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Economics

Global

The world
economys titanic
problem
Coping with the next recession
without policy lifeboats

If another recession hits


it could be a truly titanic struggle for
policymakers
Remarkably enough, it has been six years since the trough of
the last US recession. If history is any guide, we are probably
now closer to the next one. Yet whereas previous recoveries
have enabled monetary and fiscal policymakers to replenish
their ammunition, this recovery both in the US and
elsewhere has been distinguished by a persistent munitions
shortage. This is a major problem. In all recessions since the
1970s, the US Fed funds rate has fallen by a minimum of
5 percentage points. That kind of traditional stimulus is now
completely ruled out. Meanwhile, budget deficits are still
uncomfortably large and debt levels uncomfortably high:
while the US fiscal position has improved, it remains
structurally weak.
We investigate the options for policymakers given this
shortage of traditional ammunition, including: (i) reducing the
risk of recession; (ii) reverting to quantitative easing;
(iii) moving away from inflation targeting; (iv) using fiscal
policy to replace monetary policy; (v) using fiscal and
monetary policy together in a bid to introduce so-called
helicopter money; and (vi) pushing interest rates higher
through structural reforms designed to lower excess savings,
most obviously via increases in retirement age. We conclude
that only the final option is likely to lead to economic success.
Politically, however, it seems implausible. As a result, we are
faced with a serious shortage of effective policy lifeboats.

13 May 2015
Stephen King
Chief Economist
HSBC Bank plc
+44 20 7991 6700

The world economy is like an ocean


liner without lifeboats

stephen.king@hsbcib.com

View HSBC Global Research at: http://www.research.hsbc.com


Issuer of report: HSBC Bank plc

Disclaimer & Disclosures


This report must be read with the
disclosures and the analyst certifications
in the Disclosure appendix, and with the
Disclaimer, which forms part of it

As for plausible recession triggers, we highlight four major


risks: a rise in US wages which leads to a falling profit share
and a major equity decline; a series of systemic failures
within the non-bank financial sector; a major weakening of
the Chinese economy, sending shockwaves around the world;
and a premature attempt by the Federal Reserve to normalise
monetary policy, in a repeat of the mistakes made by the
Bank of Japan in 2000 and, more recently, by the European
Central Bank in 2011.

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13 May 2015

The world economys titanic problem


Remarkably enough, its six years since the last recession
suggesting the next one may not be too far away
yet there is a total absence of traditional policy ammunition

Not quite a return to normality


In most economic cycles, the recovery phase has not just marked a return to economic growth. It has also,
eventually, marked a return to policy normality. Interest rates have risen. Tax revenues have rebounded.
Welfare payments have shrunk. Budget deficits have declined and, on some occasions, have even turned
into surpluses. Put another way, a return to economic growth typically allows policymakers to rebuild their
stocks of ammunition, providing them with room to fight the next economic battle.
This latest economic cycle is, to date, fundamentally different. According to the National Bureau of
Economic Research, the last trough in US economic activity was reached in June 2009. Almost six years
into recovery, official short-term interest rates havent budged an inch. 10 year Treasury yields are at
rock bottom, still lower than they were in the immediate aftermath of the collapse of Lehman Brothers in
2008. The Federal budget deficit has dramatically improved but the fiscal position is nothing like as
healthy as it typically has been through previous economic cycles (charts 1-3).
1. Still waiting for the Fed

Federal funds target rate (horizontal lines show ECRI business cycle troughs)

20

20

16

16

12

12

0
71

73

75

77

79

81

83

85

87

89

Source: Thomson Reuters Datastream, National Bureau of Economic Research

91

93

95

97

99

01

03

05

07

09

11

13

15

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2. Yields are close to rock bottom

Yield

3. The Federal deficit has improved but, by past standards, is


still large

10 Year Treasury Yields

Yield

Lehman Brothers
collapse

7
6

Federal budget balance - vertical lines show NBER business


cycle peaks)
%GDP
%GDP
4
4
2

-2

-2

-4

-4

-6

-6

-8

-8
-10

4
3
2

-10

-12

Source: Thomson Reuters Datastream

-12
54 58 62 66 70 74 78 82 86 90 94 98 02 06 10 14

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15

Source: US Treasury, National Bureau of Economic Research

Other regions offer a similar narrative. True, the European Central Bank tried to raise interest rates in
2011, but its attempts ended in ignominious failure: having reversed its rate increases, the ECB is today
committed to quantitative easing that, on current plans, is likely to extend all the way through to
September 2016. The Bank of Japan is in a similar position. The Bank of England is no longer
increasing its balance sheet via quantitative easing but, despite having had the urge, it has so far been
unable to find an opportunity to raise interest rates. Fiscal positions, meanwhile, are mostly poor at
least when compared with those pre-crisis.
4. The ECB raised rates and ended up with egg on its face

5. Quantitative easing no longer looks unconventional


Central bank balance sheets, Jan '07 =100

Index
600

500

500

400

400

300

300

200

200

100

100

%
5

-1

-1
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15
ECB repo rate
ECB deposit rate

Source: Thomson Reuters Datastream

Index
600

0
07

08

09

10

BoE

11

12

ECB

13
Fed

14

15
BoJ

Source: Thomson Reuters Datastream, Bloomberg

Three reasons why policy hasnt normalised


One reason for this lack of action this failure to rebuild stocks of ammunition is simply that the pace
of economic recovery has not been particularly strong. Chart 6 shows the average annual US growth
rates during equivalent six-year periods following economic troughs over the last forty years. The latest
recovery is particularly weak. Then again, so was the previous recovery. Back then, however, the
Federal Reserve was able to raise interest rates 31 months after the trough in economic activity. This
time, 70 months have elapsed (at the time of writing) and still the Fed hasnt acted.

