The Three Failings of Economics

Economics, at least as it is expected to function in the West, aims to achieve normatively three fundamental and sacrosanct principles: free markets, free trade and growth. Governments try to minimize their involvement in market activity and regulate carefully so as not to interfere in the investment decisions of firms, in the mechanism of price discovery, and to also prevent private actors from influencing prices such as through price fixing of goods and services or through insider trading in the financial markets. Trade is, likewise, directed by policy to be as free as can be feasible between countries, without barriers to flow of goods and services, capital and labor. Free markets and free trade are expected to allocate scarce resources efficiently within countries and between countries for both individual countries and for the world economy to continue to grow, with growth keeping up at least with the population growth rate assuming constant availability of natural resources and continuous technological advancement to use resources efficiently. Yet, these very principles constitute the critical failings of economics in practice.

Adam Smith, the moral philosopher and classical economist during the Enlightenment in Europe, had postulated that free markets, on net, raise social welfare because they are guided by an “invisible hand” as people work in enlightened self interest. Smith had perhaps overestimated the goodness and rationality in human nature. People work in self interest and many a time in selfishness and greed with little concern for the systemic affects of their actions. John Maynard Keynes in his critique of classical economics, in fact, far from seeing people as enlightened, had postulated that they act in “animal spirits”, quite irrationally, leading to dramatic ups and downs in the markets as has been evidenced several times in economic history. Still, however, governments around the world, with a bias for laissez-faire, hesitate to thoughtfully intervene, with their visible hand, to correct anomalous market behavior during times of both market euphoria and downturns. Importantly, countries which have unstable governments and poor institutions give rise to unstable economies and corruption where laissez-faire reigns in an unenlightened condition.

David Ricardo’s theory of comparative advantage, in contrast to Adam Smith’s absolute advantage driving international trade, under free trade, leads countries to import goods and services because they are cheaper to procure from abroad even though they can make them themselves. As a result, in the current global trading system, countries which benefited first from the massive technological change of the industrial revolution, the first movers, are specializing in innovation – their comparative advantage – and moving up the production value chain, increasingly substituting capital for labor thereby reducing the labor share of their national incomes causing rising income disparities and displacement of workers from their employment with capital moving to countries with low production costs. Rising welfare abroad is threatening to reduce welfare at home which eventually may also reduce welfare globally as technology diffuses more quickly around the world increasing the capital share of national income is most countries. Capital mobility was not considered by Ricardo when he postulated comparative advantage. The capitalists – the owners of capital – will benefit while the rest see heightened economic uncertainty and a fall in their living standards.

It is estimated that the rate of consumption of natural resources on Earth requires 1.7 times what the planet can provide. Economic growth is rapidly becoming the Achilles heel of economics because no amount of technological advancement and efficiency of consumption of natural resources can prevent their depletion especially as per capita incomes rise around the world and as population grows to almost 12 billion by the end of this century. Growth theory in economics does not take into account the natural resource constraint and assumes that technological change will continue to raise average living standards by raising productivity. The average living standards may rise but the distribution of income in the society would be lopsided. This will, therefore, turn out to be the wrong model of the economy particularly in light of the increasingly skewed income distribution favoring capital between the two factors of production: capital and labor.

Economics requires radical rethinking if humanity is to achieve balanced development of all in ecological harmony.

The Challenge of the Disconnect Between Employment and Economic Growth in India

India, since 2014, has been the lone star on the economic firmament, growing consistently above 7% per year as the rest of the world struggled with economic recovery. One would expect that such a relatively stellar growth rate would create jobs but disappointingly this is not happening. The disconnect between growth and employment has only become worse. About 12 million enter the labor force every year and for India to reap the demographic dividend – of having more people of working age than those dependent on them – over at least the next four decades requires creating highly productive, well-paying jobs.

