Arnab Das, managing director of research and investment strategy at Roubini Global Economics, began his speech at the CFA Institute Middle East Investment Conference in Dubai, United Arab Emirates, by outlining a global debt crisis in which we are all caught in “this trap of excessive debt”.
Das argued that the most important parallel issues are the distribution between creditors and debtors and the balance between future and present economic activity. Central banks have sought a way out of the macroeconomic crisis by smoothing consumption through expanding public sector balance sheets. But debt, defined as spreading the cost of current investment over the future, has, as Ken Rogoff and Carmen Reinhart have pointed out, brought too much future activity to the present.
Creditor countries, such as Japan, Germany, China, and some Middle Eastern countries, are caught in the middle of this trap because their client states (countries they have lent money to) are so overleveraged. Yet money, Das says, is not the same thing as capital. Central banks have been “reflating assets as a way of maintaining wealth and mitigating liability problems,” but they are “unwilling to grapple with the fact that there is a liability problem because there is a redistributional problem”. This redistribution between creditors and debtors, between the present and future activity, has to be solved eventually.
Inflation is a key mechanism in this redistribution, but inflation is not about money alone: It is also about velocity and the multiplier. Das points out that over the financial crisis, the level of broad money has come down very sharply, along with velocity and the multiplier. Central banks have “smoothed out a drastic deleveraging that would otherwise have taken place,” Das said.
For the United States, there has been political concern and public anger about reflating the public debt beyond anything seen outside wartime, but this reflation has been necessary to “keep everything going,” Das said. There are significant constraints on exiting the strategy, one of which is inflation — which Das believes is likely to be restrained, not least by fiscal drag from the budget sequestration and the fiscal cliff. Das expects below-trend U.S. economic growth this year of 1.5–1.7% with unemployment remaining elevated. Inflation will only return as a credible risk when credit and the velocity of money and the multiplier takes off and the adjustment is complete.
A key problem for the United States, Das said, is the “danger of asset inflation leading to bubbles”. The liability problem in the United States is being dealt with by reflation of assets and the “long period of easy money”. Although fiscal adjustments are a drag on inflation in the wider economy, asset bubbles can appear in various parts of the capital markets quite easily in the current environment.
For Europe, Das sees large imbalances and a lack of union with many parallels in early American history. Mario Draghi, president of the European Central Bank (ECB), has so far managed to deflect opposing forces and bond spreads have managed to narrow. The ECB has suppressed the right hand tail risk of a collapsed euro but at the expense of increasing the left hand tail risk of slower European integration. In Europe, the choice is between mutualization and integration, politically or through the ECB balance sheet, and Das thinks Europe is actually being mutualized through the ECB balance sheet. Unfortunately, a consequence is that the peripheral countries are seeing fiscal cuts, savings rates forced up, and depression conditions emerge. Savings rates remain high in the Northern European countries, which have unrecognized losses on their balance sheets. Overall, the eurozone is heading for a current account surplus.
Elsewhere, the current account of Japan has recently gone into deficit but is likely to push back toward a surplus. China’s current account surplus has collapsed but still stands at around 3%. Some MENA countries also have large surpluses. So Das asks: Where are all of the current account surpluses going to go? The answer will be in capital outflows and central bank reflation. Ouflows will mainly go to the United States and emerging markets. Consequently, Das thinks there is a risk of asset bubbles in the United States and in emerging markets. “MENA has a substantial risk of being caught up with bubble risk,” added Das.
Das said that instead of dealing with the underlying fiscal issues, we are instead reflating assets. Central bank policy is sub-optimal and highly politicized. But Das does not see this leading to competitive currency wars, which featured in the Great Depression era. Now it’s more about dealing with the distributional issues between creditors and debtor countries.
In the Q&A session following his presentation, Das declared that the United States is in much better shape but suffers from a “lack of courage to deal with the redistributional issues”. He dismissed gold bugs outright, explaining that gold only works in two fat tail scenarios: deflation (when paper certificates of gold become useless) or high inflation, neither of which is expected to occur. Das was fairly confident about oil prices due in part to China’s rebalancing toward consumption growth. Overall, he thinks “asset bubbles are the main risks, not a great inflation.” Inflation is something the U.S. Federal Reserve would have difficulty dealing with and will, therefore, deflect. Das also described the U.S. polity as a tug-of-war in Congress between the haves and have-nots, neither of which benefits much from inflation. Labour inflation is being subdued by different labour markets than prevailed during the 1970s inflation. So inflation, at least in the United States, is very likely to be avoided.
Finally, Das asserted the importance of institutions in the development of emerging markets, not just as providers of cheap labour, and he concluded by remarking on two puzzles about the United Kingdom: its falling labour productivity and the wisdom of the half-in, half-out approach to Europe.