Breaking Bad (Habits)

Better now than later

by Stephen Roach

It was never going to be easy, but central banks in the world’s two largest economies – the United States and China – finally appear to be embarking on a path to policy normalization. Addicted to an open-ended strain of über monetary accommodation that was established in the depths of the Great Crisis of 2008-2009, financial markets are now gasping for breath. Ironically, because the traction of unconventional policies has always been limited, the fallout on real economies is likely to be muted.

The Federal Reserve and the People’s Bank of China are on the same path, but for very different reasons. For Fed Chairman Ben Bernanke and his colleagues, there seems to be a growing sense that the economic emergency has passed, implying that extraordinary action – namely, a zero-interest-rate policy and a near-quadrupling of its balance sheet – is no longer appropriate. Conversely, the PBOC is engaged in a more pre-emptive strike – attempting to ensure stability by reducing the excess leverage that has long underpinned the real side of an increasingly credit-dependent Chinese economy.

Both actions are correct and long overdue. While the Fed’s first round of quantitative easing helped to end the financial-market turmoil that occurred in the depths of the recent crisis, two subsequent rounds – including the current, open-ended QE3 – have done little to alleviate the lingering pressure on over-extended American consumers. Indeed, household-sector debt is still in excess of 110% of disposable personal income and the personal saving rate remains below 3%, averages that compare unfavorably with the 75% and 7.9% norms that prevailed, respectively, in the final three decades of the twentieth century.

With American consumers responding by hunkering down as never before, inflation-adjusted consumer demand has remained stuck on an anemic 0.9% annualized growth trajectory since early 2008, keeping the US economy mired in a decidedly subpar recovery. Unable to facilitate balance-sheet repair or stimulate real economic activity, QE has, instead, become a dangerous source of instability in global financial markets.

With the drip-feed of QE-induced liquidity now at risk, the recent spasms in financial markets leave little doubt about the growing dangers of speculative excesses that had been building. Fortunately, the Fed is finally facing up to the downside of its grandiose experiment.

Recent developments in China tell a different story – but one with equally powerful implications. There, credit tightening does not follow from determined action by an independent central bank; rather, it reflects an important shift in the basic thrust of the state’s economic policies. China’s new leadership, headed by President Xi Jinping and Premier Li Keqiang, seems determined to end its predecessors’ fixation on maintaining a rapid pace of economic growth and to refocus policy on the quality of growth.

This shift not only elevates the importance of the pro-consumption agenda of China’s 12th Five-Year Plan; it also calls into question the longstanding proactive tactics of the country’s fiscal and monetary authorities. The policy response – or, more accurately, the policy non-response – to the current slowdown is an important validation of this new approach.

The absence of a new round of fiscal stimulus indicates that the Chinese government is satisfied with a 7.5-8% GDP growth rate – a far cry from the earlier addiction to growth rates around 10%. Butslower growth in China can continue to sustain development only if the economy’s structure shifts from external toward internal demand, from manufacturing toward services, and from resource-intensive to resource-light growth. China’s new leadership has not just lowered its growth target; it has upped the ante on the economy’s rebalancing imperatives.

Consistent with this new mindset, the PBOC’s unwillingness to put a quick end to the June liquidity crunch in short-term markets for bank financing sends a strong signal that the days of open-ended credit expansion are over. That is a welcome development. China’s private-sector debt rose from around 140% of GDP in 2009 to more than 200% in early 2013, according to estimates from Bernstein Research – a surge that may well have exacerbated the imbalances of an already unbalanced Chinese economy.

There is good reason to believe that China’s new leaders are now determined to wean the economy off ever-mounting (and destabilizing) debt – especially in its rapidly expanding “shadow banking” system. This stance appears to be closely aligned with Xi’s rather cryptic recent comments about a “mass line” education campaign aimed at addressing problems arising from the “four winds” of formalism, bureaucracy, hedonism, and extravagance.

Financial markets are having a hard time coming to grips with the new policy mindset in the world’s two largest economies. At the same time, investors have raised serious and legitimate questions about Japan’s economic-policy regime under Prime Minister Shinzo Abe, which unfortunately relies far more on financial engineering – quantitative easing and yen depreciation – than on a new structural-reform agenda.

Such doubts are understandable. After all, if four years of unconventional monetary easing by the Fed could not end America’s balance-sheet recession, why should anyone believe that the Bank of Japan’s aggressive asset purchases will quickly end that country’s two lost decades of stagnation and deflation?

As financial markets come to terms with the normalization of monetary policy in the US and China, while facing up to the shortcomings of the BOJ’s copycat efforts, the real side of the global economy is less at risk than are asset prices. In large part, that is because unconventional monetary policies were never the miracle drug that they were supposed to be. They added froth to financial markets but did next to nothing to foster vigorous recovery and redress deep-rooted problems in the real economy.

Breaking bad habits is hardly a painless experience for liquidity-addicted investors. But better now than later, when excesses in asset and credit markets would spawn new and dangerous distortions on the real side of the global economy. That is exactly what pushed the world to the brink in 2008-2009, and there is no reason why it could not happen again.