Employment elasticity, defined as the percentage change in employment resulting from a 1% change in gross domestic product (GDP), has been falling for India since the late 1990s, dropping steeply from 0.3% to 0.15%. This clearly signals that India needs significantly more growth if it is to provide quality employment to its vast, young workforce to be able to create a large consumer class which feeds back into the GDP.

What is causing this disconnect between employment and GDP? The low employment elasticity shows that growth is not being labor intensive enough. In the short run, such growth which results from structural changes in the global market in industries such as telecommunications, information technology and financial services and automation in manufacturing could result in higher output per worker, but in the long run it depresses consumption and hence GDP because unemployment and underemployment will weigh on the economy.

In India, the telecom industry has been consolidating thereby shedding workers. Information technology has been subject to the impact of technological change that is happening which requires complex job skills, thus displacing workers without them. The upskilling of workers is now a major challenge. Financial services is automating many business processes such as trading and portfolio management requiring far fewer workers than before and this is a trend that is only in its beginning.

The manufacturing sector has not been immune to technological change that has been happening around the world. Even as shifting manufacturing jobs to low-wage countries in the world has played its part in the loss of jobs in developed countries, by some estimates 1 robot is displacing 7 workers in manufacturing including in developing, lower middle income countries like India.

By liberal estimates an unemployment rate of 2-3% and by most conservative estimates a rate of 5-8% could statistically respond to the critics of India’s unemployment, but dependence on the strategy of attracting manufacturing from China to India because of relatively lower wages in India does not solve the underemployment problem nor does it help in creating the high-quality, high-wage jobs the government is aspiring to especially in a global environment where outsourcing has become a bad word. Exports are necessary but not critical for the development of India.

There is a way for India to be competitive in the world market without continuing to buy into the neo-liberal paradigm which worked for China but may not work for India given the political-economic milieu the world is now in that is legitimately critical of unbridled free trade. It is important for India to be open to foreign multinational corporations (MNCs) on the condition that they “Make in India”, across all industries including national defense, for the Indian market employing Indians and reinvest their profits in India. This will help formalize and organize the large informal sector and produce Indian corporations that are globally competitive. Liberalizing the large government sector is crucial to creating Indian MNCs of the future that can compete on an even keel with the foreign MNCs from developed countries.

After all the United States is a USD 18 trillion economy for a country of 315 million people. With 1.2 billion people India can likewise do much better. The development of the vast domestic market must be the vision that India ought to pursue.

NITI Aayog

The idea that India needs transformation but no longer evolution is captured in the establishment by Prime Minister Narendra Modi of NITI Aayog, the National Institution for Transforming India, on January 01, 2015, as a successor to the Planning Commission which was instituted by India’s first prime minister Jawaharlal Nehru in 1950. Gone are the 5-year plans which have been replaced by a 15-year vision punctuated by milestones at the 3-(Action Agenda) and 7-(National Development Agenda) year marks. The primary purpose of NITI Aayog is the working together of India’s 29 states and 7 union territories toward the realization of one common vision.

If India manages to achieve the ambitious initial 15-year vision of the institution by 2030 – a document currently in its draft stage – farmer incomes are expected to double by 2022 and India’s gross domestic product (GDP) and per capita GDP are seen tripling due to an annual real GDP growth rate exceeding 8% over the next 15 years. India will also then have met all of the sustainable development goals (SDGs) by 2030.

A challenge for India is to limit its imports, in particular as the Indian rupee gets stronger because of solid growth. “Make in India” appears to be one way to limit imports, alleviate the large trade deficit, and to achieve the much belated development of India’s manufacturing sector if not as a factory to the world but at least as a factory for its own vast internal market. The transformation of India would create the millions of jobs that are needed to absorb not only India’s educated youth but also the migrating population from rural to urban areas as agriculture’s contribution to India’s GDP further falls lowering agriculture’s share of employment which currently stands at nearly 50%. Still, agriculture itself would be transformed by becoming more industrialized as small subsistence farms consolidate into large holdings and technology changes seeds and farming methods.

