Uncertainty Mounts

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April 2011

Hope that the global economy has shaken off the dust of the 2007-2008 financial crisis is giving way to uncertainty as the Arab Spring and disaster in Japan threaten to reverse recovery momentum. Market behavior is signaling a slowdown in US growth, but there are few options left for policymakers as fiscal and monetary stimulus fade. Budget pressures will make further stimulus unlikely, leading to mounting uncertainty about the way forward.

Key points in this Outlook:

  • Instability in North Africa and the Middle East, tragedy in Japan, and rising energy prices make for a highly uncertain global economic outlook.
  • Major segments of the global economy are withdrawing fiscal and monetary stimulus, and higher pressure on oil supplies will likely cut overall demand growth.
  • The global economic recovery is still dependent on US consumption and investment, but first-quarter US growth estimates have been revised down from 4 percent to 2.5 percent.
  • US policymakers have few tools left to jump-start the economy if it stalls midyear after the second round of quantitative easing and second stimulus fade.

The main problems arising from last month's compound exogenous shocks--the Arab Spring and Japan's earthquake, tsunami, and nuclear-power disaster--are the effects we have not yet foreseen or understood. We know that the level of uncertainty confronting households, firms, and policymakers in the real economy and investors in the financial sector has risen sharply. And we know that a spike in uncertainty--while never a good thing for growth and efficient allocation of resources, not to mention for just getting on with life--is especially unwelcome when we are all hoping that the elevated uncertainties associated with the 2007-2008 financial crisis are largely behind us.

The turbulence from the Middle East and North Africa as well as from Japan has elicited the usual rush of analysis from investors and stock-brokerage firms, especially those with established bets on global economic recovery. Investment banks tell us down to the decimal point what the negative impact of the earthquake and its aftermath will be on Japanese and global growth (not so bad!). Warren Buffett declares, "Japan may be a buying opportunity." The Barron's front page (March 21) cries, "Buy Japan." Meanwhile, JP Morgan, having already cut its US gross domestic product growth forecast for the entire first half of 2011 by a full percentage point, shortly before the earthquake and intensification of the Arab Spring, sees only a modest reduction in global growth and also a bounce in Japanese growth by the second half of this year.

These glib and hasty assertions must remind some observers of a prominent 2007 impression of the then-looming financial crisis. It was a "subprime crisis," to use the term adopted by none other than Federal Reserve chairman Ben Bernanke. Since subprime mortgages totaled about $1.5 trillion, a 10 percent write-down would cost the US financial system about $150 billion--painful but not devastating in a banking system with nearly $1 trillion in equity capital. That view was consoling to markets, and in July 2007 Citibank president Chuck Prince uttered ominous words when asked about banks' involvement in the mortgage markets: "As long as the music is playing, you've got to get up and dance." "Dancing," it turned out, meant real estate exposure by banks and investments banks leveraged at more than 30:1. Eight months later, Bear Stearns failed, and a global financial panic was underway. Lehman Brothers sub-sequently collapsed in September 2008.

"Buy" Calls Assume Policy Response

This is not meant to say that Japan's disaster and the revolutionary wave in North Africa and the Middle East will result in another global crisis. Rather, it is to remind the reader that the initial response to formidable problems for the real economy and the financial sector is often misleading. It is also important to bear in mind that the knee-jerk call "it's a buying opportunity" is premised on a key assumption: policymakers are going to do "whatever it takes" to fix the problem and, in so doing, will end up rewarding the sanguine outlook expressed early on by the supposedly smart money.

After Lehman Brothers failed in September 2008, the United States saw the $800 billion Troubled Asset Relief Program, zero percent interest rates, and over $900 billion in a January 2009 fiscal stimulus package. The buy crowd was bailed out by mid-2010, when deflation and a double-dip scare hit risk markets; Bernanke preannounced a second program of quantitative easing (QE2) in August 2010; and Congress and President Barack Obama enacted a surprise second stimulus package in December 2010 amid fears of "fiscal drag" in early 2011. Policy responses have consistently validated sanguine views of the postcrisis recovery. In 2010, the US economy grew at a 2.8 percent rate. The Congressional Budget Office estimates that the contribution of fiscal stimulus alone to 2010 US growth was 2.7 percentage points. One wonders about the counterfactual: without fiscal stimulus, not to mention QE2 and the remainder of QE1, would US growth in 2010 have been negative? Throw in the European Union's May 2010 $1 trillion headline sovereign-debt-crisis rescue package, and you have a global economy tracking an uneven, tepid recovery with the help of massive doses of stimulus.

