13 October 2015  9.00am - 1.00pm

2015 Annual Conference Report

The post‑crisis global economy. Challenges, uncertainties and opportunities.

The Conference Chairman, Evan Davis, started the 2015 Annual Conference with some opening remarks. He said there is considerable confusion and debate within the economics profession. There are cyclical arguments as well as structural ones about the state of the world economy:  whether the current problems are largely lagged effects from the GFC or whether they are deeper -seated (for example, Larry Summers’ “secular stagnation” thesis).

The first Keynote speaker was Spencer Dale, formerly chief economist at the Bank of England, and now chief economist at BP. He spoke about the new economics of oil. There were four core principles in which he had believed when he started the job:  that oil is an exhaustible resource; that oil has steep demand and supply curves; that oil flows from the east to the west; with corresponding capital flows; and, lastly, that OPEC stabilises the oil market - as indeed it did in 2008-09. However, his work at BP has suggested that all four are wrong and that the market has changed considerably. 

One way in which the oil market is changing is concern about climate change, as long run demand for fossil fuels is altering. Existing reserves of fossil fuels far exceed the carbon budget by suggested by scientists. A second change is the technological revolution which has led to shale oil and gas. About 5% of the global market is being supplied by the US. Cost deflation means that it is broadly in the middle of the cost curve for global production. Such new supply has affected oil prices much more than demand side issues. Indeed, since 1980 the world has consumed 1trillion barrels of, oil but found 2 trillion. Whether these new reserves can be used is another matter. Overall, it is unlikely that oil reserves will ever be exhausted. On this basis, the relative price of oil need not rise over time. It will simply depend on relative demand and supply at any moment in time. Technology matters much more and firms are becoming more innovative, making some fields more or less economical to exploit, manufacturing-like processes create significant productivity gains. US new well production per rig has risen by 30% pa for the last 8 years. A key issue is whether other parts of the oil and gas industry can share such productivity growth.

The second assumption was steep demand and supply curves for oil. Conventional wells involve long lead times, large investment and modest declines in output over time. Supply does not respond quickly to price signals. By contrast, new techniques in shale have short lead times, small fixed investment and high decline rates. Output can fall 50-75% a year. Hence shale can act as a price absorber, dampening volatility. Shale is only the marginal cost of supply in the short term though, not in the long term where more expensive areas such as Canadian tar sands become relevant. However, the financial characteristics of oil will increase as it comprises many hundreds of small firms who will go bust more quickly due to high levels of gearing and volatile cash flows.

Oil is not flowing so much from east to west, not only due to shale but also due to greater energy efficiency and the shift of manufacturing to Asia and its rise in urban demand. By 2020 BP assume that the US will become self-sufficient in oil, by 2030 for all its energy needs. This contrasts with a major expansion of energy demand / net imports in China and India over this period. One result has been the reduction in the US current account deficit, so energy on its own is on its way to halving that deficit. 

In one respect the old assumptions are true, namely that OPEC (especially Saudi) retains power to be a marginal supplier. However this relationship with the US will alter and there are more limits to that power. All in all, shale can be a major factor for, say, five years. A key judgement about shale is whether it can expand in other parts of the world. BP assumes this does not happen, partly due to politics, mineral rights and population density, and partly to the infrastructure. One opportunity will be shale gas in China due to its need for energy security, 

Ian Shepherdson, Chief Economist, Pantheon Economics followed with a talk on monetary policy, primarily in the US. The Fed is prevaricating partly due to concerns over the pace of the recovery and partly due to uncertainty over the state of the labour market. The manufacturing ISM faces a downward trend but poor seasonal adjustment will probably add to this. The fall in oil capex is a key factor, likely to fall in the energy sector from $200bn to $80bn. This will adversely affect Q3 and Q4 GDP. Employment in the shale sector, however,  is very small: it is a capital-intensive business. There are early signs that the cutbacks are stabilising. A second factor is the dollar plus weak export demand. A fall in Chinese growth to 5% pa takes about $100bn from incremental Chinese nominal GDP growth, down from $350bn to $250bn.