One objective of the 3-year action agenda from 2017-2020 is to assess the funding requirements to implement the NITI Aayog vision. A major initial step in that direction has been the Goods and Services Tax (GST) which is expected to be rolled out on July 1, 2017. Despite the touted revenue neutrality of the GST, the broad-based consumption tax will loop in considerably more tax payers than there are currently and could, in fact, increase government tax revenue.

The higher tax revenues, in both the states and the center, particularly as GDP growth rises, could make available some, but not all, of the needed funds to finance the implementation of the vision of NITI Aayog. One way to finance would be by entering into public-private partnerships for infrastructure (not only roads and rail but also energy and water) and digital transformations.

India’s infrastructure alone would require about USD 2 trillion in investment by 2025 which amounts to more than 90% of the country’s 2016 nominal GDP or an average of about 10-15% of GDP every year between 2016 and 2025. The transformation of India that NITI Aayog has taken upon itself will require at least another USD 2 trillion by 2030. All of this cannot obviously be financed by domestic public-private partnerships alone. India would still need a way to finance its transformation which remains a challenge unless the timelines are less ambitious if monetary policy is not to be coopted by the vision of NITI Aayog.

NITI Aayog is good news for the financial markets. A sustained GDP growth rate above 8% over the next 15 years could see considerable flows of funds into India’s capital markets in the form of Foreign Institutional Investment (FII), Foreign Direct Investment (FDI), and a substantial increase in the market valuation of India’s public companies due to increasing earnings as India’s large domestic market develops together with a rise in exports as the rest of the global economy mends.

Monetary Policy of India and Economic Development

India, since liberalization in 1991, has depended on foreign institutional investment (FII) and foreign direct investment (FDI) to bulk up its foreign exchange reserves, even as it built its services exports sector that depends on outsourcing primarily from the United States and Europe. Unlike China, India paid little attention to the development of domestic infrastructure and manufacturing, remaining as a primarily agricultural economy. The challenges, as a result, India continues to face are hightened poverty, among the highest in the world, and inability to create jobs commensurately to the number of young people, about a million, entering the job market every month.

On the path toward becoming the most populous country in the world by 2050, India, being a democratic polity and a mixed economy founded on Fabian socialist principles, must position itself to reap the demographic dividend in the upcoming three decades. If leveraged well, India, with its large English-speaking population, can create the needed jobs by aiming to become a global center for services similar to but beyond Singapore and by transforming its infrastructure with smart cities, “Make in India” and “Digital India” programs. This would also have a dramatic effect on poverty reduction which has not happened as one would expect after 1991. The government programs are there but the question remains about how they can be funded at the scale that is needed for India’s economic transformation.

Monetary policy of China, says Li Yunqi, a Chinese research scholar associated with the People’s Bank of China (PBOC), has always been about economic development. Industrialization, in particular infrastructure related, has been the focus of PBOC, together with, of course, expanding the exports sector. Both infrastructure and exports, which contributed to significant and sustained increase in real investment have propelled China to be the second largest economy in the world when measured by nominal gross domestic product (GDP) and the largest in purchasing power parity (PPP) terms.

Blessed with fertile land and fresh water perennial rivers both in its north and south, India is an economy waiting to happen on the world stage powered by all three of the economic sectors: agriculture, industry and services. Road, rail, electricity and water are the primary infrastructure areas that are ripe for transformation. With urban areas growing, the government’s smart cities initiative should be able to accommodate the migration from rural to urban areas without over-burdening the existing cities by expanding or building new cities along major highway or railway corridors.

China printed money for investment in the expanding infrastructure and exports sectors of its economy, thus raising the potential growth rate which also thereby managed inflation despite occasional, short bouts with high inflation. This created millions of jobs and dramatically reduced poverty in the three decades since 1978 when China began its market socialist reforms. Though China, as Li Yunqi points out in his 1991 Asian Survey article “Changes in China’s Monetary Policy”, has to deal with the paradoxes of a burgeoning market economy and a socialist state that intervenes in it, and also with finding growth drivers as infrastructure and exports wane, its management of monetary policy holds important lessons for its neighbor to the south, India.