The knee-jerk call "it's a buying opportunity" is premised on a key assumption: policymakers are going to do "whatever it takes" to fix the problem.

The winners who bought stocks in March 2009 and held on in June 2010 got bailed out by "whatever it takes" help from policymakers. Did they know policy steroids were coming (they did not say so) or were they just lucky? More important now are two sets of questions. First, do bullish investors think more of "whatever it takes" is on the way? Or do they think that the much-vaunted "self-sustaining" global recovery has taken hold? Second, what will be the near-term effects of elevated "real" economic uncertainty arising from the disruptions in Japan, the Middle East, and North Africa, and from their positive impact on the cost of energy? How will these effects compare with the effects of elevated financial-sector uncertainty that grew out of the collapse of the American-centered housing bubble?

Uncertain about Uncertainty

I do not know the answers to these questions, but neither does Warren Buffett, or Bernanke for that matter, though the latter has thought a lot more about the key issues, including the effects of elevated uncertainty. The best way to take stock of the global economy in spring 2011, given the severe exogenous shocks, is to think about how elevated exogenous uncertainty can affect the economy and thereby financial markets, and to ask what policymakers--who played such a crucial role after the September 2008 Lehman collapse--can do now to address the attendant unusual challenges. This exercise needs to be undertaken against a backdrop wherein most of the extraordinary policy stimulus measures undertaken after the Lehman crisis are either being withdrawn or are scheduled to be withdrawn, somewhat abruptly later this year in the case of the United States. The latter point is important because rapid withdrawal of fiscal and mon-etary stimulus in China, most emerging markets, and Europe has made the global economy heavily dependent on sustained, firm US growth driven largely by the American consumer.

A well-timed analysis by Goldman Sachs economists provides an initial framework for considering the effects of elevated uncertainty surrounding exogenous shocks. I will try to build on that. Goldman's work is especially of interest, as it includes a reference to a 1983 paper by Bernanke on the economic effects of uncertainty.

The basic impact of higher uncertainty is to increase the value of delaying decisions until more information becomes available to better predict future outcomes. A household confronted with higher uncertainty about the future path of the economy may delay purchases of durable goods. Firms may delay investment and hiring decisions. Both households and firms may wish to hold more liquid low-risk assets, including cash. The demand for gold, the traditional "no place to hide" asset, tends to rise in times of elevated uncertainty.[1]

The basic impact of higher uncertainty is to increase the value of delaying decisions until more information becomes available.

Given that the immediate impact of elevated uncertainty is to reduce aggregate demand, slow hiring, and increase the demand for cash and hoarding vehicles, which in turn further depresses aggregate demand, growth can slow abruptly as producers face a sharp rise in unsold inventories. They then cut production and may lay off workers. Capital spending drops sharply. When the elevated uncertainty is driven by exogenous shocks that increase the price of major energy inputs such as oil and coal, the problems for the economy, financial markets, and--by implication--policymakers who are expected to fix everything, are compounded.

Policy Response to Uncertainty

Policymakers face the daunting task of determining if and when uncertainty may drop and thereby lead to a reversal of these negative demand and output shocks. If they simply do nothing, growth can drop below stall speed and a recession can result. Alternatively, if they overreact and stimulate too aggressively, overheating and inflation can result.

Consider oil. Of course the disruptions in North Africa and the Middle East have reduced the supply of oil and the certainty of future supply--exogenous shocks at a time when the rising energy demands of a recovering global economy have already boosted the price. Elevated uncertainty about oil supply results in additional hoarding demand, which further boosts the price. Policymakers face difficult choices. If higher uncertainty simultaneously boosts the demand for cash and the price of energy, should a central bank accommodate a potentially deflationary surge in liquidity demand given an already-inflationary surge in energy prices? I do not know and neither do central bankers--public assertions of confidence aside--because nobody knows how large or persistent these forces will be.