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6. The recovery since the last trough has been very weak in the US
%
5

Average US GDP growth for the six years since trough

%
5

0
Mar-75

Jul-80

Nov-82

Mar-91

Nov-01

Jun-09

Source: Thomson Reuters Datastream, HSBC, National Bureau of Economic Research

A second reason for a lack of action reflects at least in part the very weak starting point. The US
economic collapse during the global financial crisis was far worse than experienced during all previous
post-war downswings. From peak to trough, US GDP fell 4.2% (see table 7).
In the past, however, deep recessions were typically followed by strong recoveries. This time around, a
deep recession has been followed by an insipid recovery: more L-shaped than V-shaped. Chart 8 shows
the average annual growth rate for the US economy from equivalent peaks in economic activity since the
1970s: this time around, performance has been hugely disappointing.
7. The overall decline in US GDP through the financial crisis was huge compared with earlier recessions
Cycle

Peak date

Trough date

1953-1954
1957-1958
1960-1961
1969-1970
1973-1975
1980
1981-1982
1990-1991
2001
2007-2009

July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
March 2001
December 2007

May 1954
May 1958
February 1961
November 1970
February 1975
August 1980
November 1982
February 1991
November 2001
May 2009

Source: Thomson Reuters Datastream, National Bureau of Economic Research

Annualised average
% change

Total % change

-2.5
-4.0
-0.4
-0.2
-2.5
-4.4
-2.1
-2.7
0.7
-2.9

-1.9
-3.0
-0.3
-0.2
-3.1
-2.2
-2.5
-1.3
0.5
-4.2

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8. The growth rate of the US since the last peak in economic activity has been pitiful

%
5

Average US GDP growth for the seven years since peak

%
5

0
Nov-73

Jan-80

Jul-81

Jul-90

Mar-01

Dec-07

Source: Thomson Reuters Datastream, HSBC , National Bureau of Economic Research

This, in turn, might imply that the US economy still has a significant shortfall in demand: activity has yet
to return to the path that might have been predicted before the onset of the financial crisis. Put another
way, perhaps the US still has a sizeable output gap. Some have argued that this persistent weakness
reflects a premature decision to tighten fiscal policy when what was needed was continuous fiscal stimulus.
However, other measures of slack in the economy dont fully support for this view. Charts 9 and 10 show
the unemployment rate and the manufacturing capacity utilisation rate for the US economy going back to
the mid-1970s. In each case, the first increase in Fed funds in each tightening cycle is marked with a
vertical line. On both measures, the amount of slack in the US economy is no greater than in earlier
economic cycles: indeed, it could be argued that the Federal Reserve is behind the curve.
9. Back to normal on the unemployment rate.
%
12

US unemployment rate

10. and on capacity utilisation?


%
12

11

11

10

10

3
75 78 81 84 87 90 93 96 99 02 05 08 11 14

Source: Thomson Reuters Datastream, National Bureau of Economic Research

%
90

US manufacturing capacity utilisation rate

%
90

85

85

80

80

75

75

70

70

65

65

60

60
75 78 81 84 87 90 93 96 99 02 05 08 11 14

Source: Thomson Reuters Datastream, National Bureau of Economic Research

That view, in turn, might reflect the impact on supply performance of the financial crisis either in terms of
a drying-up of credit to start-up companies and otherwise rapidly-expanding smaller enterprises or,
instead, as a result of the creation of exceptionally easy financial conditions for large inefficient
companies, thereby limiting the impact of Schumpetarian creative destruction. Either way, a lower
long-term growth rate and associated weak productivity growth would imply a structurally lower level
of real interest rates, exactly what weve witnessed in the post-crisis world.

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A third reason for a lack of action and doubtless a big influence on central bankers tasked with meeting
inflation targets is the persistence of low inflation, measured in terms of both prices and wages.
Charts 11-13 show both headline and core consumer price inflation alongside wage growth in the US
since the mid-1970s, again with vertical lines representing the beginning of each cycle of monetary
tightening. There have been no occasions during which the Fed has raised interest rates when headline
inflation has been as low as it is today. There has been only one occasion when interest rates were raised
when both core inflation and wage growth were as low as they are today and that was at the beginning
of the last tightening cycle. And no one today including members of the FOMC expects interest rates
to rise as quickly or as far as was the case back then (chart 14). So long as inflation stays low and, in
particular, so long as inflation remains below target the case for aggressive monetary action within the
context of current central bank mandates appears to be weak. That message has only been reinforced by
the persistent habit in the post-financial crisis word for forecasters to over-estimate inflationary outcomes:
there is a lot less inflation out there than is commonly supposed (chart 15).
11. US headline inflation is non-existent
% yr
16

