Legacy NEW HAVEN – The global economy could be in the early stages of another crisis. Once again, the US Federal Reserve is in the eye of the storm.
As the Fed attempts to exit from so-called quantitative easing (QE) – its unprecedented policy of massive purchases of long-term assets – many high-flying emerging economies suddenly find themselves in a vise. Currency and stock markets in India and Indonesia are plunging, with collateral damage evident in Brazil, South Africa, and Turkey.
The Fed insists that it is
blameless – the same absurd position that it took in the aftermath of
the Great Crisis of 2008-2009, when it maintained that its excessive
monetary accommodation had nothing to do with the property and credit
bubbles that nearly pushed the world into the abyss. It remains steeped
in denial: Were it not for the interest-rate suppression that QE has
imposed on developed countries since 2009, the search for yield would
not have flooded emerging economies with short-term “hot” money.
As in the
mid-2000’s, there is plenty of blame to go around this time as well. The
Fed is hardly alone in embracing unconventional monetary easing.
Moreover, the aforementioned developing economies all have one thing in
common: large current-account deficits.
According to the International Monetary Fund, India’s external deficit,
for example, is likely to average 5% of GDP in 2012-2013, compared to
2.8% in 2008-2011. Similarly, Indonesia’s current-account deficit, at 3%
of GDP in 2012-2013, represents an even sharper deterioration from
surpluses that averaged 0.7% of GDP in 2008-2011. Comparable patterns
are evident in Brazil, South Africa, and Turkey.
A large
current-account deficit is a classic symptom of a pre-crisis economy
living beyond its means – in effect, investing more than it is saving.
The only way to sustain economic growth in the face of such an imbalance
is to borrow surplus savings from abroad.
That is where QE came into
play. It provided a surplus of yield-seeking capital from investors in
developed countries, thereby allowing emerging economies to remain on
high-growth trajectories. IMF research puts emerging markets’ cumulative
capital inflows at close to $4 trillion since the onset of QE in 2009.
Enticed by the siren song of a shortcut to rapid economic growth, these
inflows lulled emerging-market countries into believing that their
imbalances were sustainable, enabling them to avoid the discipline
needed to put their economies on more stable and viable paths.
This is an
endemic feature of the modern global economy. Rather than owning up to
the economic slowdown that current-account deficits signal – accepting a
little less growth today for more sustainable growth in the future –
politicians and policymakers opt for risky growth gambits that
ultimately backfire.
That has been the case in
developing Asia, not just in India and Indonesia today, but also in the
1990’s, when sharply widening current-account deficits were a harbinger
of the wrenching financial crisis of 1997-1998. But it has been equally
true of the developed world.
America’s gaping
current-account deficit of the mid-2000’s was, in fact, a glaring
warning of the distortions created by a shift to asset-dependent saving
at a time when dangerous bubbles were forming in asset and credit
markets. Europe’s sovereign-debt crisis is an outgrowth of sharp
disparities between the peripheral economies with outsize
current-account deficits – especially Greece, Portugal, and Spain – and
core countries like Germany, with large surpluses.
Central
bankers have done everything in their power to finesse these problems.
Under the leadership of Ben Bernanke and his predecessor, Alan
Greenspan, the Fed condoned asset and credit bubbles, treating them as
new sources of economic growth. Bernanke has gone even further, arguing
that the growth windfall from QE would be more than sufficient to
compensate for any destabilizing hot-money flows in and out of emerging
economies. Yet the absence of any such growth windfall in a
still-sluggish US economy has unmasked QE as little more than a
yield-seeking liquidity foil.
The QE exit strategy, if the
Fed ever summons the courage to pull it off, would do little more than
redirect surplus liquidity from higher-yielding developing markets back
to home markets. At present, with the Fed hinting at the first phase of
the exit – the so-called QE taper – financial markets are already
responding to expectations of reduced money creation and eventual
increases in interest rates in the developed world.
Never mind the Fed’s promises
that any such moves will be glacial – that it is unlikely to trigger
any meaningful increases in policy rates until 2014 or 2015. As the more
than 1.1 percentage-point increase in 10-year Treasury yields over the past year indicates, markets have an uncanny knack for discounting glacial events in a short period of time.
Courtesy of
that discounting mechanism, the risk-adjusted yield arbitrage has now
started to move against emerging-market securities. Not surprisingly,
those economies with current-account deficits are feeling the heat
first. Suddenly, their saving-investment imbalances are harder to fund
in a post-QE regime, an outcome that has taken a wrenching toll on
currencies in India, Indonesia, Brazil, and Turkey.
As a result, these countries
have been left ensnared in policy traps: Orthodox defense strategies for
plunging currencies usually entail higher interest rates – an
unpalatable option for emerging economies that are also experiencing
downward pressure on economic growth.
Where this stops, nobody
knows. That was the case in Asia in the late 1990’s, as well as in the
US in 2009. But, with more than a dozen major crises hitting the world
economy since the early 1980’s, there is no mistaking the message:
imbalances are not sustainable, regardless of how hard central banks try
to duck the consequences.
Developing
economies are now feeling the full force of the Fed’s moment of
reckoning. They are guilty of failing to face up to their own
rebalancing during the heady days of the QE sugar high. And the Fed is
just as guilty, if not more so, for orchestrating this failed policy
experiment in the first place.
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