Some central banks, including the Fed and the Bank of England, have--so far at least--chosen to view the impact of higher energy prices on the overall price level as transitory and decided not to tighten monetary policy. So far so good, as the elevated level of uncertainty has boosted the safe-haven demand for government bonds, even in the face of rising budget deficits and rising prices of oil and other commodities. Other central banks, the European Central Bank (ECB) in particular, have signaled that tightening is imminent, apparently because Europe has more to fear than the United States from the pass-through impact of higher energy prices to higher core domestic inflation. China, meanwhile, after massive 2009 fiscal and monetary stimulus, faces unambiguously accelerating inflation and, having withdrawn much of its fiscal stimulus, now is tightening monetary policy with modest help from a tepid currency appreciation of about 4 percent since June.

Japan's central bank and policymakers are, of course, at the front line in confronting the complex problem of a negative real economic shock that has destroyed both wealth and productive capacity while sharply elevating uncertainty. The initial symptom--a surge in the value of the yen (like that which eventually followed the 1995 Kobe earthquake)--reflects a surge into yen-denominated cash instruments by Japan's holders of foreign assets. The $25-$30 billion surge in purchases of foreign exchange by Japan and other G7 members on March 18 wisely preempted a deflationary shock from a stronger yen that would have further weakened a Japanese economy already contracting at a 1.3 percent annual rate at the end of 2010 and then beset by heavy losses of infrastructure from the earthquake, tsunami, and nuclear-reactor troubles. Inflation is the last thing the Bank of Japan needs to worry about after nearly a decade of outright deflation. At least the path to take--aggressive reflation--is clear, and at least the initial response--strongly affirmed by the G7--is appropriate.

Expectations of higher inflation and higher growth caused yields on ten-year Treasuries to rise by nearly 125 basis points from October to about 3.75 percent in mid-February.

Japan's cascade of calamities, however, is problematic for the global economy and for central banks in its potential impact on global energy costs. The sharply elevated uncertainty regarding future reliance by Japan and other nations on nuclear power has produced a substitution effect in favor of elevated current and prospective reliance on oil and coal. This comes at the very time when the political upheavals in the Middle East and North Africa have interrupted oil supplies. Additional upward pressure on oil prices further complicates the task for central banks of setting monetary policy in an environment of (deflationary) sharply elevated uncertainty and (inflationary) rising energy prices. The central banks themselves, not to mention those betting on the future course of monetary policy (QE3 anyone? Or, to the contrary, perhaps a truncated QE2?), are facing plenty of policy uncertainty along with elevated real uncertainty.

Under some theories, a basic rule of policymaking is to do less or nothing in an environment of elevated uncertainty both about the need for policy actions and about their likely impact. Hence the Fed's March 15 statement essentially standing pat while the ECB keeps talking about its previously signaled intention to tighten in April. This inaction by the Fed in an uncertain environment may be viewed by some as reminiscent of its hesitant stance during the spring and summer of 2008 after the Bear Stearns crisis in March of that year. Monetary policy was, in hindsight, kept too tight by the Fed as elevated uncertainty and the belief that the crisis was over drove up commodity prices and, for a while, equity prices. Beyond unnerving private-sector decision markets, higher uncertainty tends to freeze policy markets, sometimes with deleterious effects, such as those that occurred in mid-2008, leading up to the Lehman Brothers crisis in September.

Where Is the Global Economy Heading?

A combination of factors makes for a highly problematic outlook for the global economy over the coming year. There are three main issues. First, major segments of the global economy--including China, Europe, and most emerging markets--are already withdrawing fiscal stimulus because of budget strains and monetary stimulus because of rising commodity inflation. Second, the uncertainties related to the Middle East and Japan will be inflationary in the short run due to higher pressure on oil supplies but will cut overall demand growth in the face of elevated uncertainty. And finally, the only major source of global demand growth--US consumption and investment fueled by fiscal incentives--has begun to weaken in the face of higher fuel prices, hesitant equity markets, and the prospect of earlier fiscal stimulus withdrawal tied to spending cuts being pressed by Congress. By midyear, the Fed's bond buying under QE2 will have ended, and the Treasury Department has already announced that it will begin selling about $10 billion per month of its mortgage-backed securities. With higher energy prices having effectively taxed away the extra spending power contained in last December's tax cuts, the removal of those tax cuts already scheduled for the end of this year and the deficit-cutting mood in Congress will almost certainly preclude a reprieve.

