As the global economy continues to recover slowly from the great financial crisis, central banks, led by the US Federal Reserve, have begun the process of normalisation of monetary policy, writes Sony Kapoor.
But if another crisis were to hit this year – say, one caused by a hard Brexit or a trade war – what would the central banks do? They could cut interest rates further, but with rates still near record lows they have much less scope to cut them than they did before the crisis.
Quantitative easing could be expanded, but the US has only managed to reduce its balance sheet from $4.5tn to around $4.1tn so far, and the ECB has only just ended new purchases. So, the incremental impact of further QE would be limited. The fact of the matter is that central banks have less firepower today than they did in 2008.
What could a government do when the next crisis hits? On average, in the EU and OECD countries, debt-to-GDP ratio for governments is around 30% higher today than it was back in 2008. In the event of an economic shock, governments could and should of course expand fiscal policy – but given the higher debt ratios, there is less room for manoeuvre than we had back in 2008.
Today, in the rich world (including the UK) both monetary and fiscal policy space is significantly more constrained than it was in 2008, which makes the present economic situation fragile.
It would have been fine, had the world economy been growing robustly, year on year, but growth is already slowing and a recession, particularly in the next two years or so, cannot be ruled out. The IMF has already revised its growth forecast down for the second time since spring 2018, to just 3.5%.
The other important thing is that in a crisis, you need sensible heads making critical decisions. Would you really want Boris Johnson, Jacob Rees-Mogg, Donald Trump or Marine le Pen and their ilk to be in the driver’s seat? To make decisions in the heat of crisis that can move markets and determine whether a bank is allowed to collapse or not? And who bears the brunt of the cost of that crisis?
The political centre across the developed world has shrunk substantially. If you look across the EU, for example, the share of centrist voters is 10-20% less today than it was 10 years ago. Monetary and fiscal policy has shrunk, and so has political space. This is very important, because we may have lost the ability to make sensible decisions.
Financial returns are falling
Looking at asset prices of the past 30-40 years in the markets in general, we have had a fantastic run.
If you look at the outstanding corpus of long-term funds – such as the Norwegian sovereign wealth fund – representing roughly $80tn of long-term capital, more than half of this comes from accumulated returns in the financial markets.
And the average 60/40 portfolio (securities comprising 60% equities and 40% bonds) has grown at around 7-8% in the past few decades, which has been fantastic.
But that is coming to an end. The returns generated in a 60/40 portfolio are expected to fall to around just 2.5% for the foreseeable future.
The main drivers for great returns include the decline in corporate tax rates, down by 10-15%; the rise of technology companies, which now constitute close to 20% of stock market capitalisation; favourable demographics; falling interest rates; and the rise of China, which reallocated income away from labour towards capital.
However, at best, these factors cannot continue to drive returns – and at worst, many of them will go into reverse, pulling financial returns down with them.
The only upside is that falling returns will significantly increase the number of those desperately seeking returns and higher yields. That means the scope for alternative assets, illiquid assets, will continue to increase simply because of the search for yield.
And then there is Brexit
Given Theresa May’s non-negotiable red lines – for example, on limiting freedom of movement – the UK will end up committing economic hara-kiri. If there is no free movement, there will not be an option to be in the single market. Period.
Sensibly speaking, what are the options?
There is the Norway option. Norway has no influence on the EU. Economically it is the least-damaging model, but it is not a sustainable option. Norway is a country of 5m people. In 2021, at its next general election, a significant constituency is expected to speak out against its model. Even a country as small as Norway, is dissatisfied because it has no influence. So, the EEA agreement may not be stable for Norway itself, and it is definitely not stable for the UK.
Then there is the no-deal scenario. Frankly, it is hard to see it as relevant. I have promised to eat my hat if there is a no-deal Brexit. Even now, I promise to eat my hat if there is any Brexit. Generally speaking, no-deal is not an option. No matter how incompetent you think our politicians are, no matter what new depths they might have sunk to in putting themselves ahead of the country, I do not think the UK parliament will accept a no-deal Brexit.
The only real option there is, then, is no Brexit. There, the demographics are clear, and time is on the Remainers’ side.
I think the most likely scenario will be that Brexit will be delayed; Article 50 will either be postponed or given an extension. And, frankly, if Brexit is kicked into the long grass, there will be no Brexit.
Given how we think developments in the global and European economies will shape up over the next few years, the best thing we can hope for is new engagement and dynamism in politics. Some of our institutions will have been stress-tested and will come out stronger in the process.
The EU, for having had the financial crisis, has a better idea now and will have stronger institutions than it had in 2008 – structurally, it will be stronger than ever before.
For all the bad news – the poor economic prognosis, the disenchantment of politics and rise of the crazies – perhaps five years from now we will reflect on this as a time when lessons were learnt, and people will realise what a privilege it is to have votes in a country that still values freedom and democracy – and hopefully, we will all end up in a stronger place.
Sony Kapoor is managing director of think tank Re-Define. This comment is adapted from his keynote speech at the International Property Forum’s annual lunch at the London Hilton on Park Lane on Friday 25 January.