US headline inflation rate

% yr
16

14

14

12

12

10

10

-2

-2
70

73

76

79

82

85

88

91

94

97

00

03

06

09

12

15

Source: Thomson Reuters Datastream, National Bureau of Economic Research

12. Inflation is persistently low


% Yr
14

US core inflation

13. and so is wage growth


% Yr
14

12

12

10

10

0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

Source: Thomson Reuters Datastream, National Bureau of Economic Research

% Yr

US wage growth

% Yr

10

10

0
70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15

Source: Thomson Reuters Datastream, National Bureau of Economic Research


Note: Uses average hourly earnings (USD per hour) for all private sector workers since
2006 and average hourly earnings for production & nonsupervisory workers in the private
sector prior to this.

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14. The Fed expects higher rates than the market


%
7

Fed funds target rate and median FOMC dots projections

%
7

0
0
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jan-18

Fed funds target rate

2015 projections

2016 projections

2017 projections

Forward curve

Source: FRB, Thomson Reuters Datastream

15. Inflation has been lower than expected by the consensus in most major countries and regions
Index
10

Inflation surprise

Index
10

-10

-10

-20

-20

-30

-30
Jan-12

Apr-12

Jul-12

US

Oct-12

Jan-13

Eurozone

Apr-13

Jul-13

Oct-13

Japan

Jan-14
UK

Apr-14

Jul-14

Oct-14
Canada

Jan-15

Apr-15
Asia

Source: HSBC FX Quantitative Strategy

How to deal with the next recession


Low inflation, in itself, is absolutely no guarantee of lasting economic stability. The years before the global
financial crisis were labelled by many observers the Great Moderation, a period characterised by steady
declines in inflation and inflation expectations that supposedly ushered in a longer and smoother economic
cycle. They didnt. Even though inflation itself was mostly well-behaved, its good behaviour served only to
disguise the emergence of financial imbalances that ultimately proved to be incredibly destructive.
Today, inflation isnt just low. It is, arguably, too low. At the zero rate bound (admittedly now being
challenged in parts of Europe), the risk is that real debt levels begin to increase (or not fall as quickly as
desired), the real cost of borrowing begins to rise and, ultimately, economies are unable to recover on a
sustainable basis. Under this scenario, central banks will find it difficult to rebuild their conventional
monetary ammunition ahead of the next crisis. In effect, the world economy is sailing across the ocean
without any lifeboats to use in case of emergency. What should be done to avoid another costly collision
with an economic or financial iceberg?

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16. Headline inflation, at least, is mostly well below target


% Year
US
Japan*
UK
Eurozone

Headline inflation

Core inflation

0.0
1.6
0.0
-0.1

1.8
0.7
1.0
0.6

*National CPI excluding VAT effect. Japanese core CPI is "US style core" (ex food and energy)
Source: National sources Note: Inflation rates for March 2015

Try to avoid it
Higher levels of bank capital, greater liquidity buffers, more aggressive stress tests, macro-prudential
policies: each of these is designed to prevent a repeat of the global financial crisis. In meeting that
relatively narrow aim, they might well work. However, theres more than one crisis, more than one
recession. In the postwar period, recessions have been caused by exogenous shocks (1970s oil price
hikes), inflationary battles (the Volcker monetary tightening in the early 1980s), credit slumps (the early
1990s credit crunch) and the bursting of equity bubbles (2000). While it is tempting to believe that all
recessions have roughly the same causes, in reality they dont one reason why they are so difficult to
predict. A warning comes from the IMF in its latest Global Financial Stability Review: in Europe, the
challenges facing life insurers shouldbe tackled promptly. Regulators need to reassess the viability of
guarantee-based products and work to bring minimum return guarantees.in line with secular trends in
policy rates. Promptactions are needed to mitigate damaging spillovers from potential difficulties of
individual insurers. There is no shortage of systemic risks.
The danger for policymakers is not so much that they havent worked hard to prevent the next crisis but,
rather, they cannot easily know in advance what the next crisis might look like. Admittedly, they can at
least hope to make sure that the financial system itself will be more resilient in coming crises than it was
in the last crisis, but that doesnt alter the fact that all previous crises whatever their cause have been
accompanied by sustained easing of monetary and fiscal policy.
Table 16, for example, shows the extent to which US policy rates have fallen from peak to trough
across all downswings since the 1970s. On average, rates have fallen 6.2 percentage points. At a
minimum, they have fallen 5.0 percentage points. Other than the huge early-1980s decline as Paul
Volckers monetary medicine began to work, the amplitude of interest rate cycles has been remarkably
similar, even if the level of interest rates across cycles has varied: across all cycles, interest rates have
fallen between 5 and 6.25 percentage points. Today, they cant really fall at all unless we end up in a
world of increasingly negative nominal interest rates, a situation that might ultimately prove highly
damaging to the stability of the financial system if people increasingly chose to withdraw funds from
banks to store in the form of cash.

