Beneath-Trend Growth for World Economy in Early 2019

posted by Tim Congdon on December 8, 2018 - 9:20am

Forecasts for 2019 are now coalescing. The typical view is that the first half of the year will be more difficult for the world economy than 2017 and 2018, with beneath-trend growth likely. As has been anticipated in these notes for some time, the Eurozone is the focus of concern. Not only will the European Central Bank end its asset purchases next year, but warnings are being given to the weakest banks – the banks that cannot easily fund their assets from market sources – that the ECB’s long-term loan facilities to them may not be extended in mid-2020.

An obvious risk arises that Eurozone money growth could slide towards zero, as it did in the 2011 – 14 period when the Eurozone suffered from a condition of deflationary semi-recession.

If the Eurozone’s travails were exceptional, a case might be argued for a more optimistic view on 2019. But in most countries it is easier to cite influences curbing bank balance sheet expansion than to identify influences promoting it. In the USA the Federal Reserve has started its asset rundown at the rate of $50b. a month, so that broad money growth will be lower (by, say $300b.) in the year than it would otherwise have been. In China the central bank has cut reserve requirements three times this year, but banks do not seem to be in a hurry to increase their credit allocations. In Japan and the UK the annual rate of money growth is in the low single digits. (All these developments are discussed in our usual monthly review.)

The UK also agonizes over its looming departure from the European Union, with a “no deal” Brexit now widely believed to be a probable outcome. Lurid forecasts are being made by both the Treasury and the Bank of England about the consequences of “no deal”. But importers and exporters can anticipate tariffs and transport delays by building up inventories ahead of 29th March. A logical view is that such stock-building will be positive for demand in the first quarter of 2019, and then negative for some quarters thereafter. It has to be said that high stock-building is not yet evident from business surveys, although that may change in the next few weeks. It has also to be said that – if a burst of stock-building does not take place in the first quarter of 2019 – the Treasury’s and Bank’s extreme anxiety about Brexit must be misplaced and wrong. I say this because everyone knows about Brexit, and that tariffs – even if low tariffs – may start on trade between the UK and the EU on 30th March, along with other disruption. The obvious business response is to pre-empt the problems by completing transactions and moving goods before the tariffs take effect. If stock-building is not much higher than normal in the next few months, the problems of Brexit have been overstated. The UK’s exports of goods and services to the EU are about 12% of gross domestic product, but stock-building should affect both exports and imports.

Brexit is only one issue for Europe in early 2019. As has been mentioned in these notes for many months, the tensions within the Eurozone are perhaps even more important. They are symptomized in the imbalance in the Target 2 settlement system. The latest figures (for October) have been reported by the ECB and are shown in the chart above. Germany’ credit balance again fell back towards €900b., while the debit balances of both Spain and Italy were virtually unchanged.  The fall in Germany’s credit position continues to look odd given the news, and it may have been due to behind-the-scenes manipulation and/or window-dressing. (One of the key central banks could lean on a large commercial bank and ask it, in the expectation of future favours, to make big loans to an Italian bank. Perhaps unsurprisingly the present populist government in Italy has been beguiled by Keynesian talk about the benefits of so-called “fiscal expansion”. My latest Standpoint column explains how in certain circumstances fiscal expansion can be contractionary.)

A common line in macroeconomic commentary after the Great Recession was that “monetary policy is exhausted when the central bank policy rate has fallen almost to nothing and so hit the so-called ‘zero bound’”. But that was easily refuted by central bank actions to boost the quantity of money by “quantitative easing”. (This was so, even though a majority of economists insisted – and still insist – on never mentioning “the quantity of money” in their work. Absurdly, they suffered – and continue to suffer – from an allergy to the phrase.) The nihilists then came back with the assertion that, “As central banks engaged in more QE exercises, the effectiveness of QE declined.” By extension, at some point there was a limit on the effectiveness of monetary policy…(And fiscal policy must take over….as John Maynard Keynes said in his 1936 General Theory, didn’t he?)
The economists responsible for the Law of QE Diminishing Marginal Returns appealed to one piece of evidence in particular, that the later QE injections (in the USA and the UK, in particular) seemed less able to reduce bond yields than the first injections. (An article in the current issue ofThe Journal of Economic Perspectives by Kenneth Kuttner illustrates this idea.) An implicit assumption was at work, that the bond yield (on triple-A corporate bonds, the 10-year Treasury or whatever) was not only a significant “price” for the economy, but the most important marker (or even the exclusive such marker) for the effectiveness of monetary policy.
Bond yields may be significant for some types of economic agent and some categories of aggregate demand. But the notion that they are the most important – or only – guide to monetary policy effectiveness is baloney. To take the USA as an example, bonds are about 4% of household wealth, and are overshadowed in portfolios by equities and real estate. In the accompanying video, I argue that – in the long run, when equilibrium values have been established – the nominal values of all ofvariable-income assets (i.e., equities and real estate), national income and the quantity of money move together. The evidence is that “the proportionality hypothesis” (that the velocity of circulation is constant) may not be 100% right, but that it is still a reasonable starting-point for analysis. The positive macroeconomic effect of QE-related additions to the quantity of money on real estate markets and the stock market is far more powerful than their effect on bond yields. Further, the approximate validity of the proportionality hypothesis means that monetary policy cannever – yes, never – be ineffective.

Professor Tim Congdon is the founder of the Institute for International Monetary Research. Check out his other works at