On the plus side, US consumers are well supported. Real after- tax income is growing about 3.5% pa. Poor weather led to a temporary rise in the household savings ratio last spring but this has dissipated. All in all consumption is being supported by the rise in employment and the fall in oil prices. Overall nominal retail sales are lower due to price deflation but in real terms growth is about 5% pa. These are only about one- third of total consumer spending. So the more important story is the expansion in demand for services, eg leisure. Car sales are steady about 8m units a year but light truck demand has picked up sharply to some 10m units. Similarly, total home sales have recovered to some 6m units and construction spending is back to 2008 levels. While ISM manufacturing approaches zero, its service sector counterpart  is still about 57. Manufacturing is only 9% of employment, 12% of value added and 13% of exports. Trade with Europe is more important than with China. Indeed the European monetary cycle is improving. Real M1 growth signals 3-4% real GDP growth.

Turning to labour markets, the Fed has assumed for several years that the unemployment rate will flatten out, Instead, its downward trend has continued towards the 5% NAIRU estimate. U6 has reached 10%, the same level at which the Fed last raised rates.

There has been a slowdown in payroll growth: is this due to less demand for labour or problems for firms in finding the labour they need? JOLTS openings remain firm and NFIB employment intentions have moved upwards. ISM service sector demand is picking up.

A further problem with the analysis is that wages are not rising as fast as past relationships would suggest. One measure - the Atlanta Fed’s hourly earnings index - does suggest an upturn, and this does take account of the changing mix of jobs. If that index is correct then real wages should rise strongly into the winter.

There is a gap between the core CPI and core PCE deflator due to rents and medical, care costs. Some good prices are falling again, due to China and the dollar but generally services ex-energy and rents inflation is steady about 2% pa and shelter costs are slowly expanding about 3% pa.  Obamacare is leading to low medical care costs about 1% pa but regulators are currently allowing large price rises.

Importantly, the US remains sensitive to large interest rate increases, as corporate debt has not fallen back and the household sector deleveraging was limited.

EM will remain under pressure from the Fed tightening, as always happens. Large current account deficits, politics and oil dependency problems only add to the issues.

Sarah Hewin, Standard Chartered Bank’s Chief Economist, Europe, discussed the outlook for EM against the backdrop of developments in China and the US. What happens to EM when the Fed raises rates? The taper tantrum episode in May 2013 gives some evidence. EM assets then came under pressure, eg. commonly by 20 to 30% by December that year. The outturn since May 2015 has been rather similar, although the mix of countries has varied a little depending on commodity exposure. The relationship between current account deficits and currency depreciation is strong in such periods.

China is a more important trade destination for EM as a whole than back in 2004 when the US last raised rates consistently. The relationship between Chinese and Sub -Saharan Africa growth rates is rather close for example, due to the commodity linkages.

After the break, Dr Claudio Borio, Head of the Monetary and Economic Department, Bank for International Settlements, gave a keynote address in which he summarised the analysis in the BIS annual report. He examined why global growth has been slow since the GFC. He argued that the current predicament reflects major problems in how the financial system interacts with the real economy. Outsized financial booms and busts have left long lasting scars on economic structures. They have also left limited room for manoeuvre for policy makers. More emphasis needs to be put on financial, medium-term and global factors, as opposed to real economy, short -term or country/regional specific. All in all, a faulty lens has contributed to the current predicament.

He reviewed the symptoms of the unbalanced global expansion. There is some good news, namely global GDP has recovered to a pre-crisis trend, if not above -trend, while inflation risks remain low. Indeed, there are concerns that inflation is too low. The bad news involves the financial sector - debt has not declined since the GFC and deleveraging across whole economies has been limited. In crisis -hit economies, some cuts in private sector debt has been more than offset by the rise in public sector debt. In non-crisis hit economies, there has been a clear rise in private debt, with clear signs of a build-up in financial imbalance eg property or asset prices rising well above trend.

There is little risk- taking in the real economy eg. businesses prefer share buy-backs to  capex, while there is aggressive risk-taking in financial markets eg. the hunt for yield.

There are persistently low short and long interest rates, regardless of inflation targets. This may be related to the decline in trend productivity growth rates.

There has been a progressive loss in the policy room for manoeuvre, whether fiscal or monetary.

All in all, debt is too high, productivity too low and the room for manoeuvre too limited.