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17. US rates normally fall a long way during downswings now they cant (%)
End of easing
cycle

Policy rate at end of easing cycle

Rate at start of easing cycle

Decline in target rate since start of


easing cycle

4.75
11.00
8.00
5.88
3.00
1.25
0.25
-

11.00
16.50
19.00
11.44
8.00
6.50
5.25
-

-6.25
-5.50
-11.00
-5.56
-5.00
-5.25
-5.00
-6.22

July 1977
September 1980
February 1984
November 1986
January 1994
June 2004
December 2008
Average

Source: Thomson Reuters Datastream, HSBC, National Bureau of Economic Research

Use quantitative easing


If interest rates really cannot fall and traditional fiscal policy is constrained by either unusually large
deficits or uncomfortably high debt, one option would simply be to continue with quantitative easing.
This, after all, has been the Japanese experience: QE was first introduced by the Bank of Japan in 2001,
even if it wasnt quite embraced with the enthusiasm seen in both Japan and other countries in the
aftermath of the global financial crisis. Yet there is little evidence to suggest that this first QE experiment
achieved very much: if anything, it simply reinforced the perception that raising interest rates from zero
was more difficult than had originally been expected.
Today, there are potentially bigger difficulties. They relate, in part, to the extent to which equity markets
have advanced well beyond what might be justified by underlying economic fundamentals. Chart 18, for
example, shows the Shiller historic PE ratio going back all the way to the 19th century. On this measure,
current US valuations are incredibly stretched: indeed, only in the late-1990s during the tech bubble and
ahead of the 1929 crash were valuations even more stretched. Janet Yellen, Chair of the Federal Reserve,
is understandably a little worried: on 6 May she highlighted that equity market valuations at this point
generally are quite high. There are potential dangers there.
Admittedly, there are good reasons for equity valuations being higher than normal: interest rates are
incredibly low and the profit share in GDP is currently incredibly high. However, if interest rates are low
because the long-term growth outlook is discouraging and there is a paucity of investment opportunities,
the only fundamental way in which currently high PEs can really be justified is via a continued increase
in the profit share within GDP. Otherwise, stretched PEs are only likely to be sustained through
continuous addiction to quantitative easing and other related policies.

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18. Has QE shoved equity valuations up

19. or are investors anticipating even more in the way of


profit increases?

2011

2001

1991

1981

45
40
35
30
25
20
15
10
5
0

1971

1961

1951

1941

1921

1911

1901

1891

1881

1931

Shiller PE ratio

45
40
35
30
25
20
15
10
5
0

Source: Shiller Online data

%GDP
14

US profits as %GDP

%GDP
14

12

12

10

10

6
50 55 60 65 70 75 80 85 90 95 00 05 10 15

Source: Thomson Reuters Datastream, HSBC

This creates a tricky dilemma for central banks. Quantitative easing was adopted originally not only to
push up the value of financial assets but also to encourage higher levels of spending: households would
feel wealthier thanks to rising real estate and equity prices while listed companies would more easily be
able to raise funds for investment thanks to buoyant stock markets. To the extent that QE prevented a
1930s-style meltdown, that ambition might have been met. Policymakers, however, hoped not only to
avoid a depression but also to encourage a return to reasonable economic growth. That has proved more
difficult. Even the better economic performers notably the US have struggled to return to the growth
rates of old.
It may be that QE has merely driven a wedge between financial hope and economic reality. Worse, if the
next recession simply provokes more QE, are investors already beginning to believe that, once again, they
are to be continuous beneficiaries of what was once affectionately known as the Greenspan put? This
was the belief held most strongly during the late-1990s tech bubble that the Fed would stand ready
to offer support in the event of economic weakness, inevitably encouraging even more in the way of
risk-loving behaviour.
Knowing that central banks are potentially hooked on QE for the long term is, at best, likely to lead to the
mis-pricing of financial assets. That, in turn, might lead to a deterioration in the quality of investment
and, hence, lower productivity growth over the medium term. At worst, it may lead to a repeat of the
asset price bubbles that have proved to be so disruptive to economic activity. In the absence of
conventional policy ammunition, an addiction to QE could ultimately mean that the second great
depression was only postponed, not avoided altogether.

Move away from inflation targeting


Inflation targeting in theory offers precision, transparency and predictability. While that all sounds rather
marvellous, there is an obvious problem: if central banks only worry about inflation and not, for
example, about asset price bubbles the danger is that the rest of us start to take risks which ultimately
lead to the kinds of imbalances that preceded the onset of the global financial crisis. Put another way,
if nothing is expected to go wrong, it surely will go wrong.

