The (latest) Asian trade and financial market slump is merely yet another instalment in what we would regard as a process of rolling credit booms and busts that began in the mid-1980s. When we first began practicing what we would describe (we hope) as practical economics, the US budget deficit was at unprecedented levels by peacetime standards, the US dollar was occupying extremely high levels, the US manufacturing sector was weak and the LATAM Debt Crisis was in full swing.
Asia was in a quasi-recession, the UK was, though, doing well, but Euro sclerosis was already becoming established under the auspices of the old European Exchange Rate Mechanism, the forerunner of the Euro. In response to these issues (although quite why the UK joined in has never been clear), the world's policymakers contrived to create a series of credit booms, the first being in the US and the UK, then in Japan and even to a more limited extent in Europe. The resulting developed world credit boom in the late-1980s was based in both the corporate and household sectors of the OECD economies but this situation did at least provide a genuine trade stimulus to Asia. When the FRB, BoE and BoJ began to tighten at the end of the decade, though, the global economy slowed and a number of legacy problems emerged in the US savings and loan sector and Japan's financial system. By 1990, many of the global economies were facing recessions – a situation that was subsequently made worse by the first Gulf War.
The OECD governments' perhaps predictable response to these assorted problems was to reduce interest rates and, even in some cases (particularly the US), to initiate what were, in fact, prototype Quantitative Easing strategies. At the same time, there was, for a variety of reasons, a move afoot (led by Greenspan) to make central banks more predictable and also to adopt explicit inflation rate targets (led by the RBNZ). The result of these twin developments was to unleash a terrific expansion in the volume of global capital flows in the early to mid-1990s, both in an absolute sense and relative to the size of the underlying real economies. Central banks that were offering both seemingly predictable and certainly lax monetary policies clearly helped to create the boom in international capital flows that we believe came to dominate and define international financial market conditions in the 1990s, 2000s and early 2010s.
USA: International Capital Movements
Many of the capital flows that were sponsored by the OECD central banks in the early to mid-1990s found their way into the emerging markets(EM)of Asia and Latin America. These capital flows were quickly recycled by the recipient countries' banking systems into what often became intense domestic credit booms that financed rising levels of consumption, investment and speculation in local property markets and some quantum of productive investment in the recipient economies. By 1994, though, many of the EM were beginning to overheat and they were also beginning to export inflation to the rest of the world via not only their own export pricing trends but also their surging demand for commodities and other goods.
Again,perhaps unsurprisingly, the authorities in the OECD economies then reacted to the perceived increase in (global) inflationary pressures by tightening their own policy stances (Japan was even threatening to raise rates in 1994 and the FRB raised rates quite aggressively at that time). The (again) unsurprising result of these tightening efforts was a marked slowdown in global capital flows over the mid-1990s and eventually the Asian and EM Crises of 1997-98. By the middle of the 1990s, many EM countries had become dependent upon ever-expanding levels of capital inflows to sustain their growth but, when the flows dried up, it was only a short and inevitable step to the crises that followed.
Crucially, as the EM slipped into crisis mode in 1997 and hence began not to export inflation but instead to export deflation through their collapsing currencies and demand for imports, the Western authorities responded yet again by easing their own policy regimes and this, in relatively short order, fostered the massive US corporate sector credit boom that was to morph into the TMT bubble/NASDAQ bubble. Rather bravely, the FRB decided to burst these bubbles – if only temporarily – in 2000 but, when the results of the bust proved deflationary in the early 2000s, the Fed and other central banks soon relented and instead conspired to create another credit boom. On this occasion, the credit boom was centred within the Western economies' consumer and mortgage sectors.
Moreover, by 2005-6, this credit boom had also begun to spill over into the EM once again and by 2007 global inflationary pressures were rising as the global economy accelerated. Unfortunately, as these inflationary pressures became more and more obvious and the FRB threatened to become more aggressive with regard to an eventual tightening of policy, the credit bubble burst quite spectacularly and the GFC was upon us.
Yet again, deflation threatened to occur in 2008/9 but the Western authorities once again responded by easing their monetary policies and the modern version of QE was born. Unsurprisingly given the legacies of the GFC, even the new QE regimes largely failed to restart the credit booms in the West – quite probably because the countries' existing debt ratios were already too elevated – but once again the Western central banks did succeed in creating yet another tidal wave of global liquidity that once again engulfed the EM and, in the process, caused another round of new credit booms in these economies.
As a result of these successive waves of capital flows and the credit booms that they encouraged (and indeed facilitated), we find that the EM world is now even more indebted than was the developed world in the mid-2000s ahead of the GFC. This is part of the current EM Problem.