The Reserve Bank of India (RBI) should expand money supply for targeted funding of economic transformation initiatives. Money supply targeted to investment and growth initiatives only raises the potential growth rate but does not cause inflation. India is not yet an economy whose monetary policy can behave as if it is a developed economy.

Sustainability: The Great Race in Asia

Two sleeping giants had been awakened by economic liberalization since the end of the Cold War. Both Asian, China and India, the world’s most and second most populous countries, began liberalizing their economies particularly after the fall of the Berlin Wall in 1989. In the nearly three decades since, China has transformed itself from being a low income country with significant poverty into a middle income country with nearly a billion people lifted out of poverty. It now aspires to the status of a high income market economy. In the same 30 years, India – a democratic country which had its historical Fabian socialist economic structure continue to co-exist with the market – remained a lower middle income country still with considerable poverty. Yet both China and India today, on purchasing power parity terms (PPP), are among the top 3 largest economies of the world.

In terms of infrastructure and industrial development, India is significantly behind China. While China built world class infrastructure and became the factory to the world, India primarily focused on developing its information technology (IT) services industry and continued to remain a principally agricultural economy. Growth, however, for both these very large markets, has not come without costs for themselves or for the rest of the world. The pressure on global natural resources and the environment grows as China and India continue to develop.

Both these countries thus far have argued that they should not disproportionately bear the burden of climate friendly policies when, in fact, such policies were not a constraint during the development of advanced high income countries. They say that economic growth and raising the per capita incomes of their peoples should come first to close the gap with rich countries before they can consider sustainable development. While India is yet to achieve all the MDGs, China may have met all its Millennium Development Goals (MDGs) by 2015 but is far from reaching the new Sustainable Development Goals (SDGs) by 2030. That this is so, for example, can be seen in their smog-filled mega cities where air quality is dangerously poor.

Sustainability presents a unique set of challenges to all countries, not just to China and India, and, therefore, all countries begin on a level playing field. This is what makes the great race in Asia between China and India particularly interesting. Sustainability – besides requiring clean air, clean water, clean energy, efficiency in natural resource use and social inclusion among its 17 SDGs – most importantly requires consumption to be sustainable in all countries as they grow. Consumption, however, is the cornerstone of mainstream economics because it is the majority part of any country’s gross domestic product (GDP) and is indicative of the living standards of countries.

The new economic paradigm the SDGs herald is collaboration and competition among countries to grow sustainably without economic development and, thereby consumption, leading to severe stresses on natural resources and the environment, because for about 2.5 billion people in China and India to enjoy the same standard of living as the high income countries, each country’s nominal GDP needs to be about USD 40 trillion today, much higher than that of the United States or the European Union. That this is not so is the reason why per capita incomes in China and India are far less than those in rich countries despite China and India being relatively very large economies in aggregate.

India’s 15 years from 2015 (or by 2030) when MDG time frame ended and the SDG time frame began – when done with policy consistency, commitment and execution over time – can put the country directly on the path to sustainable development instead of having to redo development sustainably as the rich countries and China are now doing. An example is Norway which is aiming to transition itself and the corporations in which it invests its massive near-trillion dollar sovereign wealth fund based on its profits from oil sales to embrace sustainability. So are Saudi Arabia and the United Arab Emirates diversifying their oil-based economies to become sustainable.

The SDGs – requiring sustainable development – are not merely goals but a whole new way of approaching economic growth and living standards around the world. For example, profit maximization is a core and fundamental concept of neo-classical economics, only that the price of a product fails to account for the cost of all the negative externalities in its production such as social and environmental costs. If it did, products would be far more expensive. Intrinsically, the current economic model is unsustainable and, therefore, using the model to grow is a fool’s errand. India would do well to integrate sustainability into its economic policy and planning to achieve growth, higher standard and quality of life without necessarily consuming more natural resources, and sustainability overall because living standards and sustainability are interdependent and deeply intertwined.

