexico (down 0.7 percentage points due to policy uncertainty, weakening confidence and rising borrowing costs)1, and for the Middle East (down 0.5 percentage points mainly due to a downward revision to the outlook for Iran due to tighter US sanctions). In the case of emerging Asia, the IMF has trimmed its expectations for China (down 0.1 percentage points where the drag from tariffs is expected to be largely but not fully offset by policy stimulus) and India (down 0.3 percentage points on softer domestic demand).

Trade volumes

The cuts to the IMF’s trade forecasts are larger than the cuts to projected GDP growth. The Fund has slashed its estimate for growth in the volume of goods and services trade this year by almost a full percentage point, to 2.5 per cent, while the outlook for trade growth in 2020 has been trimmed by a more modest 0.2 percentage points.

While growth is still expected to strengthen next year, the Fund is careful to stress that this assumes that financial market conditions remain generally supportive, allowing what are currently stressed and collapsing economies (Argentina, Turkey, Iran and Venezuela) scope to either recover or to stabilise: about 70 per cent of the increase in growth forecast for 2020 relative to 2019 is accounted for by an anticipated improvement in these economies.

The IMF also judges that downside risks are now greater than they were at the time of the April WEO. It reckons that ‘The principal risk factor to the global economy is that adverse developments – including further US-China tariffs, US auto tariffs, or a no-deal Brexit – sap confidence, weaken investment, dislocate global supply chains and severely slow global growth’. In addition, the Fund is worried about the possibility of an abrupt rise in risk aversion and the dangers associated with a return to disinflationary pressures across the world economy.

Finally, the IMF acknowledges that the US-China economic conflict has expanded beyond trade: the WEO update refers to the pressing need to ‘reduce trade and technology tensions’ (emphasis added) as a key policy priority.

Why it matters:

The IMF’s baseline scenario – for a subdued global economy marked by sluggish global growth and weak international trade – is consistent with the overall flow of data during the first half of this year, which has seen economic disappointments continuing to exceed positive surprises.

Citi Economic Surprise Index

It seems likely that the high level of policy uncertainty has taken a toll on investment decisions (and possibly on consumer durables spending) and that this has then weighed on manufacturing production and on trade flows.

Global economic policy uncertainty index

This weakness has triggered a pattern of downgrades in the IMF’s forecast for trade growth for this year and next that mimic the downgrades for trade growth last year that started with the July 2018 WEO update.

IMF forecasts for world trade growth: 2018 to 2020

Another key part of the global picture is the ongoing shift in the monetary policy stance of the world’s major central banks. The US Fed is now widely expected to cut rates at the end of this month and the European Central Bank (ECB) has already committed to keep interest rates at current levels until at least the middle of next year. That in turn has allowed an easing in global financial conditions that has served to support financial markets, despite the economic headwinds.

United states and euro area

What happened:

US politicians look to have reached a deal to suspend the debt limit until 31 July 2021.

Why it matters:

The debt limit (or the debt ceiling) is the total amount of money that the US government is authorised to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. When the ceiling is reached, the US Treasury can no longer issue any more debt (Treasury bills, bonds and notes) and can only settle its bills as it receives tax revenues – which in times of deficit are insufficient to cover all the government’s obligations. Hence, as the US Treasury puts it, ‘Failing to increase the debt limit would have catastrophic economic consequences. It would cause the government to default on its legal obligations – an unprecedented event in American history. That would precipitate another financial crisis.’

A version of the debt limit has been around since the early 1900s. It was originally created in 1917 to facilitate the issuance of Liberty Bonds to help finance US participation in the First World War. That was followed by the introduction of an aggregate debt limit in 1939 before US participation in the Second World War. For most of the time after it was introduced, Congress has either temporarily or permanently increased the debt ceiling or revised the definition of the debt limit without a great deal of political drama. But in recent years what was once a routine procedure has become much more contentious, morphing into a tool of political brinkmanship. Perhaps the most notorious example of this relates to August 2011, when Congress and then President Obama managed to reach an agreement to extend the limit just hours before the deadline was due to expire, prompting Standard & Poor’s to downgrade the US’s credit rating from AAA to AA+.

In February last year, President Trump signed a bill suspending the debt ceiling until March of this year, allowing the Treasury to borrow as needed during the suspension, but not allowing for any increase beyond that period. Treasury Secretary Steven Mnuchin had warned earlier this month that the US government was at risk of running out of funds by September, and global economy watchers have been citing the possibility of a technical US debt default due to a failure to agree to raise the debt ceiling as a significant, if low probability, risk to the US and global economic outlook.

In this context, the agreement should remove a key tail risk from the global economy, which is a useful piece of good news. The deal pushes the next potential conflict over the debt limit out until after the next presidential election.

