VR Logo

A Depressing Recession II

No one knows what caused the Great Recession, but the evolving structure of world finance must have had something to do with it

The Euro is a common currency system existing today, which is closest to the Gold Standard of yesteryears. Except in one major aspect, it is superior, at a pinch, supply of money can be increased by fiat, when the Central Bank sees itself faced with deflation. Otherwise, the currency system has many of the same elements: a natural limit on the expansion of money, for example. You just have to trust that so many countries will never get together and pump up the supply of money, unless the whole region is facing deflation (or, as we saw recently, a break-up of the Currency Union itself).

But can you say that of the new globalised world? Let us approach this step by step.

GDP growth rate = Population growth rate X Productivity growth

Real growth is the latter, as we saw in Japan during “The (so-called) Lost Decade”. Despite negative growth rates, the per capita income levels in Japan never fell much, because some of this was offset by a demographic decline; so despite falling, or even negative growth rates, per capita GDP did not decline, in fact, GDP per capita of working population actually rose. Hence, living standards did not decline.

Now, different parts of the world have different components active, in their GDP growth rates. Poorer countries like India have a certain population growth rate (currently running at 1.4%), but rising productivity growth rates (>3.5%) form a big percentage of their growth rates. Europe and Japan must depend exclusively on productivity growth, while the US brings in immigration to boost its population. But productivity growth has a natural cap, and usually stabilises at a trend rate of 2.5% per decade; China has been an exception, its mass migration to manufacturing gave it a decadal growth rate above >8%, despite flattish population growth. Hereon, it will see a sharp slowdown in growth rates.

Real GDP growth + Inflation = Nominal GDP growth

The actual GDP growth that we experience is the nominal growth in GDP. Inflation is the difference, and this inflation has different causative factors. The most common contributor to inflation is the growth in Money Supply, so predominant that it provoked the great Milton Friedman to say, “inflation is always and everywhere a monetary phenomenon”. Yes, there is demand-side inflation and sometimes supply crunches due to natural factors, but mostly, it is caused by the mis-calibration of money supply growth with the growth in GDP.

Money supply growth, in turn, is driven by the growth in the monetary base (M) X the velocity of money (V). The former is in the control of the Central Bank (mostly), but the latter is definitely not, and this is the cock-eyed joystick with which Central Bankers try to control inflation. Most end up looking like jokers because velocity of money is so out of their control.

Matters are made even more complex by the globalisation of capital, which transfers savings and debt across the globe at a flick of a button, putting all calculations of velocity of money in the realm of speculation.

Readers who are following my logical train of thought may be getting some idea of how complex the global economy has become, since the times of the Great Depression and its aftermath. It is like trying to understand the ocean with all its undercurrents, versus trying to understand the patterns of a placid lake.

Quite obviously, this is beyond the pale of any individual, or even institution. It has to be left to the markets, which are least worst alternative whenever multiple streams of thought have to be worked out. Which brings us to the world of markets, derivatives, CDOs/ CLOs and the like. In short, a huge alphabet soup of instruments that nobody can make sense of, but which works in some chaotic fashion to bring order to a complex world.

Now compare this to the simple, or simplistic, world of a unified Gold Standard and fixed currency pegs, no multilateral institutions and an inability to manoeuvre the various components of GDP and inflation to keep disaster and deflation under control. The closest to this dinosaur is the Euro, and we know how that fared. The jury is still out whether the Euro will survive without further political union. Inflation targeting, for example, is a new buzzword. After the Great Depression, the world learnt to fear deflation more than inflation; that is not intuitively obvious, till you learn about the “paradox of thrift”, which says, in short, that what is good for the goose is not good for the geese. Today, we talk proudly about deflecting deflation after 2008. The 'space' kept for inflation is really every Central Banker's estimate of the variation in productivity growth. Notice that most inflation targets of Central Banks are nominally close to their country's normal rates of productivity growth.

So how do you predict so many moving parts, many of them dependent on each other, and interlinked in a web-structure that often creates a 'contagion effect'. This last is a new creation, that did not exist during the times of the Great Depression, although the shadows of an interlinked world were already visible in the tariff wars of 1933 and the preceding BoP problems.

This is caused by the 'feedback loop', e.g. high inflation creates high interest rates, which raises Forward Premium, which forces most importers to stay open on Fx exposures, thereby increasing the likelihood of a panic when debt funds pull out. Currency depreciation, in turn, increases inflation even more, creating a 'feedback loop', a spiral that feeds on itself.

The 'feedback loop' creates a 'contagion effect' that we saw in the 1997 East Asian Crisis. These days, we see it in the broader basket classifications like EMs, BRICS, etc that club one and all under the same umbrella. So, in some obtuse way, Turkey is linked to India because their bonds are funded by the same basket of funds that India gets. So if Argentina sneezes, India can catch a cold.

This 'web effect' creates transmission mechanisms for synchronised growth, as well as recessions. Yet Central Bankers and governments are not really co-ordinated and tend to follow independent agendas, like in the recent of the US Fed kicking off a 'tapering' programme of its money printing, without first verifying where the money had gone. It (the money) turned out to be in EM equities and high-yielding debt, creating a major currency crisis in the recipient countries. Their crime? That they were investible at a time when the world was going through its biggest slowdown over the last century.

As you can see, plenty of things have changed in the global economy. What used to be a series of independent (and different) lakes at different levels of development, productivity growth, technology and innovation, has now turned out to be a similar set of inter-connected lakes, with enough disparity between them to create serious confusion. Sometimes, they look like an ocean, sometimes they look like discrete puddles. When they will do what, is what one has to figure out.

We know from nature that simple structures are more durable than complex ones. The amoeba, or the cockroach, even the crocodile are much simpler than, say, the Tyrannosaurus Rex. It is the same with the evolution of the globalised world economy, which has brought in its wake, the development of a world financial system. The blowouts are many, as we saw when European or Chinese savings ended up back in the US, creating a housing bubble. Then, we saw the aftermath of the Great Recession expose structural flaws in the European currency union.

The next stop seems to be China, as the wheel comes full circle. China is now setting out to right its own growth model, shifting to domestic consumption from its investment-led export model. This will create another consumption engine, while the US emerges as an energy producer, and maybe sees a resurgence of manufacturing based on lower energy costs (or new technology).

We still have answer the question: what caused the Great Recession? Nobody really knows, but the evolving structure of world finance must have had something to do with it. It wasn't JUST the bankers, or just the Hedge Funds, something had to be structurally wrong. Finally, maybe the inter-connectedness and web-like structure of the transmission mechanisms had something to do with it.

The writer teaches & trades: spandiya.blogspot.com.

This column appeared in the May 2014 Issue of Mutual Fund Insight.