Private Debt to GDP ratios
What should also be noted, though, is that much of the credit that was advanced to the EM companies during the 2005-2014 capital flows/credit boom was not in fact used to fund higher levels of household consumption. Instead it was primarily used to finance the building of ever more industrial capacity and the accumulation of ever larger stocks of inventories. Unfortunately, it seems that much of this new capacity and many of these inventories have not, in fact, been needed (credit booms often give rise to "unwise" investment decisions) and as a result many of the EM countries are now very much too long of fixed assets, too indebted and increasingly short of cash flow.
In an effort to remedy this weak cashflow situation, many countries within the EM have embarked on the heavy discounting of goods, the outright dumping of goods and weaker currency regimes. Hence, these EM are once again exporting significant amounts of deflation to the rest of the world (and we might add to each other as well).
It is perhaps somewhat ironic that the, in theory, inflationary capital flows that the West exported to the EM were not used to fund an increase in consumer spending (that would have most likely led to an increase in goods prices, as would probably have occurred if these events had been occurring within the Western economies) but rather the funds were used to finance an expansion in aggregate supply potential in these economies.
Korea: Export Prices in USD
Rather than inflating the level of demand in the EM, the capital flows were used to inflate the level of supply and this has proven to be highly deflationary for the global economy.
When faced with the deflation threats of 1998 and 2002-3, the Western central banks – and particularly the FRB – were able to ease their own monetary regimes to attempt to reintroduce credit growth and inflationary pressures back into the system. In 2015, though, we find that Western interest rates are already close to zero and that bond yields are probably already too low from the point of view of the internal workings of the financial system (particularly the pension and insurance sectors). Therefore, unless the central banks are prepared to move to negative interest rates, which would, out of necessity, involve the outlawing of cash in favour of digital money (something that we doubt that Western societies would allow), we suspect that there is little that the major central banks can do to fight the deflation that is emerging from Asia. Moreover, the West's commercial banks are now heavily regulated and there are perhaps few would-be borrowers left in the system – debt ratios are already stretched across the private sectors of much of the world.
Even the US economy, which is experiencing a level of capital inflows that, relative to its size, has probably not been witnessed since the middle of the 1920s, is clearly finding it incredibly difficult to generate faster rates of credit growth. In fact, the latest credit data from the economy has been notably soft despite the FRB's seemingly still expansionary stance. Admittedly, there are seemingly rapid rates of credit growth occurring within the US financial system as companies borrow heavily through the corporate bond markets to fund ever larger amounts of equity buy-backs, but very little of these funds are finding their way out into the real economies and hence they are exerting only a minimal impact on aggregate demand trends in the economy.
USD: Bank Credit
We are therefore left with the rather worrying conclusion that there are probably no significant players left within the global system that can borrow more and inflate their balance sheets further to offset the deflation that is emanating from Asia. This implies that, as a group, the world's central banks are, in effect, becoming relatively powerless, despite the positive spin that they attempted to put on the situation at their regular Jackson Hole conference. Individual regions can seek to insulate themselves through competitive devaluations but these tend only to provide a temporary salve and they are, by their very nature, deflationary for the global system as a whole, not that this seems to be preventing M. Draghi from attempting to engineer another round of Euro weakness.
In the near term, we suspect that financial markets will have to reconfigure themselves to the notion that the once presumed omnipotent central banks are rapidly becoming impotent and we suspect that risk markets will therefore continue to suffer as this realisation spreads. Such a realisation will turn what has been the accepted for the last thirty years in markets on its head. As to whether this process occurs slowly or more rapidly will likely depend on whether the central banks themselves panic into faster beggar-thy-neighbour competitive devaluations, or whether they attempt to hold some form of mutual cooperation. Either way, we suspect that the outlook for risk markets may prove difficult over the near term.
In the medium term, we can assume that the central banks' political masters will come to recognise the problem (in fact, this realisation is already dawning in Japan) and we suspect that, as this recognition spreads, the governments will turn back not just to more public sector expenditure (that is, wider budget deficits) but that they will also seek to take more direct control of the private sector's capital stock. We have already witnessed the beginnings of this process with the trend towards higher minimum wage legislation, the threats to cap utility and drug prices and other populist measures. We can also expect to see more SYRIZA/Corbyn/Trump-type characters and regimes appearing and perhaps even being elected. Unfortunately, more state control of the capital stock is unlikely to be profit-friendly, although at least an increase in fiscal spending in 2016 may do something to revitalise economic activity for a while.
In our opinion, rather than embarking on credit boom "ping pong" with the EM, the Western world should have invested in raising productivity through better education, encouragement of R&D and provision of physical infrastructure, but we suspect that it was simply "easier" to leave the fate of the economies to the central banks, despite the fact that in the 1970s it had been proved without reasonable doubt that the central banks cannot affect real economic variables over anything other than the short term. We suspect that over the next few months, governments and markets alike may come to rue this missed opportunity to produce real wealth gains rather than transitory asset price booms.