That said, the deal does nothing to address the current US fiscal outlook in a substantive manner. Last month, the Congressional Budget Office (CBO) published its latest annual long-term budget outlook.2 This report produces budget projections for the next 30 years based on current legislation. With the current administration having combined large tax cuts with no significant offsetting spending measures, the CBO is predicting a sequence of large and growing budget deficits.

Federal budget deficit

Based on those deficit projections, the CBO estimates that the stock of US federal government debt held by the public would increase from 78 per cent of GDP in 2019 to 144 per cent of GDP by 2049, far above the previous peak reached in World War Two.

Federal debt held by the public since 1970

As we’ve highlighted in previous readings in the Weekly (and see also the links to the Grenville and the Blanchard and Ubide pieces below), there’s a major rethink underway on the part of academic and policy economists as to the appropriate role for fiscal policy and the importance of public debt. While it seems highly unlikely that the current fiscal trajectory in the United States can be explained as a product of this debate, it is certainly the case that concerns about large budget deficits and rising public debt are not in fashion in Washington, making for an interesting contrast with Canberra.

What happened:

Boris Johnson was elected as the new leader of the UK’s Conservative Party, subsequently taking over from Theresa May as the UK’s new prime minister. Mr Johnson has promised to take the UK out of the EU by the currently scheduled exit date of 31 October, ‘no ifs or buts’. This, apparently, will be a ‘do or die’ moment, and the new PM has said that he’s prepared to leave without a deal if that’s what’s required to meet the deadline.

Why it matters:

Brexit has been a long-running source of uncertainty for both the UK and the global economies (as noted above, a no-deal Brexit gets flagged in the latest IMF assessment as a key downside risk). Even so, markets have tended to discount the worst-case possibility of a no-deal outcome on the seemingly plausible grounds that, since both sides would be better off with a deal than without, that makes a deal the logical outcome. But the probability of no deal is on the rise, even if the new PM has claimed that the odds that kind of outcome are ‘a million to one against’.

What would the economic consequences of a no-deal Brexit look like? The honest answer is nobody knows for sure, which is why most assessments of possible outcomes are presented as scenarios rather than as forecasts. Still, for what they are worth, most scenarios do not paint a particularly encouraging picture. Earlier this month, for example, the Office of Budget Responsibility (OBR), the UK’s independent fiscal watchdog, published it latest Fiscal Risks report. As part of the analysis, the report includes a stress test that attempts to assess the potential cost of a no-deal Brexit. The test is based around the scenarios included in the IMF’s April World Economic Outlook.3 The Fund presented two scenarios: scenario A, which assumed no border disruptions and only a relatively small increase in UK sovereign and corporate spreads and scenario B which assumed significant border disruptions and a more severe tightening in financial conditions. The OBR bases its tests on the relatively benign scenario A and on this basis, the UK would enter into a year-long recession beginning in the fourth quarter of this year. This would see real GDP fall by 2.1 per cent relative to the baseline and the economy shrink by 1.4 per cent in 2020 (that’s a decline that would be in line with the UK recession in the early 1990s but would only be about a third the size of the downturn triggered by the global financial crisis) before returning to growth of 0.8 per cent in 2021. Sterling would fall and the Bank of England would cut interest rates to support activity. The long-run impact (via lower investment and lower migration) on UK GDP of a no-deal Brexit under this scenario is a hit of about 5.9 per cent. And the cost of all this for the UK’s public finances is estimated to be on the order of an annual increase in public borrowing of about £30 billion from 2020-21 onwards.

Again, the OBR is careful to stress that these are simulations, not forecasts, and that the actual consequences of a no-deal Brexit could turn out to be more severe than the relatively benign scenario it models. Back in November 2018, for example, the Bank of England published its own Brexit scenarios, which included two versions of a no-deal exit: Disruptive Brexit and Disorderly Brexit. Both of those scenarios envision a deeper initial recession for the UK and a greater medium-term loss of potential output than the OBR’s scenario.

Lastly, in terms of implications of a no-deal for the rest of the world, there are two main channels to consider.

The first is the direct impact of a no-deal Brexit on economic activity. A UK recession and the hit to growth in the EU more generally would be bad news for trading partners in proportion to their economic exposure to those markets. In the case of Australia, for example, our direct exposure to the UK is fairly modest: in 2018 the UK accounted for just 3.2 per cent of two-way trade, taking 2.4 per cent of exports and supplying four per cent of imports. (Exposure to the EU overall was larger of course: 12.8 per cent of two-way trade, 6.9 per cent of exports and 19.1 per cent of imports.) Under the IMF’s scenario A discussed above, for example, the impact of a fall in UK demand translates into a hit to GDP of about one seventh the size of the fall in UK GDP for the EU overall (albeit with big differences across member economies) and ‘negligible’ effects on the rest of the world.

