Ignacio de la Torre. Professor. IE Business School
2 July 2012
The threat of a new recession in the US, the drop in the price of raw materials, and decisions taken by the ECB, might just bring about a turnaround in the world economy.
The traveler Javier Reverte once commented how when he set out on a trip to places he did not know he made a mental provision for scams, so that when a taxi driver overcharged him he didn’t get angry, given that he had already factored the “surcharge” into his provision. Now that we are over the hurdle of the recent European summit, in which for the first time political leaders adopted that old market practice of affording a false sense of happiness by means of pre-martyrdom (i.e. by lowering expectations and then subsequently announcing measures that are not quite that bad), it’s time to shed some light on other sources of basic risk for the world economy, so that we can set up our own mental provisions. Given that I have always criticized market players for only seeing black swans in the economy, in spite of the fact that the majority of swans are white, I am going to talk about three risks - one negative, one ambivalent, and one positive, because they are the type of risks that will allow us to think that things are not really quite so bad if they do actually happen.
First, and this is very important, the US economy is showing alarming signs of deceleration, with anemic levels of consumption due to disappointing growth in available income. This anemia has led to to less investment and smaller inventories, and has taken manufacturing levels to their lowest point in three years, further depressed by the world economic situation. Nevertheless, the greatest threat for the US lies in the so-called fiscal cliff, or the automatic fiscal contraction that will take place on January 1, 2013, when fiscal cuts from the Bush era automatically expire. This will produce a drop in spending and a rise in tax equivalent to three points of GDP, in other words one of the largest fiscal contractions in the history of the US. This situation coupled with an anemic economy could cause a double dip recession, just like that of 1937. In order to avoid this, republicans and democrats would have to reach an agreement between the elections and January 1, but 8 weeks are not likely to be enough for two parties who have shown scant signs of fiscal responsibility over the last twenty years. As if this weren’t bad enough, many US firms are currently preparing their tax for the next tax year, which in many cases starts on October 1. This means that an improbable agreement between the two parties would not affect these budgetary decisions, which in turn will impact hiring practices and investment, and subsequently the growth of GDP. There are, however, two things that might serve as buffers: a) the real estate market in the US, which is beginning to show signs of improvement, and b) the growing availability of credit as a result of the rationalization of the banking system carried out three years ago.
Second, the drop in the price of raw materials makes a mockery of the argument in favour of the “supercycle” caused by a structural lack of supply and high demand. The surprising and rapid deceleration of the Chinese economy and its collateral effect on other economies like that of India or Brazil, coupled with the European recession and deceleration in the US, have resulted in an agonizingly low level of demand (the world today is growing at a scant 2%, compared to the 3.45 rate during the first quarter). The context could not be worse, given that most of the thousands of millions of operative cash flow accumulated by producers of raw materials during the good years have been reinvested in increasing production capacity. Because supply is not very elastic (years pass between finding material and taking it onto the market) the product of massive investments made since 2005 is now starting to reach the market. It could not be happening at worse time for producers. The implications for emerging markets are negative (including Australia or Canada, but excepting China) and positive for the OECD (particularly the drop in the price of petrol, which is excellent news for consumption in the US or the Spanish economy). This context will remain thus for years, and will lead to a rebalancing of world growth, benefitting developed countries more than emerging economies.
Third, the economic recession is closely linked to the credit crunch the banks have imposed on the private sector. Said credit crunch is in turn a result of the demands for more capital from Basel III, a greater balance between deposits and loans, and lastly the fact that interbank finance markets are not working due to a mutual lack of trust (as I have explained before, if you play at poker and you know that one of the players is bankrupt but you don’t know which one, it is better not to place any bets). Although the first two factors are structural, we may soon see changes with regard to the third, which is far more volatile. The bank’s cash, instead of being invested in the interbank sector, is piling up in the ECB, and meanwhile the ECB is providing enormous cash injections for the banks to keep them afloat. As countries recapitalize and the true balances of their banks come to light, conditions will eventually be right for cash to be re-injected into the interbanking system. All the ECB has to do is penalize the accumulation of liquidity in the central bank (morphine is highly addictive stuff). If the ECB, for example, decided to apply a negative interest rate for the 700 billion euros deposited in the central bank, a measure already applied in the past by the Swedish Central Bank, it would be possible to start mobilizing that liquidity in the interbanking system, which would enable liquidity to flow in the private system. The GDP would then expand instead of contracting, as the monetary mass and the speed of money increased, creating a multiplier effect. If this process were to take place in the fall, Europe might be capable of giving us a pleasant surprise in 2013.
Some time ago a speaker at a conference expounded the theory that the world was heading for a LUV-shaped recovery. The V referred to emerging countries, which after a relapse would experience steep growth. The U referred to the US, where growth has bottomed out and will start to grow strongly again. The L represented Europe, which has not done its homework and will not start to grow again anytime soon. If you think about the basic points set out in this article, perhaps the countries to which the first and last letters have been applied should actually be the other way round.