Is the world facing systemic crisis?

18 October 2022, 02:18 PM

As the IMF meetings kick off this week I  read thru the IMF’s latest WEO and it really made for grim reading.

Overall though I think it made a pretty good stab at describing the challenges facing the global economy and offered some sensible solutions - monetary policy tightening and targeted fiscal support, while not using energy price caps to the point of distrorting markets. However, what I think it failed to do, for obvious reasons I guess, was put all these in the context of the really difficult geopolitical setting, important therein to assess whether the world will club together to ensure a sufficiently credible policy response so as to avert systemic crises. The IMF details policy responses, but will our leaders take the advice? It seems unlikely at this point in time.

Video of day

As the Fund detailed, the world is facing multiple headwinds, from supply disruptions as we come out of Covid, the impact of China’s zero Covid tolerance policy on world growth, deglobalisation hitting trade and spurring inflation, Russia’s genocidal campaign against Ukraine and the global supply and now demand distortions that is causing, climate change, ESG related costs, debt. But overall I think it is a story of stagflation - the message from the IMF is lower growth and higher inflation, and that complicates the policy response. We are seeing the Fed and many other central banks tighten policy but his complicates policies to address the challenge of growth. And higher policy rates, and lower growth just causes more debt distress.

The above headwinds makes me think back to the GFC, and makes me wonder are we facing the similarly sized globally systemic risks?

Back then I think the problems were severe but simpler to diagnose, and we saw unity in purpose and resolve to work together to address the problems.

In 2008 it was clear that at the heart of the problem was the subprime saga, with the vulnerabilities plain to see in the global banking and financial system. Yes, the system came close to collapse. It did not as we had global leadership from the US, the EU and the multilaterals, and we had the creation of the G20 and all members generally pulled in the same direction to bring a coordinated policy response -  now we can argue whether throwing the monetary sink or firing the bazooka at the problem was, with hindsight, the right response. But it initially worked and I would perhaps argue that some of the problems we are now experiencing are not because the initial response of monetary easing and QE were wrong but that we kept these policies in place too long. I think Western politicians and policy makers were freaked out by the rise of populism and became obsessed on inclusive growth as the antidote that they let the inflation genie out of the bottle. The cost of living crisis which has ensued is actually more dangerous in terms of its impact on more of the world poorest, and the potential therein to further the rise of populism. Everyone feels inflation, relatively few feel the lack of growth.

But back to the current crisis in what worries me is the world now pulling in different directions.

We are seeing misdiagnoses of the problems - the UK, for example, with the Truss government focusing on growth as the problem, rather than inflation (and Brexit). More later….

We have Russia reverting back to 20th century, actually 19th century, concepts of territorial conquest, imperialism in effect, and the use of war and genocide to secure its foreign policy objectives.

We have OPEC, with the leadership of Saudi Arabia, seemingly going into direct conflict with the US and the West over oil production and pricing. The Saudi leadership has argued that their actions last week to cut oil production by 2mbd were not political but based on economic fundamentals. However, with oil prices at close to their 15 year average, and with most oil analysts suggesting the market outlook is still tight, I struggle to understand how output cuts and then price rises will help the oil market or the global economy. Saudi Arabia must have even more bearish global growth assumptions than the IMF is suggesting in the WEO, but then efforts to push oil prices artificially higher surely will just make global recession that much more likely by further worsening the global cost of living crisis. And how can Saudi Arabia not understand the geopolitical setting with the West facing the existential threat from Russia in Ukraine, spelled out surely by Biden visiting Riyadh to specifically ask for help, and in turn facing midterms next month? Saudi Arabia surely cannot be blind to real geopolitik or it just does not care?  How would the Biden team not take the move then to cut oil production thru OPEC as a huge snub? And now the prospect of US/Western battle with/against OPEC, creating yet another point of friction when all of G20 needs to be working in lockstep to resolve the numerous problems facing the global economy.

Even in central Europe, we have countries which face very similar problems/economic structures, but coming up with quite different solutions. With inflation in/close to the 20s, we have Hungary hiking policy rates to 13%, while the likes of Czech Republic, Poland and Romania all keeping rates at or below 7%, implying massively negative real rates.

And even within countries we see disunity, as evidence now with the open warfare on the NBP’s MPC. Policy makers cannot even seem to agree within ruling political parties (Tories in the U.K.) or central banks (NBP). And the later is particularly shocking when the likes of the UK, Central Europe face the mutual threat from Russia. This is not a time for gambles with policy, as is now playing out in the U.K., risky monetary policy settings with heavily negative real rates (Poland, Czech Republic, Turkey) or overly complicated monetary policy settings - Hungary. Policy makers need plain vanilla, simpler policy which populations can easily understand and which offers some hope of anchoring inflationary expectations lower.