India Importing Cotton is an Example of What is Wrong With World Trade

Cotton has a long history in India. It is the crop which galvanized the independence movement against the British. The movement led by Gandhi to produce domestic cloth woven from domestic cotton and the boycott of cloth imports from Great Britain had undercut the colonial British economy. Economic self-reliance or a form of near-autarky was what was advocated by Gandhi to undermine the British empire which imported cheap natural resources from its colonies and sold finished and semi-finished goods made in the industrial mills in Britain in the territories it occupied. Many argue that this is also the neo-colonial strategy that China is currently pursuing in its trade relations with other countries.

India is usually an exporter of cotton. Lately it has begun importing it, contributing to the country’s trade deficit. Two reasons standout for India’s cotton imports. One, limited domestic supply because of droughts or crop disease and two, a strong rupee which sometimes makes it cheaper to buy cotton in the world market than produce it domestically. While the first reason may, on occasion, make imports necessary and sensible, the second reason is purely the current global paradigm of trade at work: in a regime of free trade, under Ricardian comparative advantage, if it is cheaper to produce a good or a service in another country then countries which incur higher costs of producing the same goods or services domestically will import. The importing countries’ economic structure and labor market will shift away from producing the imported goods and services domestically and focus on others where they have comparative advantage in the ideal world that trades in goods and services freely across borders without any protections for domestic products.

The Ricardian comparative advantage may be attractive at an initial glance because it envisions a world of freely trading countries engaging in only that economic activity in which they are more economically efficient. However, the reality is such a division of labor across countries in the production of goods and services may be unsustainable because the world demand for various goods and services will always be higher than the possible world supply due to fewer producers and a disproportionately large number of consumers. Prices could be higher than in autarky over the long run and oligopolies of suppliers of goods and services will be created around the world.

Moreover, if, for example, selling natural resources cheaply is the comparative advantage of some countries, no domestic industry will be developed in such countries because they would import goods and services with the revenues earned from their natural resource exports. This lack of development of domestic industry has negative feedback effects on the amount of revenues extraction of natural resources can generate for these countries because the technology to extract natural resources does not belong to them but to other countries which specialize in those technologies. Therefore, despite being rich in natural resources, many countries remain poor due to lack of technical know how to exploit their own resources to their maximum benefit and they also enter into lopsided bad deals in their eagerness to earn income.

What we see in reality is some balance between economic specialization in world trade and competitive domestic production of the same or similar goods and services in various countries. What needs to be done in this age of the multinational corporation (MNC) in a largely sovereign and democratic world – which is very different from the age of the colonial multinationals such as the East India Company when the colonial master profited from the assets of the colonies without colonial development – is to institute a global trade regime of quasi-autarky as Gandhi had envisioned. Only natural resources and food that countries are deficient in and management and technical know how cross borders, and most needs of goods and services of countries are met through production within their borders by both the MNCs and domestic companies either in collaboration or in competition with each other.

India, given that it has proven to be self-sufficient in agriculture, must ensure its agriculture sector does not trigger the need for imports as with cotton as an example. This, however, does not mean that India should shoot for a cheaper rupee to make Indian cotton less expensive. It means that whatever the global price of cotton, India should specialize in cotton and cotton-related goods and services while committing to at least self-sufficient domestic cotton production through perhaps better agricultural techniques or better seeds that are drought and disease resistant. India should commit to innovation in agriculture, develop its own agricultural MNCs while welcoming foreign MNCs into its domestic market. This applies not only to agriculture but to all sectors of the Indian economy.

Quasi-autarky is a feasible option for India and in fact, as Gandhi envisaged, for the rest of the world as well.

The Indian Rupee and India’s Economic Development: Should India Emulate China?