The second channel is the impact on sentiment. As noted above, markets have been assuming that a no-deal Brexit is a low probability, high impact event. Were it to eventuate, not only would there be a direct hit to confidence, but it might also prompt a more general re-pricing of risk and/or a rise in risk aversion across the world economy.

What I’ve been reading: articles and essays

Productivity Commission Chair Michael Brennan describes three key trends that will shape the contribution that economics can make to better policymaking: (1) tailoring the general approach of economics to the specific challenges offered by non-traditional (for economists) areas of policy, such as health and education; (2) a shift from a focus on correcting the large-scale misallocation of resources to a reform agenda based around dynamism, including human capital development, the generation of new disruptive ideas, products and business models, and their diffusion through the economy; navigating the empirical revolution triggered by the proliferation of data and the exponential increase in computing power to manipulate it.

The Commonwealth Bank has launched a new series tracking household spending intentions, which marries the bank’s transaction data with insights from Google Trends.

The Economist on Australia’s minimum wage.

Also from the Economist, the Banyan column on the troubled Japan-South Korea relationship which has triggered a trade spat that risks disrupting the global technology chain.

Jacks and Novy draw some lessons from the 1930s version of trade wars for their modern successor. Possible contemporary parallels with the interwar period include the prospect of a formerly dominant multilateral trading system in danger of being replaced with a set of bilateral deals and an intensification of trade blocs, which in the current content could potentially lead to world trade reorienting around China- and US-centric blocs. The big difference in the landscape relative to the earlier period is the key role now played by global value chains, which they think might constrain the scope for a trade bloc style trading order.

The 2019 Global Innovation Index has been released. Switzerland is ranked as the world’s most innovative economy, followed by Sweden, the United States, Netherlands and the United Kingdom. Singapore (#8) is the highest ranked economy in our region. Australia has slipped from 20th spot last year to 22nd this year. In a familiar story, we do better on inputs, where Australia is ranked 15th, with high rankings for human capital and research (10th) and for institutions (13th) than we do on outputs, where our rank is just 31, reflecting lower rankings for creative outputs (29th) and knowledge and technology outputs (36th). Since the first report was published in 2007, Australia’s ranking has moved between a high of 17th place and a low of 23rd.

Nouriel Roubini really doesn’t like cryptocurrencies, worrying that a lack of regulatory oversight has created ‘an unregulated casino, where unchecked criminality runs riot.’

The new Fortune Global 500 list marks an important world power transition: the number of companies on the list based in China (including ten in Taiwan) has reached a record 129, exceeding for the first time the number of US-based companies (121).

The Lowy Institute’s Steve Grenville looks at the relationship between progressive US politics and radical economics.

Related, Blanchard and Ubide have both made the case for a more relaxed approach to public debt and budget deficits, arguing that (1) lower interest rates decrease the fiscal and economic costs of debt and (2) lower rates plus the effective lower bound on nominal interest rates limit the efficacy of monetary policy relative to fiscal policy. Here they take on some of the criticisms of their arguments, including the idea that their proposals are a licence for fiscal irresponsibility, and the risk that the current low interest rate environment may not last. Interesting, the OBR’s Fiscal Risks report, discussed above in the context of Brexit, also includes a chapter on government debt. The OBR is rather more cautious than Blanchard and Ubide, making the case for a healthy degree of caution when making bets on the future relationship between growth and interest rates that will determine overall debt sustainability.

The FT’s Rana Foroohar on investing in the age of deglobalisation: she thinks that the new era belongs to emerging market middle classes, not to US multinationals. Makes for an interesting counterpoint to the FT piece in last week’s roundup, which asked whether investing in emerging markets still made sense.

A Quartz profile of economist Mariana Mazzucato.

To listen to: Ezra Klein in discussion with Rutger Bregman, author of Utopia for realists. The discussion covers the case for a universal basic income, the future of work and Keynes’ famous Economic possibilities for our grandchildren (pdf). It might have been more interesting to have had an interviewer a bit more sceptical of Bregman’s views – Klein does push back occasionally, but only gently – but still worth a listen.

1 Elsewhere in Latin America, the IMF thinks that the Venezuelan economy could shrink by a devastating 35 per cent this year.

2 Note that the CBO’s projections are extremely sensitive to changes in the underlying assumptions it makes around factors such as productivity growth and interest rates. For example, the CBO notes that if productivity growth was half a percentage point lower than assumed in the baseline, the debt stock in 2049 would instead be 185 per cent of GDP. If instead it was half a percentage point higher, the projected future debt burden would then be a much lower 106 per cent.

3 See Scenario Box 1.1 A No-Deal Brexit. Chapter one, pp. 28-31.