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Even the multilaterals appear in poor shape to address the acute global challenges with Georgieva’s credibility at the IMF damaged by the WB Doing Business scandal, and Malpass at the WB struggling with his Trump baggage and now slated for the Banks fitful climate change response.

The Common Framework for debt relief/restructuring has largely failed, albeit there is at least some new found optimism that the on-going Zambia restructuring process can give it one last kiss of life.

All this makes me worry that we are on the brink of a looming systemic crisis, not that the individual challenges suggest such an outcome is obvious but just because the divided world lacks focus to nip problems in the bud, and that problems look set to get out of hand, deepen, accentuate and not helped by the wrong diagnosis and diverse and sometimes plain wrong policy responses.

And where might the next big systemic crisis come?

The U.K. does worry me here, and I have written herein already on the subject.

It worries me that the Truss/Kwarteng government can so badly diagnose the U.K’s most pressing problem as growth, when unemployment is at the lowest level since 1974, and yet inflation is running at the highest level since the 1980s, with all polls suggesting the cost of living crisis is the number one concern for the population. I would agree that the U.K. faces longer term competitiveness issues, which will weigh on growth over the longer term, and I would argue that these are partially Brexit related (immigration constraints worsening skill shortages, collapse in trade with Brexit bureaucracy and red tape) but also about years of failing to invest in education, housing and transport/infrastructure. The problems are not about tax levels, or bankers bonuses - these are not deterring talent from locating to the UK, but the racism around Brexit are. But these problems can be addressed over time while the cost of living crisis is now.

But from a basic macro perspective, if the U.K. were an EM economy and the symptoms were high inflation, a tight labour market and signs of wage price pressure and mounting industrial action, a wide current account deficit leading to pressure on the currency and risks of more pass thru to inflation, a high budget deficit because of energy subsidies to alleviate Ukraine war shocks, I doubt that the best advised policy response would be to pump prime growth some more. This will just lead to tighter labour markets, more inflation, a wider current account deficit, weaker pound and higher rates, ironically feeding back to lower growth. It’s Econ 101 Kwasi, but maybe you missed that course.

Now the Truss/Kwarteng “special budget operation” by clearly misdiagnosing the problem, and rolling out the wrong policy responses, with inadequate preparation and an arrogant disregard for the likely market response, had dealt a critical blow to the credibility of the U.K. economic policy setting, at a time when international faith in the U.K. was already rock bottom because of the Brexit mess. Government policy misteps have now revealed structural weaknesses in the pension, gilts and mortgage markets - why did the U.K. regulator not understand the risks to the Gilts/pension market, why did the BOE not earlier address the structural weaknesses in the U.K. mortgage market (focus on short term fixes making the population catastrophically vulnerable to interest rate hikes). The defence could be that the short term fix of the UK mortgage market made monetary transmission mega efficient in the U.K, and the central bank could never have expected such a hit to market confidence from a budget such as Kwarteng’s “special budget operation”. But then why did the BOE not signal the risks to the Chancellor and, if it did, why did Kwarteng not listen to the advice on the risks he was taking with the very stability of the U.K. financial system?

And even now we have mixed messages coming from the BOE in terms of support to the pension/gilts market - is it ending on Friday, or will it be extended? The communication from the BOE has been diabolical, and not leaving any confidence that they are in control of the current crisis. This all leaves a question as to whether Governor Bailey was appointed as the best person for the job, or because he was was willing to give the Brexit loving government lots of slack, and would not call out obvious problems with Brexit? I guess we will now find out whether he is up to the task. Clearly though this all underlines that we need a fully independent central bank which needs to be clear about government policy failings and willing to act decisively to adjust BOE policy accordingly. At present we have a huge credibility cloud hanging over U.K. economic policy - fiscal, monetary, trade, Brexit, et al. And for a top tier economy, with a GDP of close to $3 trillion (but falling), with a globally systemic financial sector - of a size of mulitiples of U.K. GDP, this is a problem not just for the UK, but the global economy. I just hope global policy makers realise the risks are building and are still able to come up with the right diagnosis, policy responses, and are able to coordinate these effectively. I have my doubts now on all these points.

This material was first published on Mr. Ash’s Substack. We are republishing it here with permission.

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