The world is one financial downturn, one major terrorist attack or one regional war away from collapse. 9/11 happened when the U.S. was on the brink of another economic bubble whereas the downturn of 2008 was a bubble created during the Clinton years in which it was only a matter of time before it popped.
As matters stand, the next recession will push the Western economic system over the edge into deflation
Half the world economy is one accident away from a deflation trap. The International Monetary Fund says the probability may now be as high as 20pc.
It is a remarkable state of affairs that the G2 monetary superpowers – the US and China – should both be tightening into such a 20pc risk, though no doubt they have concluded that asset bubbles are becoming an even bigger danger.
“We need to be extremely vigilant,” said the IMF’s Christine Lagarde in Davos. “The deflation risk is what would occur if there was a shock to those economies now at low inflation rates, way below target. I don’t think anyone can dispute that in the eurozone, inflation is way below target.”
It is not hard to imagine what that shock might be. It is already before us as Turkey, India and South Africa all slam on the brakes, forced to defend their currencies as global liquidity drains away.
The World Bank warns in its latest report – Capital Flows and Risks in Developing Countries – that the withdrawal of stimulus by the US Federal Reserve could throw a “curve ball” at the international system.
The report said they may need capital controls to navigate the storm – or technically to overcome the “Impossible Trinity” of monetary autonomy, a stable exchange rate and free flows of funds. William Browder from Hermitage says that is exactly where the crisis is leading, and it will be sobering for investors to learn that their money is locked up – already the case in Cyprus, and starting in Egypt. The chain-reaction becomes self-fulfilling. “People will start asking themselves which country is next,” he said.
Emerging markets are now half the global economy, so we are in uncharted waters. Roughly $4 trillion of foreign funds swept into emerging markets after the Lehman crisis, much of it by then “momentum money” late to the party. The IMF says $470bn is directly linked to money printing by the Fed . “We don’t know how much of this is going to come out again, or how quickly,” said an official from the Fund.
One country after another is now having to tighten into weakness. The longer this goes on, and the wider it spreads, the greater the risk that it will metamorphose into a global deflationary shock.
The ECB’s Mario Draghi talked up the need for a “safety margin” against deflation before Christmas but now seems strangely passive, as if beaten into submission by the Bundesbank. I heard him twice in Davos repeating – woodenly, without conviction – that core inflation is merely back to where it was in 1999 after the Asian crisis and in 2009 after the Lehman crisis, and therefore benign.
Those who think deflation is harmless should listen to the Bank of Japan’s Haruhiko Kuroda, who has lived through 15 years of falling prices. Corporate profits dried up. Investment in technology atrophied. Innovation fizzled out. “It created a very negative mindset in Japan,” he said.
Japan had the highest real interest rates in the rich world, leading to a compound interest spiral as the debt burden rose on a base of shrinking nominal GDP.
Any such outcome in Europe would send Club Med debt trajectories through the roof. It would doom all hope of halting Europe’s economic decline or reducing mass unemployment before the democracies of the afflicted countries go into seizure. So why are they letting it happen?
Full article: World risks deflationary shock as BRICS puncture credit bubbles (The Telegraph)