What looked liked a gentle tap on the brakes by the two monetary superpowers has proved too much for a fragile world economy, still locked in “secular stagnation”.
The latest investor survey by Bank of America shows that fund managers no longer believe the European Central Bank will step into the breach with quantitative easing of its own, at least on a worthwhile scale.
Markets are suddenly prey to the disturbing thought that the five-and-a-half year expansion since the Lehman crisis may already be over, before Europe has regained its prior level of output.
That is the chief reason why the price of Brent crude has crashed by 25pc since June. It is why yields on 10-year US Treasuries have fallen to 1.96pc, and why German Bunds are pricing in perma-slump at historic lows of 0.81pc this week.
We will find out soon whether or not this a replay of 1937 when the authorities drained stimulus too early, and set off the second leg of the Great Depression.
If this growth scare presages the end of the cycle, the consequences will be hideous for France, Italy, Spain, Holland, Portugal, Greece, Bulgaria, and others already in deflation, or close to it. The higher their debt ratios, the worse the damage.
Forward-looking credit swaps already suggest that the US Federal Reserve will not be able to raise interest rates next year, or the year after, or ever, one might say. It is starting to look as if the withdrawal of $85bn of bond purchases each month is already tantamount to a normal cycle of rate rises, enough in itself to trigger a downturn. Put another way, it is possible that the world economy is so damaged that it needs permanent QE just to keep the show on the road.
Traders are taking bets on capitulation by the Fed as it tries to find new excuses to delay rate rises, this time by talking down the dollar. “Talk of ‘QE4’ and renewed bond buying is doing the rounds,” said Kit Juckes from Societe Generale.
Gentle declines in the price of oil are typically benign, a shot in the arm for companies and consumers alike. The rule of thumb is that each $10 drop in the price adds 0.3pc to GDP growth over the next year.
Crashes are another story. They signal global stress, doubly dangerous today because the whole industrial world is one shock away from a deflation trap, a psychological threshold where we batten down the hatches and wait for cheaper prices. That is the Ninth Circle of Hell in economics. Lasciate ogni speranza.
The world is also more stretched. Morgan Stanley calculates that gross global leverage has risen from $105 trillion to $150 trillion since 2007. Debt has risen to 275pc of GDP in the rich world, and to 175pc in emerging markets. Both are up 20 percentage points since 2007, and both are historic records. The Bank for Settlements warns that the world is on a hair-trigger. The slightest loss of liquidity can have “violent” effects.
Saudi Arabia has clearly shifted strategy, aiming to force high-cost producers out of business across the globe, rather than defend OPEC cartel prices by slashing its own output to offset rises in Libyan supply. Bank of America thinks the Saudis are targeting $85 a barrel, partly in order to squeeze three enemies, Iran, Russia, and the Caliphate.
If crude prices stay low for long, almost all the major oil producers will have to start dipping into their foreign reserves to fund their welfare states and military apparatus. The “fiscal break-even” price needed to cover the budget is $130 for Iran, $115 for Algeria and Bahrain, $105 for Iraq, Russia, and Nigeria, and almost $100 even for Abu Dhabi. The Saudis themselves are probably well above $90 by now.
This means that they will have to sell holdings of foreign bonds, assets, and gold to plug the gap. Russia has run through $7bn in recent days defending the rouble. The scale of this could be huge, and it comes at a time when China has stopped accumulating reserves for its own reasons, taking away the biggest global source of fresh purchases.
Nor does the chain reaction stop there. Lower prices chill the US shale industry, which has lifted US (liquids) output from 7m barrels a day (b/d) to 11.6m since 2008, and turned America into the world’s biggest producer. Bank of America says the pain starts at around $75 for the most costly fields. “Shale oil output is very sensitive to price conditions,” it said.
The US Energy Department says oil and gas companies have been amassing huge debts drilling for marginal output in ever more hostile regions. Net debt rose $106bn in the year to March, on top of $73bn of asset sales. Yet revenues were stagnating even when crude prices were above $100. The fossil fuel nexus has spent $5 trillion since 2008, and much of this is at risk. It has in itself become a systemic threat.
Yet the oil crash is not merely a supply story. “There has been a rapid collapse of demand,” said Edwin Morse from Citigroup. The International Energy Agency says demand fell by 50,000 b/d in France, and 45,000 b/d in Italy in August, below earlier estimates. China’s oil demand is no longer rising by half a million b/d each year. It has slowed to a quarter a million.
The global slowdown has caught the global authorities off guard, as it always does. Above all, it has confounded the central banking fraternity. In thrall to “creditism”, it insists that QE works by forcing down interest rates across the maturity curve. Ergo, Fed tapering does not matter so long as rates stay low. By the same logic, ECB policy is “accommodative” because rates have collapsed, a claim would have Milton Friedman turning in his grave.
Monetarists say this is a cardinal error, bound to cause serial mishaps. Indeed, Robert Hetzel from the Richmond Fed blames the Lehman crisis and all that followed on monetary overkill in early to mid 2008, arguing in his book “The Great Recession” that the Fed ignored the warning signs that M2 money was buckling.
We forget that the Venetian Grain Board regulated commerce over the centuries by altering the quantity of money, not interest rates. So did the Bank of England in the 18th Century, injecting liquidity when Easterly winds brought ships into London. The Bank continued to target the quantity of money in the early 20th Century when QE was known as open market operations. Quantity was Friedman’s lodestar in his great opus.
Quantity is not doing very well. The Center for Financial Stability in New York says “Divisia M4” – its measure of broad money growth – has fallen to 2.5pc from around 6pc in early 2013. The US economy can perhaps handle some loss of dollar liquidity. The world as a whole cannot. There are $11 trillion of cross-border loans outstanding, and two thirds are still in US dollars. Emerging market companies have borrowed a further $2 trillion in dollars since 2008.
China is no longer tightening, but it is not loosening much either. It is actively steering down the growth rate of M2 money, even though house prices have been falling for five months, industrial output has stalled, and factory gate inflation has dropped to minus 1.8pc. President Xi Jinping seems resolved to break China’s credit bubble early in his 10-year term, come what may. This will not be pretty. Standard Charted says debt has reached 250pc of GDP, off the charts for a developing economy.
Property curbs have been lifted. The central bank has injected small bursts of liquidity into the banking system. But this time China has not let rip with credit from the state banking system to keep the game going. “We cannot rely again on increasing liquidity to stimulate economic growth,” said premier Li last month.
He is targeting jobs, not growth, willing to deflate the economy and purge excess capacity in the steel and ship-building industries as long as unemployment does not rise much above 5pc. This may be the right course for China, but it is an unpleasant shock for those across the globe who feed the dragon for a living.
China will eventually blink if the slowdown deepens, and so will the Fed in Washington. First the markets will have to learn the hard way that they have mispriced the reality of a broken global economy.