RIYADH, 12 June 2006 — Warnings on inflation from the US Federal Reserve plus interest rate hikes from around the world threw shudders into global financial markets that the cost of borrowing is rising across the world at a time when the major economies maybe slowing down.
Five central banks raised interest rates last week, including South Korea, India and South Africa, and the US Fed and the ECB are set to raise rates again in their upcoming meetings.
Is this the end of the global liquidity boom that has been in place since early 2000 to counteract the previous recession? The key question is the timing of the almost certain moves by global central banks, particularly, the US Fed and the European Central Bank. Some economists and analysts are also questioning whether: (1) major central banks like the Fed and the ECB have gone too far in engendering a massive global liquidity boom and then busting it equally rapidly with inflation as their sole objective (more generally, have central banks become too much of inflation fighters without regards to economic growth), and (2) the current global wisdom of economic policy-making with only one leg, i.e. monetary policy.
The International Herald Tribune wrote, “(The) golden age of liquidity is drying up... It is not just money that makes the world go round. To cash, add credit and related financial instruments. That equals liquidity, the lifeblood of financial markets.”
“Liquidity surged in the past decade, fueled by relaxed monetary policies of central banks, globalization, new technologies and such exotic financial instruments as derivatives. They in turn drove down interest rates and bond yields and encouraged investors to pump more money into assets.” Rising assets prices, which means rising financial wealth, combined with record borrowing, fueled a consumption-driven spending spree that has helped the global economy to turn around from its 2000 recession.
A rapid/steep reversal in the opposite direction will engender a global reduction in spending on financial and real assets (stocks, bonds, housing, real estate, etc) as well as in consumer goods and services (food, clothing, electronics, travel and entertainment, etc).
While this does not necessarily lead to a recession, the key question in many people’s mind is the timing of the reversal (how long and how steep) — is it coming on top of an on-going economic/demand slowdown in the face of one-and half-years of rising US interest rates and high oil prices?
The second issue in the view of some economists is that the world has lost its nerve to use government spending as a policy tool to support economic growth. Since the mid-1980s, “fiscal policy” has fallen out of fashion as a tool to encourage economic growth, despite experience to the contrary in Japan, Singapore, Malaysia, India China and the GCC-Middle East.
Even in the Western world, e.g. in the US during the Reagan-era, government spending had a huge impact on US economic activity. In the past, governments often used fiscal policy to cushion the economy from the impact of recessionary forces.
Today, while monetary policy reigns supreme, it seems that the only policy goal of governments in advanced economies is “fighting inflation,” and letting the chips fall as they may vis-à-vis economic growth.
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)
