The glue keeping things together

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By Cees Bruggemans, Chief Economist of FNB.

With serial shocks pummeling financial markets and global economy, the inclination is to read downside in every incoming salvo.

Event risk certainly is a negative for system performance, be it higher oil prices (income erosion), debt default or bank failure shocking confidence and inciting risk-averse reactions.

Yet there is a greater glue that keeps things together and should be given its full due rather than be taken for granted, or (worse) imagined to be a very weak force.

Capitalist incentives (business profits, asset price gains, labour wages, bonus culture) are powerful levers, keeping people inclined to seek out opportunity and acting thereupon.

With governments being powerful regulators and having control over massive shock absorbers (fiscal and monetary policy, meaning state spending and taxing powers, and interest rates and the exchange rate), capitalist market systems are highly flexible and adaptable to change, any change, including abrupt shock treatment.

That well-honed market production system in turn plays consumer wants and needs like so many violins, creating powerful temptations that induce to consume nearly all income, and then some.

For better or worse, that is how most economies are constituted today. The power of these many glues remind of gravity in nature.

On an average day, sitting on your stoep with a view over city or ocean, it is hard to believe that the entire lot is moving at 300m/s in a due easterly direction without so much a hair out of place, making a full earthly resolution every 24 hours.

That’s power.

True, nature does throw curved balls, like volcanic eruptions, hurricanes, earthquakes, tsunamis, even tectonic movements pushing up mountain ranges, but these tend to move the earth only in very limited localized fashions.

Meteorites 10km or more in diameter are another proposition altogether. Getting kissed by one of those babies does tend to rearrange earthly furniture for longer, but even then eventually gravity resurrects its power over everything.

Something similar operates within large market systems populated with many and large players, on which incentive and state influence works like gravity does in nature, keeping things in place rather than allowing everything to fly apart at the merest touch.

The financial crisis impact of 2008 was the biggie that weakened banks and consumers, inviting deleveraging. But that is mostly absorbed as policy compensated.

The growth recovery story in rich developed countries with large output gaps (large unemployment and slack capacity) is well-vested, with large-scale support from governments through a combination of deficit spending, low interest rates, asset buying and/or currency depreciation.

Where some such emergency policy actions have started to be reversed (fiscal austerity), the other policy levers carry a greater burden (currency depreciation) and/or the economy’s natural recuperative powers are coming back more fully.

The growth expansion in most emerging markets and commodity producers was never as badly hit as it was in the rich countries. The growth dynamic of many such countries remains fully operational, in addition to which many such governments also ensured supportive policy stances which are only gradually being withdrawn.

Indeed, in many of the latter countries output gaps have closed sufficiently for underlying inflation to be rising, further worsened by commodity price surges, and increasingly needing urgent countervailing attention.

This is not a world devoid of growth, even if it progresses unevenly at times.

In weighing up shock impact (higher priced oil, food price surges, debt fears, Japanese industrial disruption) one needs to consider short-term issues (Japan), risk distortions (debt) and income erosion (oil, food) and ask how successful this could be in unsettling the larger global market economy engine.

The global expansion that commenced in 1Q2009 looks good for many years still, if with course corrections, mainly policy exits (‘normalisation’) first and eventually even tempering actions when output gap strains become too big.

Any new shocks in between will probably be flexibly absorbed (mainly by tweaking policy levers anew).

This statement in no way belittles the seriousness of Europe’s banking problems and its many existentialist challenges, nor the complexity of the Arab world’s current attempts at institutional renewal and what this may mean for oil supply security. America’s challenges are similarly huge.

Yet we may just find that besides at times violently impacting on various markets, the bigger picture does not ultimately get unhinged (or unsaddled) that easily.

Not even the financial crisis of 2008 came close to doing that in retrospect (though for those at ground zero it must have felt different at times). Just shows up the importance of adequate policy response, something that often takes much time to fully play out.

In the case of Anglo-Saxon banks it is “too big to fail” that remains an issue. In Europe one may query just how adequate the reform approach really is. The Arab world faces political choices with uncertain outcomes. And the US will need to show it has a clear picture of its future and the will to achieve it.

Meanwhile globally it remains a growth decade, with inflation to be kept down rather than starting to run away or falling into deflation.

It is supposed to be a recovery story and it will remain all of that in the rich half of the world this decade.

For the other half of the world, the emerging growth story remains a given, with the focus increasingly on keeping inflation within bounds.

All of this is also definitive for South Africa, supporting our growth, trade and capital flows, allowing us to proceed unmolested with our 21-month expansion.

Our main performance constraint already for a decade is therefore internal, not external (except for that fearful 4Q2008).

We, too, continue to face inner challenges as big as they come, with too slow growth, huge disparities in skills and opportunity and many political agendas complicating a successful breakout.

Source: Cees Bruggemans, FNB, May 4, 2011.

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