The lens which the BIS puts forward to understand all this includes five key propositions.

Macroeconomics cannot ignore the financial cycle. Joint booms and busts in credit and property cycles are more frequent and larger than in the traditional business cycle.

Financial crises cause major and long lasting damage to the real economy. Sectoral misallocations - before and after a crisis - have large effects for example on labour demand and supply. The BIS calculates that the cumulative impact on productivity over a decade before and after a crisis is about 6%.

Financial cycles have become more frequent and larger since the liberalisation of the 1980s. Other drivers include the objective of monetary policy focusing only on inflation and also globalisation which encourages disinflation.

The international monetary and financial system amplifies these problems through the interaction of domestic and external regimes. Free mobility of capital encourages a spread easing bias from core economies to the rest of the world eg. the surge in dollar finance to EM. Examples include resistance to exchange rate appreciation.

Post- financial balance sheet recessions are less amenable to demand management, there is less policy room for manoeuvre whole transmission mechanisms are weaker and balance sheet repair takes time. Monetary policy pushes on a string. Not all output gaps are equal.

Overall, policy makers have failed to come to grips with the GFC. They did too little to constrain the boom, they relied too much in demand management to address the bust - rather than balance sheet repair which has been delayed. Monetary policy has become overburdened. Low interest rates in countries fighting the aftermath lead to problems elsewhere, for example leading to unwelcome currency appreciation in EM. A policy of intentional currency depreciation results to gain short- term benefits. The symptoms Include early signs of banking sector and GEM distress.

Are market interest rates at an equilibrium level? The prevailing view is that the natural rate reflects output at potential and price stability in a given period, while the behaviour of inflation signals disequilibrium. The BIS lens suggests that the natural rate is consistent with sustainable good macro performance. Low rates contribute to financial instability by encouraging booms and busts so they are not equilibrium. Frameworks which exclude financial instability are dangerous. Long term rates can be misaligned for a long time.

Why has the long term rate declined in recent years? In part it is a disequilibrium process. Monetary policy has been asymmetrical, over the crisis, imparting a downward bias to rates and an upward bias to debt. It becomes harder to raise rates without too much real economy damage. This embeds instability in the real economy. Over time low interest rates are self-validating of a crisis to come. Low rates beget low rates.

In conclusion, the global economy is struggling to achieve a sustained and balanced expansion. The recent decline in GEM is the latest chapter. A key aspect is the inability of policy frameworks to come to grips with the global economy’s financial risks. We will see further episodes of severe financial stress, entrenching instability and chronic economic weakness. There is a threat of a rupture to the open global economic order. Adjustments to policy frameworks are needed, using a variety of policies to tackle the financial crisis, rebalancing the policy- mix towards more structural measures, not presuming simply because one country is in order that the global economy won’t affect it, and to lengthen policy horizons. We cannot afford to rely on the current debt- fuelled growth model any longer. The sooner we recognise this the better.

The Conference closed with a talk from SBE Vice President, and PwC’s Senior Economic Adviser, Dr Andrew Sentance CBE. In his talk, Andrew discussed some aspects of the economic recovery globally and then focused upon the UK. 

Nominal GDP of the world economy will rise from $33tn in 2000, currently about $74tn and on course for $96tn by 2020. Global GDP growth is close to its long- term trend, but well below that of the pre-crisis period. The length of the expansion has allowed G7 unemployment to fall below the 6.5% average since 1980. 

Myths and realities of the UK economic recovery:

  • The March of manufacturing did not materialise
  • Austerity does not appear to have held back growth
  • The labour market has been flexible. The rise in employment has been far better than normally seen after a recession
  • The recovery has been driven by private non-financial businesses especially in services investment and exports
  • The number of mortgage holders has declined from 40-45% towards some 30%, the lowest since the early 1980s.

In Europe, the disparity in growth is marked, with Poland, Spain and Sweden 3.0-3.5% pa and France, Austria and Italy under 1% pa. This partly reflects structural problems as well as limited restructuring of the banking systems. High public spending has weighed on tax burdens. There is weakness in key economic decision- making at the EU level.

The sessions ended with a networking lunch. Our thanks go to all the speakers for ensuring that another successful annual conference took place.