A 50% chance of a crisis in 2019
Beware balance sheet dangers
by Brian Reading in London
Wed 21 Mar 2018
According to the International Monetary Fund, GDP growth almost everywhere should accelerate to a respectable rate this year and next. Owing to the UK's decision to leave the European Union, Britain will be the exception. But there is a whiff of 2007 about this – when few forecasters saw the global financial crisis coming. There is a 50% chance of a crisis in 2019.
Conventional short-term forecasts begin with leading indicators coupled with an expectation of the fiscal and monetary stance. They proceed to project growth in terms of investment multipliers (whereby an increase in investment spending has a more than proportionate positive impact on the economy) and accelerator theory, which states that when demand increases, companies tend to increase investment in order to increase production, which, in turn, attracts more investment, driving growth. What goes up, goes on going up and what goes down does likewise. Hence forecasting errors are greatest at turning points. Booms burn out in accelerating inflation, which needs to be curbed. Budget tightening and central bankers halt overheating. Accelerating growth this year is hardly questioned, but the issue is whether the recovery can be sustained in 2019.
A mild application of monetary brakes in 2007 was expected to steady growth in 2008. G7 inflation was low and stable, between 2% and 3%. Instead, growth froze in a balance sheet crisis. Most forecasters pay scant attention to private sector balance sheets, while public sector and foreign balances are endlessly scrutinised. Yet improvements in public sector deficits and debts are mostly reflected in a private sector deterioration that spells trouble. The combination of fiscal austerity with monetary laxity has been dangerous, generally restoring private sector debt to pre-crisis levels.
Strengthening recoveries are not hard to explain. Central banks are aware of the withdrawal risks as quantitative easing ends and interest rates are normalised. They are careful. Fiscal austerity is over. Tightening or easing is not measured by budget balances. Changes in structural balances, what government revenues and expenditure would be if output were at its potential level, define policy stances. In 2008, the Organisation for Economic Co-operation and Development estimated structural easing in 25 of its 35 member economies. This changed to 26 tightening in 2013. This year it is back to 25 easing.
Faster growth and a bit more inflation with only a hesitant rise in interest rates will tempt some to ease further. The primary budget balance is the budget balance excluding government debt interest payments. If it is balanced, the growth in debt equals the average rate of interest on debt. This changes slowly depending on average debt maturity. If nominal GDP grows at the same rate as the average rate of interest on debt, the debt/NGDP ratio remains stable whatever its level. Where the two differ, the primary balance to stabilise the debt ratio depends on the difference and the initial debt level. With debt levels mostly below 100% and average interest rates significantly below NGDP growth, primary deficits can reduce debt ratios. Some countries will use this opportunity to increase public spending somewhat. But negative real interest rates cannot last indefinitely.
The OECD warns of the danger of a balance sheet crisis. In its November 2017 Economic Outlook, it cites research showing that housing market and credit-related early warning indicators are highly correlated with forecasting errors. It analyses its May 2008 forecast for UK 2009 growth, which it put at 1% and which turned out to be minus 5%. The original fan chart, based on historic forecasting errors, gave a more than 90% chance that growth would be more than 1%. Using domestic early warning signs, this changed to worse than minus 4%. Adding international indicators brought the chance of minus 5% to under 80%.
Given the return to pre-crisis private debt levels, I fear the chances of recession in 2019 could be as high as 50%.
Brian Reading was an Economic Adviser to UK Prime Minister Edward Heath and is a Member of the OMFIF Advisory Board.
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