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Witches Brew: Satyajit Das' Outlook for 2015


An international finance expert looks forward in time and sees trouble.

In 2013, an asset management consultancy identified alien invasion as a risk for the global economy, albeit an unlikely one.

An online reader wryly observed that even such an event would be an excuse for markets to rally as businesses could look forward to the prospect of demand from new non-human customers.

Over the last 2 years, financial markets have largely ignored risk, constructing a favourable narrative around events and rallying on information of all kinds.

In 2014, growth in advanced economies disappointed. Europe flirted with recession. Even the fireworks of Abenomics could not prevent Japan from sliding into its fourth technical recession in six years.

The US and UK were the cleanest of the dirty shirts. But even they grew below trend.

Low inflatin compounds the problem. In Japan and Europe, there is concern about deflation.

Emerging markets have lost momentum. Chinese and Indian growth has slowed. While still stronger than that of advanced economies, growth is below peak. It's also below levels needed to absorb new entrants into the work force and maintain a social and economic equilibrium. Brazil, Russian and South Africa are at a standstill, disproportionately affected by weaker commodity prices.

Already-high debt levels continue to grow. High debt levels increase vulnerability to economic weakness as well as a normalisation of interest rates which would increase debt servicing costs.

The global economy is weakening despite extraordinary levels of stimulus.

But there is now increasing concern that these policies have reached the limits of effectiveness. Central bankers have voiced increasing fear that policy options are now limited. Japan's 25-year experience highlights the limits of massive government fiscal and monetary stimulus as an economic problem-solving mechanism.

A new round of currency wars is under way.

Japan, Europe and China are attempting to engineer devaluations to increase competitiveness. But one nation's weak currency equates to someone else's stronger currency. A stronger dollar affects US exporters and reduces foreign earnings of multinationals.

In a race to the bottom, other countries will be forced to cut interest rates and potentialky inject liquidity into money markets to avoid the appreciation of their currency.

Currency devaluations combined with excess capacity, driven by debt-fueled over-investment in China, is also helping maintain strong deflationary pressures.

Social stresses are increasing. High levels of unemployment have persisted despite stabilisation and recovery in many economies.

Work pressures combined with rising inequality are driving political changes. Major parties in many countries have lost support. More extreme and populist parties like Greece's Syriza, Spain's Podemos, and Italy's Five Star movement have gained support.

At a minimum, this makes for complex politics and difficult decision making. It increases political uncertainty. The economic difficulties and loss of faith in traditional political parties facilitated the rise of fascism and communism in the twentieth century.

Despite a small group of vocal and well financed deniers, the effects of environmental change continue to become an increasing factor. Extreme weather events, hurricanes, floods, droughts and fires, are an increasingly disruptive influence. But attempts to stabilise and reduce emissions would increase energy costs and also result in losses for investors in standard traditional fossil fuel assets.

Geopolitical risks are also increasing.

Financial markets and investors prefer to ignore these risks. They rely almost exclusively on continued monetary stimulus. Reduction of US Fed liquidity injections is being offset by looser policies in Japan, China and Europe, supporting asset prices. Falling oil prices also underpin optimism, boosting incomes in oil consuming advanced economies supporting consumption. But low commodity prices are not the boon that some surmise, being at best a transfer from oil producers to consumers. Most importantly, low energy prices may trigger new instability in financial markets through falls in equities and the debt servicing problems of highly-levered energy companies.

Like 2008, when sub-prime mortgages triggered the global financial crisis, sub-prime oil may be the catalyst for the adjustment to financial markets which have grown complacent on low interest rates and abundant liquidity.

In effect, few of the problems that led to the great recession of 2008 have been resolved. The BIS summarised the position in its 2012/ 2013 Annual report: "Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to... real growth... What central bank accommodation has done during the recovery is to borrow time... but the time needs to be used wisely, as the balance between benefits and costs is deteriorating."

Current policies have encouraged an excess of financial risk taking rather than economic risk taking, in the words of IMF President Christine Lagarde. The risk of a financial system crisis is now high.

The position is worse than in 2008. Weaker government finances mean that the ability to support the economy and financial system is limited. With interest rates at zero and liquidity already abundant, policy options are restricted. Emerging market weaknesses mean that they will not contribute to global growth as they did after 2008.

A new crisis will be like a virulent infection attacking a body with a compromised immune system.

Satyajit Das is a former banker and the author of Extreme Money and Traders, Guns & Money.
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