Once again there is talk about the strength of the Indian rupee potentially hurting Indian exports because it has appreciated in the past few weeks relative to the U.S. dollar. “Should the Reserve Bank of India (RBI) intervene and if so when to halt the rise of the rupee?” has become the staple of the discussion.

The world is chained to the U.S. dollar. It is in this currency that most payments in international trade are made, severely handicapping countries from importing if they do not have adequate reserve of dollars. Conversely, to earn dollars, countries have to export their goods and services which have to be price competitive in global trade to be saleable. And this means their currencies have to cheaper relative to other currencies to spur their exports. In all of this, there is no effort made to trade in native currencies but only the anxiety to export to acquire dollar reserves. The idea is that goods and services exported by a country to other countries will cause economic development at home. Domestic investment and consumption usually do not factor in this calculus and economies are oriented entirely toward exports.

China has developed by becoming the factory to the world, thus far typically assembling imported parts of goods to export finished goods back to foreign markets. But China has also done something different. It invested in domestic capital accumulation and consumption using its export revenues in dollars to be able to eventually wean itself of export dependency while also attempting to climb up the export value chain by increasing its manufacturing sophistication to make high-end manufactured goods entirely within China and by diversifying into services. In this process, the Chinese currency, the renminbi (yuan), is gradually joining other currencies that are used in international trade and is now officially a global reserve currency.

The attractiveness of China’s economic development to countries importing from China is its vast market of about 1.3 billion people if foreign companies are allowed to compete on an even keel with domestic companies. The country has used this well to its advantage to turn itself into a global economic power but by principally subsidizing the Chinese industry giving it a leg up over foreign competitors. The next step of the Chinese juggernaut is global expansion to create and develop markets for its exports and technology acquisition to achieve advanced market economy status. None of the other developing countries are doing what China has done and by doing so the country has catapulted itself to become the world’s largest economy in purchasing power parity (PPP) terms and the second largest in nominal terms. China’s role in the current paradigm of globalization is to become a net exporter like Germany and Japan, curtailing as many imports as it can.

The key issue for economic development here, however, is the existing international currency and trading system which requires, for economic development, foreign currency reserves of stable currencies in which international trade is done. Little or no thought has been given to changing the system to develop capacity within countries to use their own currencies for domestic investment, consumption, and trade. China has succeeded by taking advantage of the status quo to its benefit but this is not a model that is sustainable because the advanced countries cannot continue to be net importers of goods and services from developing countries providing reserve currency hoards in the process to developing countries. Therefore, India emulating China is not a sustainable option either for itself or for its trading partners despite India being the leading exporter of information technology (IT) services to the United States and Europe.

India should insist on making payments in the Indian rupee for its imports while working to produce most of what it needs domestically to minimize imports and must accept trading partner currencies as payments for its exports, displacing the intermediation of the U.S dollar in global trade, thus heralding a new paradigm in global trade and economic development.

The Trump Trade

There have been two trends since toward the end of 2016. The election of Donald Trump as president of the United States in large part due to his promises to boost economic growth and bring jobs back to the country and the turning of the corner by the Chinese economy returning it to consuming once again the world’s natural resources for its infrastructure and manufacturing sectors. Both of these trends have lifted the global economy out of deflationary pressures by reflating while investors in the financial markets are carefully watching their sustainability.

Trump’s election brought into focus the U.S. personal and corporate tax regimes, burdensome business regulations, deteriorating infrastructure and America’s trade policies that have proven to be detrimental to its economy. Promised reforms to all these determinants of the health of the U.S. economy greatly encouraged the equity markets on Wall Street which are eager for the expected reforms to become law. The president’s ongoing difficulty with members of his own political party in negotiating health care reform to end Obamacare is raising doubts about his ability to pass major economic reforms into law. If he cannot deliver, the markets could be deeply disappointed which could lead to a 10% drop or a correction in the major equity indices.