10

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Its not just the financial crisis that demonstrates this problem. In the late-1980s, Japanese inflation was
mostly well-behaved: between 1985 and 1990, the average rate was a mere 1.1%. Judged on inflation
outcomes alone, it appeared that Japanese policymakers were doing a very good job. Indeed, given that
inflation was, on average, below the 2% rate which has become the inflation target du jour, it could be
argued that Japanese monetary policy was, if anything, too tight.
20. Japanese inflation was too low in the late 1980s even though monetary conditions were too loose
%Yr

Japanese inflation - national measure

%Yr

10

10

-2

-2
80

81

82

83

84

85

86

87

88

89

Source: Thomson Reuters Datastream

In hindsight, however, its clear that monetary conditions in Japan in the late-1980s were far too loose.
Inflation may have been quiescent, but equity and land prices were soaring, corporate debt was exploding
and monetary growth was through the roof. The absence of inflation merely camouflaged the underlying
imbalances emerging within the Japanese economy. Eventually, of course, the bubble burst, asset prices
collapsed, deleveraging began in earnest, monetary growth shrivelled and Japan succumbed to deflation
and, thereafter, to two lost decades.
Taking the Japanese experience and, indeed, the experience of the US in the years before the onset of
the global financial crisis it could be argued that central banks should stick to their inflation targets less
rigidly. There are times when an inflation rate higher than 2% might be perfectly acceptable. Equally,
there are times when an inflation rate significantly lower than 2% perhaps even a period of deflation
might be acceptable, notably during periods of excessive hot money inflows which boost both asset prices
and the value of the exchange rate (as happened in Japan in the late-1980s and may now be happening in
Sweden). What matters is not the inflation rate alone, but rather the inflation rate in the context of
broader measures of financial and economic instability. In Japans case, monetary policy in the 1980s
should have been tighter than it was, even if the inflation rate would have been even lower as a result.
Tighter monetary policy would have reduced the risk of asset price bubbles and credit booms. Ironically,
it might even have reduced the risk of deflation in the 1990s: a smaller asset price bubble would
presumably have led to a smaller asset price bust.
In the late-1980s, virtually all indicators suggested Japan should raise interest rates: money supply, credit
growth, asset prices, unemployment, a rapidly-narrowing balance of payments surplus and rapid
economic growth all suggested interest rates should be higher. Only the inflation rate suggested there was
no need to act. The situation today, however, is rather more ambiguous. The problem is not so much a

11

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disconnect between the inflation rate and all other indicators: it is, instead, a disconnect between growth
and inflation on the one hand and asset prices on the other. There is, if you like, both a real and a virtual
economy, and they are heading in different directions. Tighter monetary policy to deal with potential
asset price bubbles might simply intensify deflationary pressures or throw economies into recession
(as the ECB and Riksbank discovered having raised interest rates in 2011). Continuously loose monetary
policy designed to support growth and prevent inflation from falling too far might simply intensify asset
price bubbles, paving the way for eventual economic collapse.

Use fiscal policy instead of monetary policy


Traditional macroeconomic analysis particularly that based on a Hicksian IS/LM framework argues in
favour of fiscal activism, particularly in a world where interest rates are close to or at zero. If, in the
event of another recession, interest rates really cannot fall and QE threatens to drive an uncomfortable
wedge between the real and the virtual economy, fiscal policy would appear to be an obvious alternative.
Yet, as with monetary policy, its difficult to argue there is a great deal of flexibility on fiscal policy
unless, that is, governments are willing and able to tolerate deficits and debt levels far higher than seen in
the peacetime past. Yes, debt levels have been significantly higher in wartime, but wartime is very
different: market economies become siege economies, inflation pressures are hidden through rationing
and notably for those who end up in military service individuals are willing to make greater sacrifices
than normal for the good of the nation.
Charts 21 and 22 show the history of government debt in both the UK and the US going all the way back
to the 1700s. UK government debt has often been significantly higher than it is today, but in the early
days of Empire thanks to the booty associated with conquest it was a little easier to cope with the
servicing costs (in any case, the increases in debt in the 18th Century were mostly a reflection of an
absence of tax revenue: income tax was eventually introduced at a paltry rate by William Pitt the Younger
in 1798). In the US, however, debt levels are already very high relative to all periods other than the
Second World War and, according to the Congressional Budget Office, set to head a lot higher.
21. The history of UK public debt its been higher, but they were different times

UK public sector debt to GDP

The Congress of Vienna

300%

300%

The Battle of
Waterloo

The French Revolution

250%

World War 1 World War 2

250%

Income tax
introduced

200%

200%

150%

150%

100%

100%

50%

50%

0%

0%
1700

1725

1750

1775

1800

1825

1850

1875

1900

Source: Bank of England. Number since the global financial crisis include the debts of publically-owned financial institutions

12

1925

1950

1975

2000

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22. The history of US government debt unprecedented peacetime levels


