Key Trends in Globalisation

Quantitative easing - US and non-US markets

An important article by Gavyn Davies on his Financial Times blog analyses the effects of US quantitative easing (QE) on bond, share and commodity markets and the relation of these to trends in the productive economy.

Gavyn Davies charts the graph in Figure 1.

Figure 1

 

His commentary is self-explanatory:

‘A quick glance at the graph suggests that equities, bonds and commodities have all been in bull market trends ever since the successive rounds of quantitative easing started. However, a closer inspection reveals that this is not in fact the case. Only bonds have been in a continuous uptrend. The behaviour of global equities and commodities can more meaningfully be split into two separate phases.

‘From the start of the recovery to the end of April 2011, both equities and commodities recorded extremely strong bull markets, with both asset classes rising by some 90 per cent.

‘Since then, however, the bull market in risk assets has fizzled out. In the second phase (shaded blue), equities have been volatile around a broadly flat trend, and commodities have actually fallen by 16 per cent from the peak, despite their recent rally. Quantitative easing has not been powerful enough, at least up to now, to restore the 2009-11 bull market.’

As regards bond markets the essentially continuous upward trend of prices noted by Gavyn Davies naturally indicates that the intended goal of QE of depressing interest rates has been achieved. As regards commodity prices he is accurate that these have not yet regained their post-financial crisis peaks reached in April 2011 – as is clear from Figure 2.

Figure 2

 

World share prices have also not significantly risen above their April 2011 post-international financial crisis highs – see Figure 3. However this graph also illustrates the sharp difference between US and non-US share price performance.

US shares have continued to advance since April 2011, more than overcoming their decline in the second half of 2011. Non-US shares have, however, fallen back from April 2011 levels.

Whereas up to April 2011 US and non-US share markets moved in the same direction, both showing recovery, since April 2011 US and non-US share markets have moved in opposite directions with the former having risen and the latter fallen.

Figure 3

 

In order to illustrate this more clearly Figure 4 shows the changes in world, US and non-US share prices since 31 March 2011. By 21 September US share prices were 9.9% above their 31 March 2011 levels whereas non-US share prices were 9.2% below them.

Figure 4

 

These contrary trends in US and non-US share prices naturally don't contradict Gavyn Davies’s fundamental argument. But they highlight an important trend within its overall framework.

US QE policies have been accompanied by, almost certainly caused, a significant and continuing rise in US share prices which continued after April 2011. But US QE policies have been accompanied since April 2011 by a fall in non-US share prices. Any analysis of trends in world markets must take into account and explain these divergent trends.

It is also unlikely that the explanation can simply be more rapid economic growth in the US compared to other economies . Despite some recent slowdowns emerging economies have grown significantly more rapidly than the US, but emerging economy share prices have performed significantly worse than the US – Figure 5. Whereas emerging economy share prices have fallen by 14.2% since 31 March 2011 US shares have risen by 9.9%.

Figure 5

 

The Federal Reserve could, therefore, argue that it has created a ‘wealth effect’ within the US through QE – US house prices have also stabilised and then risen slightly this year. However the data from commodity markets and non-US share markets indicates no such effect has been created by QE outside the US.

Whether US QE has contributed to the negative trends in non-US economies, as countries such as Brazil have argued, would of course requires a separate article. The distinction between US and non-US markets is however relatively clear.

The shape of the new EU downturn

The data released by the OECD for 2nd quarter GDP for the EU shows clearly the shape of Europe's new economic downturn. The situation is dominated by the decline in fixed investment – see charts below.

In the US$ Parity Purchasing Power (PPP) terms in which the OECD now releases such data EU GDP, in inflation adjusted terms, is still $307 billion below its peak in the 1st quarter of 2008. However EU fixed investment is down by $485 billion – that is the decline in fixed investment more than accounts for the entire fall in EU GDP. EU consumer expenditure is also down, by $122 billion, but this is only one quarter of the decline in fixed investment. Net trade and government consumption are positives.

In short the EU’s economic situation, as in the developed economies as a whole, is dominated by the fixed investment decline.

Figure 1

Figure 2

Fundamental errors of the World Bank report on China

The World Bank's report China 2030 has, unsurprisingly, provoked major criticism and protest. I have read World Bank reports on China for more than 20 years and this is undoubtedly the worst. So glaring are its factual errors, and economic non-sequiturs, that it is difficult to believe it was intended as an objective analysis of China's economy. It appears to be driven by the political objective of supporting current US policies, embodied in proposals such as the Trans-Pacific Partnership.

Listing merely the factual errors in the report, of both commission and omission, as well as the elementary economic howlers, would take up more column inches than are available to me. So what follows is just a small selection, leaving space to consider the possible purpose of such a strange report.