As China – the world’s largest economy by purchasing power parity (PPP) and the second largest in nominal terms – navigates the stabilization of its economy at a lower level of growth, transitioning, according to conventional wisdom, to a services and consumption-based economy from a manufacturing and exports-based model in its attempt to move up the economic value chain, a closer examination of China reveals that it wants to strengthen all four – manufacturing, services, consumption and exports. It is climbing up the manufacturing ladder to more innovative and higher-end manufacturing from simply being an assembler of imported components, building up the services sector, raising domestic consumption, and aggressively seeking and building markets for its exports with initiatives such as “One Belt, One Road.”

China intends to primarily import natural resources and food it is deficient in, make in China using Chinese producers for the Chinese market and for export. It is not a country that is open to foreign firms who wish to make in China for Chinese consumption even as it is beginning to expand the global footprint of its own corporations to produce for the consumption of others within their countries. When faced for some time – nearly four decades – with such globalization that takes advantage of the current global free trade regime not only by China, but by other aggressive exporters such as Germany and Japan, the United States cannot stand still without adjusting its global trade posture of playing the unsustainable consumer of global exports which is costing America jobs. This makes the sustainability of the Trump Trade all the more critical – an imperative. The president must succeed in passing economic reforms in America.

Any future success of the expected reforms in the United States will have a significant impact on the world. Lowering personal income taxes for the middle class while expanding the tax base with taxes on consumption (as India is doing) would economically strengthen the society. Cutting corporate taxes and facilitating repatriation of foreign profits of American firms at a low tax rate will increase business investment in the U.S. Streamlining regulations and making regulations smart will reduce the cost of compliance of firms, create a business-friendly environment and increase the ease of doing business while reducing the chances of events such as financial crises. Investing in infrastructure reduces business inefficiencies. Most importantly, a local, global and sustainable model of international trade which encourages local production by multinational corporations and local companies for sustainable local consumption while importing only natural resources and food items a country is deficient in will lead to global economic development by creating and developing local markets and political and economic institutions. All these reforms will be emulated by other countries once they become operational in the United States, pushing less open countries such as China and Japan to become reciprocally more open.

The American president may be lending his name to real estate projects around world but he may not have anticipated branding the global economy. The Trump Trade signals a paradigm shift in the structure of the world economy. It not happening will be a costly disappointment.

Will The Expected Faster Fed Rate Increases Drive the U.S. Economy into a Recession?

US monetary policy appears to be transitioning from “very gradual” to “gradual” normalization. After raising the Federal Funds Rate (FFR) twice with a gap of one year between the two increases – one in December 2015 and another in December 2016 – the Fed appears to be comfortable to raise the FFR a bit faster by possibly again telegraphing about 3 increases in 2017 after doing the same in 2016. In 2016 the Fed did not follow up on its signal of 3 increases and it may not also in 2017. Annual growth in 2016 is at 1.6% which is about 1% less than annual growth in 2015 and annual growth forecasts based on the Quarter 1, 2017 numbers indicate that growth in 2017 could be similar to 2016.

Discussion about U.S. growth data, however, is missing from the current debate about whether the Fed will raise the FFR by 25 basis points to between 0.75 and 1 percent on March 15. The markets have priced-in the rate increase looking at the recent pronouncements by senior Fed officials, inflation, and labor market data, and the rate increase seems to be a certainty with the markets wholly concurring with the Fed that the rates should go up. In fact, if the Fed delivers a surprise on March 15 by not raising the FFR, financial markets could fall fearing that the Fed signaled a lack of confidence in the US economy.

Fed’s confidence in the economy and its view that the economic environment in the rest of the world is also improving – diminishing foreign risks to the US economy and also lower risks to global economic growth – should, the Fed appears to expect, keep US growth on a solid footing. Such a rhetorical expectation appears to be grounded in data because US growth in the most recent two quarters – Q4 2016 and Q1 2017 – points to an annual growth rate in both 2016 and 2017 that is close to the potential growth rate of between 1.4% and 1.7% according to estimates by the Congressional Budget Office (CBO) suggesting that there are no risks yet to inflation from growth unless it is above 1.7%.