%GDP

US Federal debt held by the public


The Great Depression

120

World War 1

Civil War

100

%GDP
Projections

World War 2

120
100

80

80

60

60

40

40

20

20
0

0
1790

1830

1870

1910

1950

1990

2030

Source: Congressional Budget Office

Those increases are, in effect, a consequence of claims already made on future economic production,
most obviously in areas associated with population ageing: pensions and healthcare. It is the same story
through much of the developed world. Government debt levels are set to rise rapidly as a share of GDP
even in the absence of another recession. Throw a recession into the mix and its a lot more difficult to
see how much cyclical fiscal flexibility there could be unless governments and voters are ultimately
willing to follow Japans path: slow growth thanks to an ageing population accompanied by eyewateringly high levels of government debt.
These future claims suggest the room for fiscal flexibility is a lot smaller than was the case in the 1930s
when Franklin Delano Roosevelt launched his New Deal. Back then, Roosevelt inherited a fiscal position
from Herbert Hoover that was relatively healthy: an insignificant deficit accompanied by government
debt that amounted to only 38% of GDP. Moreover, there were no significant future spending
commitments of the kind we see today. Fiscal stimulus a novel idea at the time may have been
controversial, but the chances of it working to boost economic activity were quite high given the healthy
starting position and an absence of future spending commitments. Today, it is much more difficult to
make the same argument. The best that can be said and this certainly chimes with the Greek experience
is that pursuing aggressive fiscal austerity in the midst of a deep recession is likely to end in tears. That,
however, is not an argument in favour of aggressive fiscal activism.

Use fiscal and monetary policy in conjunction with each other


When debt levels are low, interest rates are high and budget deficits are small, dealing with recessions is
relatively easy, even if preventing them in the first place is problematic. When debt levels are high,
interest rates are at zero and budget deficits are large, dealing with recessions is a lot more troublesome.
There is little room for policy adjustment and, given high levels of debt, policy multipliers are likely to be
either very small or totally non-existent. This suggests that high levels of debt need to be tackled directly.
One way to do this is to push asset prices higher in the hope that, by doing so, debts will be more
willingly held, balance sheets will look healthier and the pressure to deleverage will be reduced.
Quantitative easing has done precisely that but, as already noted, the increase in asset values has, to date,

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not translated fully into decent economic growth and higher inflation which, in turn, suggests it might
not be immediately effective in another downswing.
An alternative approach is simply to accept that debts are too high and that their value needs to be
reduced. There are many explicit ways of doing this ranging from default, public spending cuts and
punitive wealth taxes but there is also one much-used implicit way: the creation of inflation.
Despite huge amounts of monetary stimulus zero interest rates and quantitative easing so far there has
been little evidence that central banks have managed to push inflation higher on a sustained basis. True,
UK inflation was higher than expected in the years following the financial crisis but the rate subsequently
collapsed. Japanese inflation excluding the consumption tax - edged a little higher in the months
following the adoption of QE in 2013 but, more recently, has been heading lower again. If the aim is to
reduce the real debt burden via higher inflation, its clear that the policy has, so far, failed.
There is, however, a way of almost guaranteeing higher inflation. Its called helicopter money. It works only if
the fiscal and monetary authorities work together not only to expand the supply of money but also to guarantee
the extra money is spent rather than saved. The finance ministry announces a large increase in government
borrowing funded by bond sales not to the public but, instead, to the central bank. The newly-issued money is
then used to provide a monetized tax cut or increase in public spending. In other words both the supply of
money and its velocity rise, virtually guaranteeing an acceleration in the growth rate of nominal GDP. The
likelihood in the short term would be a rise in both prices and quantities.
If, however, the benefits of this policy are so blindingly obvious, why has no government or central bank
so far fully gone down this irresponsible path? The answer is simple. Monetized deficit financing can
all too quickly lead to a loss of faith in the integrity of a countrys monetary and financial institutions.
The risk is a mixture of currency collapse on the foreign exchanges and, eventually, a revulsion towards
money that would create a world of hyperinflation. Preserving the integrity of our monetary and financial
institutions is an important public good: risking another 1920s Weimar or modern-day Zimbabwe doesnt
make a whole lot of sense (chart 23).
23. No one wants a Zimbabwe
Zimbabwe inflation rate
250000000%

250000000%

200000000%

200000000%

150000000%

150000000%

100000000%

100000000%

50000000%

50000000%

0%

0%
99

00

01

Source: The Zimbabwe National Statistics Agency

14

02

03

04

05

06

07

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Economics
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13 May 2015

Facing reality: creating conditions in which ammunition can be rebuilt


Ideally, policymakers need more in the form of conventional policy ammunition. As yet, they dont have
it. Those who have tried to rebuild their ammunition have failed: rate increases have been followed by
rate reductions, deficit reduction plans have largely gone unmet and, where governments have been
forced to deliver aggressive austerity, the output losses have been unacceptably large. Policymakers need
some new lifeboats to deal with the next recession but their attempts to build these lifeboats are in danger
of causing the next recession.
The challenge, then, is to find a way of building lifeboats without threatening another economic
downswing. To do so will require acts of political bravery. There has to be a reason for higher interest
rates and, if it isnt a decent economic recovery, it needs to be something else. Persistently low interest
rates in a simple sense represent an excess of savings over investment. Raising investment has, to date,
proved problematic, at least in the developed world. Companies may be profitable but have preferred to
hoard cash than take risks with capital spending. Meanwhile, attempts by governments to bring deficits
under control have tended to have a bigger negative impact on capital than on current spending.
A better option might be to reduce savings. Falling interest rates are not just the result of central bank
policy. Indeed, central banks are often merely rubber stamping forces beyond their control. One of
those forces is an ex-ante excess of savings.
Ben Bernanke the former Chairman of the Federal Reserve famously once talked about the global
savings glut, a story loosely linked to the idea that some countries had excessively high savings, leaving
them with large balance of payments current account surpluses and, hence, huge capital outflows. Some
elements of that glut have now disappeared: the Chinese current account surplus has tumbled, the
Japanese now have a current account deficit and on the other side of the equation the US has a much
smaller current account deficit. Despite these developments, however, interest rates have remained very
low by past standards (chart 24).
24. The global savings glut looks smaller today

