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CONSTANTIN VAYENAS
Until last year, the word “trillion” rarely crossed our lips. Even economists had little occasion to use it. But now we hear it everywhere we turn. From the trillions of dollars in financial-sector write-downs to the trillion-plus budget deficit and the trillions added to central banks’ balance sheets, “Trillion is the new billion,” as the saying goes. At least linguistically, inflation is on the rise.
While it is still too soon to say that the financial crisis has been vanquished, the efforts of governments to combat it are truly astonishing. A few weeks ago, the Fed announced that it intends to swell its balance sheet by more than a trillion dollars to buy mortgage-backed securities, agency bonds, and, for the first time since the 1960s, Treasury bonds. In sum, these measures will more than triple the US monetary base from its September 2008 level, which boggles this writer's mind. We are in new territory here, undertaking a reflationary experiment on a scale never before applied in developed countries.
With the news flow relating to the financial crisis and the economic downturn still intense, it is difficult – but vital – to take a step back and analyze the long-term implications of the crisis and the various government interventions it has spawned. This is what we have done in our new UBS research focus: “The financial crisis and its aftermath.”
The conclusions of this in-depth study are rather sobering. In the aftermath of the crisis, a new economic era is taking shape. In short, the patterns and drivers of growth and inflation over the last twenty-five years look certain to change over the next twenty-five years.
Falling trade barriers, increased international capital flows, and the spread of private-sector activities produced enormous benefits for the world economy in the last quarter century. At the same time, however, these burgeoning international trade and capital flows became increasingly unstable. Restoring sustainable economic growth will not be easy.
Even before the crisis hit, demographic forces were already pointing to both slower long-term economic growth and greater pressure on government finances. In the aftermath of the crisis, the unwinding of household and corporate balance sheet leverage, as well as heightened regulation we expect, are likely to slow economic activity even further. The state is already playing a much bigger role in economic affairs than it did before the crisis and it is unlikely yield center-stage after the situation stabilizes.
We therefore expect public-sector imbalances to grow steadily as countries grapple with tough choices over potential spending cuts or higher taxes. In this context, inflation could become an expedient tool for policymakers to redistribute the burden of high levels of private and public debt. Finally, protectionism looms as a regrettable knee-jerk reaction during times of economic upheaval.
For investors, two important truths are clear: the past two years, since the financial crisis began, should not be taken as a benchmark for the future. Nor should the past twenty-five years.
Dr. Constantin Vayenas is Head Emerging Market Research at UBS Wealth Management Research.