An important point of discussion for the rate setting Federal Open Market Committee (FOMC) of the Federal Reserve would be the natural or neutral rate of money supply: is the FFR below, at or above the natural rate of interest? If the FFR is neutral, then inflation must be stable and growth must be at the trend rate. This may already be the case. Growth is at potential and inflation – by the Fed’s preferred measure of rise in core personal consumption expenditures (PCE) – should be hovering around 2%. With core PCE currently around 1.7% there is no impending risk to the Fed’s inflation target.

Considering that annual growth has fallen by 1% in 2016 when compared to 2015, and 2017 growth rate could be the same as that of 2016, the behavior of growth in 2016 and 2017 shows counter-intuitively that, given the economic structure, the FFR is perhaps already at the neutral rate and that any higher FFR will suppress growth. It may fall to fiscal policy to identify new growth drivers to push up both the potential growth rate and the natural rate of interest. The financial markets are thus, quite appropriately, reacting positively to promises by the new US administration of fiscal expansion.

A commitment by the Fed to accelerate the pace of interest rate increases should also take into consideration growth data and not merely inflation and labor market statistics if the Fed is to avert the risk of driving the economy into a recession with faster rate increases.

Political Risk and the Financial Markets

The global financial markets, on the one hand are attempting to reflect the true health of corporate and government finances and, on the other hand are grappling with their expectations of political changes which could affect the major economies of the world. The rise and spread of populist politics in these economies is confounding the status quo and is being branded by the guardians of the mainstream as a political risk to the economic order of the day.

While the populist politicians across countries are placing their finger on the genuine economic grievances of their peoples such as the rise in migration of people from unstable parts of the world (whose integration can put host societies under considerable economic, cultural, safety and security duress) and economic displacement due to technological change and globalization, the critics of populism wish to continue to defend and advance the status quo. They cannot fathom how the populist politicians can really address their people’s concerns without upending the extant economic order. However, the financial markets are reacting positively to political promises about a brighter economic future in developed countries by building-in hopeful economic outcomes of such promises into their expectations. Thus far, the financial markets do not see two seminal populist events – Brexit and Donald Trump – as a risk, instead they see them as opportunities for economic growth for the United Kingdom and the United States.

Populism is not always necessarily detrimental to societies and economies. Many great upheavals in history have been populist uprisings by leaders who created movements to address the grievances of their peoples. Such movements dislodged the status quo and replaced it with political and economic orders which represented the people’s will about their governance. Amidst rising income disparity in societies wrought by the neo-liberal economic order of the past four decades, Brexit, Donald Trump and the nationalist movements gathering steam in Europe, if done properly, bode well for how the world’s economies engage with each other to better distribute the benefits of globalization within countries. The extant economic order has become far too beneficial to the entrenched elites around the world.

In the major emerging markets, the anti-corruption crusades in Brazil and South Korea, the policies by President Vladimir Putin to ensure that Russia’s vast natural resource wealth benefits the Russian people and not the oligarchs in the aftermath of the Soviet Empire, anti-corruption sentiment which swept Narendra Modi into power in India, and dissatisfaction over corruption in South Africa are all signs that political risk could, in fact, lessen in the long term because of the strengthening of the rule of law and institutions to provide a peaceful, stable and predictable environment for the economy and the financial markets to function.

Developed economies could bring about changes in the international trade regime to favor local investment, job creation, and development of local markets around the world by replacing the global supply and production chain with local production for local markets by multinational corporations and local companies. International trade could then mostly be in commodities instead of in offshore services and finished and partially finished goods. This is how the current international economic order could be upended to ensure the continued economic development of the world in an equitable manner.

The restructuring of international production and trade as a win-win for all participants and peoples, if this is what the populist movements are set out to achieve, is not a political risk but a transformation that is very much needed. It is a risk for the status quo interests and they do not have a choice but to bear it.