USDbn
500
400
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
00

Current account

01

02
US

03

04

05

06
China

07

08

USDbn
500
400
300
200
100
0
-100
-200
-300
-400
-500
-600
-700
-800
09
Germany

10

11

12

13

14

Japan

Source: HSBC, National sources

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13 May 2015

One possible explanation for the persistence of structurally-low interest rates is that the Eurozone has
replaced China and Japan as the saver of first resort: an ever-larger German current account surplus has,
more recently, been accompanied by smaller deficits and even surpluses in austerity-hit southern Europe.
Even this, however, doesnt quite capture the underlying problem: after all, balance of payments positions
are merely accounting identities which say nothing about the level of interest rates required to make sure
the numbers add up.
A more fruitful explanation which certainly ties in with German savings behaviour is that nations with
ageing populations are full of people keen to postpone expenditure from the present to the future, in the hope
that they will be able to enjoy a long and rich retirement. Each person has an intuitive sense of the required
amount of financial wealth. Yet thanks to peoples collective savings behaviour, their individual wealth
targets remain out of reach: the more they save, the more interest rates fall; the more interest rates fall, the
lower the returns on their wealth; and the lower the returns on their wealth, the more they have to save.
The underlying problem is that countries with ageing populations tend to suffer from slower growth yet to
pay for all the extra retirees the countries need to have faster growth. If returns on investment are simply
not high enough, all the extra saving will simply reduce interest rates to pitifully low levels, leading for
example to remarkably low returns on annuities.
To break out of this vicious circle, the easy answer economically, at least is for the retirement age to rise.
This would, at a stroke, reduce the need for high savings. Faced with a longer period of work and, hence,
of earned income the need to save to meet a retirement nest-egg objective would be greatly reduced.
Lower levels of savings would mean higher levels of consumption, higher levels of demand and, hence
higher levels of investment. Importantly, faster economic growth would also provide higher tax revenues
and higher interest rates. The ammunition needed to repel the next recession would be replenished.
Unfortunately, the chances of such radical reforms emerging are low. Political expediency because
older people tend to be more willing to vote than the young will doubtless trump economic necessity.
As a result, the recession-fighting ammunition will remain in short supply and the risks of a major
economic contraction will be that much greater. We will carry on sailing across the ocean in a ship with a
serious shortage of lifeboats. Many including the owner of the Titanic thought it was unsinkable: its
designer, however, was quick to point out that She is made of iron, sir, I assure you she can.

..and the likely cause of the next recession?


Finally, it may seem that the global financial crisis was only a short while ago but we are now six years
into economic recovery, at least in the US. Recessions dont come along like clockwork but,
nevertheless, history suggests that we are now closer to the next recession than the last one. We may not
know what will cause the next downswing but, at this stage, we can categorically state that, in the event
we hit an iceberg, there arent enough lifeboats to go round.
As for possible causes of the next recession, the best that can be offered is a list of possible suspects.
Given that recessions are triggered for all sorts of reasons and mostly arrive unannounced, it would be
foolish to claim that the list of suspects is anything but speculative and incomplete. Still, to end on a
less-than-cheerful note, here are those suspects:

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Higher US wage costs alongside continued weak productivity growth leading to a falling profit share
within US GDP, triggering a collapse in equity prices, a loss of confidence among both households and
businesses and, thus, another economic contraction. Put another way, another equity bubble bursts.
A series of increasingly-systemic failures within the non-bank financial system as both pension funds
and insurance companies find themselves increasingly unable to meet their future liabilities: those
failures, in turn, trigger a huge increase in demand for liquid assets, leading to panic selling and,
eventually, a collapse in demand that paves the way for a recession.
A recession made abroad, not at home: the Chinese economy weakens so much that the authorities in
Beijing have no choice other than to let the renminbi slide. Collapsing commodity prices lead to
severe weakness elsewhere in the emerging world. The dollar surges, but the Fed is unable to
respond via interest rate cuts. The US is eventually dragged into a recession through forces beyond
its control.
The Federal Reserve raises interest rates too soon, in a bid to normalise monetary policy. The
monetary tightening itself reveals the fragile nature of the recovery and the economy quickly goes
into reverse: in effect, the Fed repeats the mistake of the ECB in 2011 and the BoJ in 2000.
And, to make matters worse, these suspects are not mutually exclusive.

17

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Disclosure appendix
Analyst Certification
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opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their
personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific
recommendation(s) or views contained in this research report: Stephen King

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Additional disclosures
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This report is dated as at 13 May 2015.