The prospects for a US growth slowdown were already in place before the shocks in the Middle East, North Africa, and Japan, along with their implied higher energy costs. These major disruptions and the attendant near-term growth plunge in Japan, still the world's third-largest economy, all entail negative consequences for global demand growth and employment growth. First-quarter US growth estimates have been reduced from an annual rate of about 4 percent to 2.5 percent. Consensus second-quarter forecasts are held at a 3.5-4 percent rate, but they may start to slip lower under pressure from negative uncertainty effects.

In the face of these risks and demand-killing elevated uncertainty, the consensus for robust global growth at a 4 percent-plus rate during 2011 and 2012 remains largely in place. The major concern of markets and policymakers seems to be attached to an acceleration of inflation, and indeed, as noted, policymakers in most emerging markets and Europe have already begun to confront tangible evidence of rising commodity prices with tighter money. The Fed, however, with some signs of misgiving, has so far stuck to its plan to complete QE2.

Market Signals on Growth

Through all the turmoil and talk of higher inflation risks, some market behavior is consistent with the prospects of a US slowdown. Expectations of higher inflation and higher growth caused yields on ten-year Treasuries to rise by nearly 125 basis points from October to about 3.75 percent in mid-February. Since then, they have dropped by about 40 basis points. While the drop in ten-year yields may be transitory--there is plenty of uncertainty here--if it persists, it will signal fears of a negative global-growth scare akin to the one that appeared in April 2010.

Simultaneously, both the real and nominal trade-weighted dollar have weakened since the fourth quarter, with the real trade-weighted dollar close to its all-time lows of 1995 and 2008. Both moves reflect a drop in expected real growth and are consistent with the policy mix implied by the prospect of tighter fiscal policy and continued monetary accommodation (a zero fed funds rate for an "extended period"). No doubt the ECB's early March signal of possible April tightening has further weakened the dollar. Should US real growth dip midyear, while the safe-haven motive might tend to support the dollar as it did during past phases of the postbubble crisis, higher rates in Europe could continue to weaken the greenback.

That said, there may be resistance to further dollar weakening. If G7 intervention to weaken the yen continues, that will help support the dollar. Further, if the global economy slows below consensus growth at midyear, widespread currency intervention to prevent a weaker dollar in a world of weaker aggregate demand may return. China especially comes to mind and perhaps Brazil.

The dollar and interest rates will provide a clear reading on the market's outlook for US growth and inflation. The prospect of steady, continued US growth and nervousness about inflation probably produced the 3.75 percent year-to-date high in US ten-year yields. If yields push above that rate and through previous highs of 4 percent, that suggests the market is rejecting the notion of slower US and global growth even in the face of heightened uncertainty, higher energy costs, and a broadening withdrawal of monetary and fiscal stimulus. Holding below the 3.75-4 percent ten-year rate level would suggest the reverse and, with that, some serious risks for global recovery.

Not Many Policy Options Left

If the global recovery stalls again at midyear in 2011 as it did in 2010, the prospects for US revival from the likes of QE2 and stimulus 2--and of global revival under a smooth transition to a stable inflation path in China, Europe, and most emerging markets--are not good. The Fed and to a greater extent the other central banks, save the newly beleaguered Bank of Japan, are set to remove monetary accommodation. The upward pressure on energy prices exacerbated by the shocks of the past few weeks will likely keep them on that path. Budgetary pressures on governments elsewhere and the political consensus to tighten fiscal policy mean that fiscal -stimulus will be steadily removed.

Policy steroids are being withdrawn on the assumption that the global economy, although burdened with extra uncertainty and higher energy costs, is on a self-sustaining path to recovery. If the uncertainty goes away quickly enough and elevated equity markets hold up, a benign global scenario may yet emerge. Alternatively, if a global- growth scare reemerges in 2011, those who bet on a policy fix akin to that of 2010 will be disappointed. It is all very uncertain, and that reality, by itself, makes a growth pause more likely.

John H. Makin ([email protected]) is a resident scholar at AEI.

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1. See Goldman Sachs, "The Economic Effects of Uncertainty," US Economics Analyst, no. 11/11 (March 18, 2011); and Ben S. Bernanke, "Irreversibility, Uncertainty, and Cyclical Investment," Quarterly Journal of Economics 98, no. 1 (1983): 85-106.

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