Sun, Jan 03, 2016 page9

• This year will light a fuse on an imminent economic explosion

  Oil prices, China and Brazil are likely to influence the international economy’s drift toward another crisis next year, but the real pain is likely to come later

  • By Larry Elliott / The Guardian
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  Economic forecasting is a mug’s game. One thing that has been learned from the financial crisis and Great Recession is that even those equipped with the most sophisticated models get it wrong, sometimes spectacularly.

  So it is with both humility and trepidation that I will try to fulfill the promise made two weeks ago and make predictions for what is going to happen this year. In all honesty, the future is unknowable and anybody who says otherwise is lying.

  So, with that health warning, here is what I think might happen.

  At some point, a recovery built on booming asset prices, weak growth in earnings and rising personal debt is going to lead to another huge financial crisis. However, not in the next 12 months.

  Instead, this year would be the year of living dangerously, a year of papering over the cracks, a year of buying time before all the old problems resurface.

  Here is why. The big story of the past month has been the collapse in oil prices, which has taken the price of crude back to levels last seen in 2004. This has two beneficial effects for the international economy: It provides additional spending power for the households and businesses that consume energy, and it bears down on inflation.

  There is always a bit of a delay between oil prices falling and spending going up in response, in part because people want to be sure that the lower costs are going to stick. However, it is now 16 months since crude began its decline from an August 2014 peak of US$115 per barrel and there is a good chance they would fall a bit further from their current level in the mid-US$30 per barrel range. With no sign that the OPEC oil cartel has the political will to agree to production curbs, it is quite possible that prices could fall below US$30 per barrel in the early months of this year.

  The impact of that would be to keep inflation lower than any of the world’s major central banks are anticipating. Policymakers at the US Federal Reserve, the Bank of England and the European Central Bank (ECB) insist they “look through” rises and falls in oil and other commodity prices, and make their interest rate judgments on the basis of what is happening to core inflation, which excludes energy and food costs.

  However, it is harder to raise interest rates if, for whatever reason, inflation continues to undershoot official forecasts. More importantly, there is evidence a fall in inflation caused by cheaper oil has an effect on wage bargaining.

  When, in the pre-crisis years, UK inflation was regularly hitting the government’s 2 percent target employers used to offer pay awards of 4 percent. Now that inflation is zero they see no reason to offer more than 2 percent.

  That matters, because central banks are looking for signs of wage inflation picking up as a result of years of steady growth and falling unemployment. If wage inflation does not go up, there is less of a reason to raise the cost of borrowing.

  So, prediction number one for next year is that both inflation and interest rates are likely to stay lower for longer than currently anticipated.

  The US Fed raised interest rates for the first time in almost a decade earlier last month, but is likely to be extremely cautious about its next move. The Bank of England is also likely to hold off from its first move. Cheap money would boost both borrowing and — for a time — growth.

  The next theme of this year would be China, where the question is not whether the pace of growth would slacken, but by how much. Expert opinion differs about the state of the world’s second-largest economy: Some analysts say Beijing has everything under control, others that the nation is already having a hard landing from years of overinvestment in unproductive manufacturing plant and speculative real estate.

  It is hard to know for sure exactly what is happening in China, a big nation with a reputation for unreliable economic statistics. Official data show the economy is growing by 7 percent a year, yet data for electricity consumption and rail freight suggest the actual figure is lower.

  However, whereas official interest rates are zero — or thereabouts — in the major developed nation of the West, in China they are still above 4 percent. This gives the People’s Bank of China scope to cut the cost of borrowing if it wants to stimulate growth, a scope it would almost certainly use if the government thinks the economy is slowing too rapidly.

  The exchange rate can also be cut to make Chinese exports cheaper. China also has the option of raising public spending.

  The risk, of course, is that China cleans up the mess caused by one collapsing bubble by inflating another, which is what former US Fed chairman Alan Greenspan did in the early 2000s.

  Here, then, is a second prediction. China will slow this year, but policy easing would prevent a collapse. Over the past six years, the eurozone has shown an unerring ability to snatch defeat from the jaws of victory. Every time the crisis has appeared to be over, something nasty has happened. This year, that “something” could be Greece, caught in a debt and austerity trap, it could be rudderless Spain, it could be moribund France.

  However, there are a couple of reasons why the eurozone might stumble through to next year before there is fresh trouble. The first is that the eurozone would benefit from the delay in tightening policy in the US and the UK, and from the pro-growth measures in China. The second is that the ECB would keep using quantitative easing in the hope that an increase in the supply of money would get the banks lending.

  The ECB is also keen to drive down the value of the euro to boost exports, although this might prove more difficult if the US Fed raises interest rates more slowly than the markets currently expect. There is a good chance the US dollar will fall rather than rise against the euro.

  The biggest immediate risk to the international economy comes from the emerging world, especially those parts of it affected by the crash in the cost of commodities.

  Brazil is the country to watch out for. It is the largest economy in Latin America and in serious trouble. The economy is contracting at its fastest rate since the 1930s, inflation is above 10 percent, the currency has collapsed and the Minister for Finance has just resigned. A visit from the IMF may be unavoidable.

  This is a case of history threatening to repeat itself, because the buildup to the 2008 crisis began on the periphery of the international economy. So, here is my final prediction: There will be no explosion this year, but a fuse will be lit.

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