All market data included in this report are dated as at close 11 May 2015, unless otherwise indicated in the report.
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[460502]

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Global Economics Research Team


Daniel John Smith
+612 9006 5729

daniel.john.smith@hsbc.com.au

Li Jing
+86 10 5999 8240

jing.econ.li@hsbc.com.cn

Karen Ward
Senior Global Economist
+44 20 7991 3692
karen.ward@hsbcib.com

Prithviraj Srinivas
+91 22 2268 1076

prithvirajsrinivas@hsbc.co.in

James Pomeroy
+44 20 7991 6714

Europe & United Kingdom

Murat Ulgen
Global Head of Emerging Markets Research
+44 20 7991 6782
muratulgen@hsbc.com

Janet Henry
Chief European Economist
+44 20 7991 6711
janet.henry@hsbcib.com

Bertrand Delgado
Senior EM Strategist
+1 212 525 0745
bertrand.j.delgado@us.hsbc.com

Fabio Balboni
European Economist
+44 20 7992 0374
fabio.balboni@hsbc.com

Jessica Wu
EM Strategist
+852-2822 4337

Simon Wells
Chief UK Economist
+44 20 7991 6718
simon.wells@hsbcib.com

CEEMEA

Global
Stephen King
Global Head of Economics
+44 20 7991 6700
stephen.king@hsbcib.com

james.pomeroy@hsbc.com

Elizabeth Martins
Economist
+44 20 7991 2170

liz.martins@hsbc.com

Germany
Stefan Schilbe
+49 211910 3137

stefan.schilbe@hsbc.de

Rainer Sartoris
+49 211910 2470

rainer.sartoris@hsbc.de

France
Mathilde Lemoine
+33 1 4070 3266

mathilde.lemoine@hsbc.fr

Francois Letondu
+33 1 4070 3933

francois.letondu@hsbc.fr

North America
Kevin Logan
Chief US Economist
+1 212 525 3195
kevin.r.logan@us.hsbc.com
Ryan Wang
+1 212 525 3181

ryan.wang@us.hsbc.com

David G Watt
+1 416 868 8130

david.g.watt@hsbc.ca

jessica.m.wu@hsbc.com.hk

Simon Williams
Chief Economist, CEEMEA
+44 20 7718 9563
simon.williams@hsbc.com
Alexander Morozov
Chief Economist, Russia and CIS
+7 495 783 8855
alexander.morozov@hsbc.com
Artem Biryukov
Economist, Russia and CIS
+7 495 721 1515
artem.biryukov@hsbc.com
Agata Urbanska-Giner
Economist, CEE
+44 20 7992 2774
agata.urbanska@hsbcib.com
Melis Metiner
Chief Economist, Turkey
+90 212 376 4618
melismetiner@hsbc.com.tr
David Faulkner
Economist, South Africa
+27 11 676 4569
david.faulkner@za.hsbc.com
Razan Nasser
Economist, Middle East and North Africa
+971 4 423 6928
razan.nasser@hsbc.com

Latin America

Asia Pacific
Qu Hongbin
Managing Director, Co-head Asian Economics Research and
Chief Economist Greater China
+852 2822 2025
hongbinqu@hsbc.com.hk
Frederic Neumann
Managing Director, Co-head Asian Economics Research
+852 2822 4556
fredericneumann@hsbc.com.hk
Paul Bloxham
Chief Economist, Australia and New Zealand
+612 9255 2635
paulbloxham@hsbc.com.au
Pranjul Bhandari
Chief Economist, India
+91 22 2268 1841
pranjul.bhandari@hsbc.co.in
Izumi Devalier
+852 2822 1647

izumidevalier@hsbc.com.hk

Su Sian Lim
+65 6658 8783

susianlim@hsbc.com.sg

Sophia Ma
+86 10 5999 8232

xiaopingma@hsbc.com.cn

Ronald Man
+852 2996 6743

ronaldman@hsbc.com.hk

Trinh Nguyen
+852 2996 6975

trinhdnguyen@hsbc.com.hk

John Zhu
+852 2996 6621

john.zhu@hsbc.com.hk

Joseph Incalcaterra
+852 2822 4687
joseph.f.incalcaterra@hsbc.com.hk
Julia Wang
+852 3604 3663

Global Emerging Markets

juliarwang@hsbc.com.hk

Nalin Chutchotitham
+662 614 4887
nalin.chutchotitham@hsbc.co.th

Andre Loes
Chief Economist, Latin America
+55 11 3371 8184
andre.a.loes@hsbc.com.br
Argentina
Javier Finkman
Chief Economist, South America ex-Brazil
+54 11 4344 8144
javier.finkman@hsbc.com.ar
Ramiro D Blazquez
Senior Economist
+54 11 4348 2616

ramiro.blazquez@hsbc.com.ar

Jorge Morgenstern
Senior Economist
+54 11 4130 9229

jorge.morgenstern@hsbc.com.ar

Brazil
Constantin Jancso
Senior Economist
+55 11 3371 8183

constantin.c.jancso@hsbc.com.br

Central America
Lorena Dominguez
Economist
+52 55 5721 2172

lorena.dominguez@hsbc.com.mx

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