The report has no serious factual analysis of the present stage of China's economic development. On the one hand it is behind the times and "pessimistic", saying China may become "the world's largest economy before 2030". This is extremely peculiar as, by the most elementary economic calculations, (the Economist magazine now even provides a ready reckoner!) China will become the world's largest economy before 2020.

On the other hand, the report greatly exaggerates the rate at which China will enter the highest form of value added production. As such, the report calls for various changes in China, and bases its calls on the rationale of "when a developing country reaches the technology frontier'. But China's economy, unfortunately, is not yet approaching the international technology frontier, except in specialized defence-related areas. Even when China's GDP equals that of the US, China's per capita GDP, a good measure of technology's spread across its economy, will be less than one quarter of the US's. Even making optimistic assumptions, China's per capita GDP will not equal the US's until around 2040, by which time China's economy would be more than four times the size of the US's! Put another way, China will not reach the technology frontier, in a generalized way, for around three decades, so this rationale can't be used to justify changes now.

The report appears to envisage China's development path differing from that of every other country on the planet. It claims that in China "the continued accumulation of capital… will inevitably contribute less to growth". But one of the most established trends of economic development, first outlined by Adam Smith and econometrically confirmed to the present day, is that capital's contribution to growth increases with development. Deng Xiaoping certainly argued that economic policy must have "Chinese characteristics", i.e. be adapted to China's specific conditions. However, he never argued that China was exempt from economic laws, which is what this report appears to envisage!

The report makes elementary economic mistakes, such as confusing the consequences of high export shares with trade surpluses. It argues: "If China's current export growth persists, its projected global market share could rise to 20 percent by 2030, which is almost double the peak of Japan's global market share in the mid-1980s when it faced fierce protectionist sentiments… China's current trajectory… could cause unmanageable trade frictions." But if China increases its import share at the same rate as exports, this would not create major trade frictions. Japan's problem was trade surpluses, not export share.

It is almost impossible to believe, given such elementary mistakes, that this report was intended as a serious objective analysis of China's economy. What, then, is its goal? , The report spells out its goal clearly enough in calling for China to abandon the policies launched by Deng Xiaoping which brought such success. It says: "Reforms that launched China on its current growth trajectory were inspired by Deng Xiaoping… China has reached another turning point in its development path when a second strategic, and no less fundamental, shift is called for."

What is this new "non-Dengite" economic policy? Deng Xiaoping's most famous economic statement was "it doesn't matter whether a cat is black or white provided it catches mice". Effectively, this means, in economic terms, that a company should not be judged by whether it is private or state owned but by how it performs. The proposed new economic policy overturns Deng's dictum by saying: "Reintroduce judging cats by colour, promote the private sector cat."

The consequences of this are clearly seen in the report's financial proposals. During the international financial crisis, China was protected by its state-owned banking system. The US and European privately-owned banks simultaneously created the financial crisis and were flattened by it, throwing their economies into crisis. China, however, suffered no significant setback.

The reasons for the US and European banking crisis are well understood. Modern banks are necessarily very large, both in order to undertake international operations and because of the inherent risk of large investment projects. They are literally "too large to fail", as the failure of any large bank creates an unacceptable economic crisis. This theoretical point was rammed home by the devastating consequences of Lehman's collapse, following which no government will allow a large bank to fail.

But a situation in which the state is blocking the bankruptcy of a large bank, whose profits are being privately retained, creates disastrous risk. If large private banks are state guaranteed against crippling losses, but retain profits, they are incentivized to undertake potentially profitable but highly risky operations. The disastrous results of this scenario were seen during the financial crisis.

Extraordinarily, this report proposes that China abandon the financial system which brought it successfully through the financial crisis and instead adopt the one which led the US and Europe to disaster. This is the real significance of "privatization would be the best way to make SFIs [State Financial Institutions] more commercially oriented".

This ties in with US TransPacific Partnership pressure for the elimination of China's state-owned companies, which are seen as giving China a completive advantage over the US. The US, of course, does not possess such companies. If the US is worried about the competitive disadvantage created by not having state-owned companies, it should create some, not call for China to abandon its own.

The last World Bank report of this type was published in February 1991 and its Study of the Soviet Economy provided the basis for Russia's economic policies of the 1990s.

The result was that Russia suffered the greatest peacetime economic disaster to befall any country. GDP declined by more than half. Russian male life expectancy fell by four years and we saw the beginning of a population decline, which continues to this day. The USSR subsequently disintegrated, in what Vladimir Putin called the greatest geopolitical catastrophe of the 20th century. Russia has not recovered.

This type of economic program is therefore not simply a "theoretical" model. It has been thoroughly and demonstrably discredited on account of the catastrophes it has produced. Russia was ill advised enough to adopt this type of economic program. It is to be hoped, then, that China does not follow the same course

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This article originally appeared on China.org.cn.