Capital misallocation and productivity are the dark and the light sides of the economic force. The battle is eternal, and the latest episode is epic.
Sundays are for movies. Faced with a difficult existential choice—between watching Wong Kar-wai’s masterpiece 2046 and the pandering and somewhat vacuous Star Wars—there could only be one winner: Star Wars. It ticked most boxes—a revival of the original story, a Game-of-Thrones-style execution (you’ll be shocked!) and the juicy promise of a sequel.
What really didn’t work at all, however, (spoiler alert!) was that the young “new Luke” first mentally and then physically defeated the “new Darth Vader’” with absolutely no training. Very weak. Luke, back in the day, had to cross star systems to find Yoda and train long and hard to get even halfway there.
And that sets up the geeky, real world analogy: Capital misallocation and productivity are the economic equivalents of the dark and the light side. The battle is eternal, and the latest episode is epic. But here, in the real world, productivity won’t gain the upper hand quite that easily.
We’re in the fourth wave of global rebalancing now. Each wave has shocked global growth and raised the specter of a global recession. The unwinding of the US housing boom, Southern Europe’s excess, and Japan’s slow return to capital expenditure—the shocks from all three past capital misallocations are now mostly behind us. The only one left? The “Great Emerging Market Unwind,” which puts China/EM center stage.
But, while China/EM clearly needs to be the focus now, markets are being forced to reassess what I believe is a paradigm shift in monetary easing. G3 central banks—the Bank of Japan, the European Central Bank, and the Federal Reserve—are not ready, at least not at this point, for aggressive easing because their respective economies have adjusted a fair bit already. Markets haven’t loved the incremental steps that have replaced their bazooka expectations.
I recently argued that central banks have new tools to ease, but did not expect the BoJ to introduce one of those tools just yet, even if in a small step. A bigger move with a new tool needs to have a higher threshold for G3 central banks and, perhaps, this one is designed to tell markets: “We can do quite a bit.”
Concerns about China and it renminbi currency, also known as the yuan, are valid. What’s striking, however, is that a paltry depreciation of the renminbi since August has created such concern globally, while huge policy-driven weakness in the dollar, euro and yen, in their respective time frames, were almost cheered on. Why? What was different?
The crucial difference has more to do with domestic than global impact. Central-bank-engineered weakness in dollar, euro and yen were part of a package that also stabilized macro conditions at home, and supported domestic asset prices. However, if China allows its currency to weaken while domestic conditions are improving, our guess is that renminbi depreciation would be viewed far more favorably and would happen much more smoothly.
Where does this leave emerging markets? In the middle of a final and painful stage of adjustment. Reluctant G3 central banks and China downside risks will likely deepen, but perhaps quicken that adjustment. EM-like EM economies (high inflation, current-account deficits) should adjust faster because markets can enforce it. Developed-market-like North Asia economies (disinflation, current-account surpluses) can resist markets considerably and, therefore, adjust at a slower pace.
But the adjustment is coming—we believe that India, Indonesia, Mexico and even Russia have already inflected. Brazil has more pain to go, but even that saga cannot last forever.
Does this raise the risk of a global recession? Yes. Fourth-quarter data were flat at low levels in EM, a touch weaker in China and notably weaker in the US. But let’s consider two offsets.
- First, if US/DM trend growth is now—let’s say—1.5% a year instead of 3% a year, a recession is twice as likely to materialize, but it may not have the same punch as before.
- Second, housing is the business cycle, as the economist Edward Leamer has argued. Resilient US/DM housing markets, ironically supported by lower yields from the China/EM disinflationary shock, could prevent a recession, or keep it shallow—just as Japan’s slowdown last year left labor markets mostly intact. If the housing market turns, all bets are off—but we’re not there right now.
For now, productivity remains harder to come by than our young protagonist’s climbing of the Jedi ladder. What is reassuring, however, is that both will eventually win.