Everything seems to be going wrong in the global economy right now.
Chinese growth is slowing, Hong Kong’s Hang Seng is officially in a bear market, Greece is heading into elections, and emerging markets around the world are feeling the strain of the strong US dollar.
In the advanced world, the US and UK are seeing some decent growth, while Japan and the eurozone are expanding modestly at best.
And the next important question for everyone is whether the US Federal Reserve thinks the backdrop they’re looking at is good enough to raise interest rates for the first time in nine years. The Fed Funds rate has been sat at 0.25% since December 2008.
September has been pencilled in as a strong possibility for a long time now, though markets are now starting to reconsider. What’s the worst that could happen?
Well, it could be like 1937 again.
In late 1936, the US economy was looking relatively good for the first time in a while. The unemployment rate had fallen by between 5 and 10 percentage points from its post-crash high (accurate estimates weren’t kept at the time), the economy was growing, and markets had rebounded considerably.
There were a bundle of different things that then contributed to the 1937 recession — including tax hikes, a change in the US Treasury’s policy on gold, explained here, and an increase by the Federal Reserve in bank reserve requirements.
The hike only caused a pretty small spike in Treasury yields, in comparison to the levels that were common before the 1929 crash. Bank of America Merrill Lynch produced these charts for a note back in June:
But that tiny jump following the rate hike did not have small effects on stocks or the economy. The Dow Jones Industrial Average was cut in half, falling by 49% in 1938:
The real economy took a beating too. After a prolonged period of falling unemployment in the mid-1930s, jobless numbers began to climb again after the rate hike.
The 1937 episode had a huge influence on economic policy in the future. It’s one of the episodes that Milton Friedman argued that shocks to the monetary base of an economy, which are ultimately controlled by central banks, are the general cause of recessions.
So what’s the risk for the world today?
The tools are slightly different, but the situation bears many similarities. After a major financial crisis and recession, the US was trying to find a way to normalise economic policy, just as it is today.
In recent years other parts of the world have already had the problem that the Fed may soon face. The eurozone, for example, hiked interest rates in the middle of 2011, before having to backtrack quickly afterwards.
No central bank wants to do that at the moment. Those that want to hike rates soon — like the Fed and Bank of England — want to keep doing so slowly over the following couple or few years. A slow, gradual upward increase is what they’re aiming for, so they need to economy to be strong enough to manage that.
Back in September 2014, US financial economist Robert Shiller warned about the parallels between the state of the global economy and those in 1937.
You could sum up the reasons that the world doesn’t look ready for a rate hike by the Federal Reserve quite easily:
- Growth in Europe and Japan is still pretty anemic. Their central banks look more likely to ease than hike interest rates, and won’t prop up global demand if the US falters.
- US interest rate hikes usually mean a stronger dollar. The US currency has already strengthened considerably, and countries with dollar-denominated debt will struggle more and more to service it.
- The US recovery looks good, but not amazing. Wages are rising, but not at the sort of pace generally seen before the crisis. Retail sales rose by 2.4% in the year to July. Economic growth is solid rather than stellar.
- Inflation is nowhere to be seen. Tumbling oil prices have sent inflation to basically zero across the world’s advanced economies. For good reason, the Fed wants to hike interest rates before inflation is back at its 2% target, since small rate hikes won’t immediately slow down the rising prices. But they need to be really quite sure that it’s headed in that direction before they pull the trigger.
Some of these things matter to the Fed, and some of them don’t. Janet Yellen won’t change her mind based on whether an Indonesian business can repay its dollar-denominated loans. But it is relevant for the world as a whole. The dollar is the world’s reserve currency, and what happens in Washington absolutely does not stay in Washington.
Michael Arone at State Street makes some excellent points against the 1937 comparison. The economy is generally a lot healthier and we haven’t had years of deflation, for starters.
But some measures seem to indicate a weaker expansion — divisia money growth, one measure of the expansion of an economy, is still relatively weak in the United States:
There are reasons that a failure this time would be easier to mitigate against — central banks in 1937 were flying blind then even more than now, with far fewer stimulus tools, and only a few years of experience in fighting a recession without the gold standard.
There are also reasons to be concerned — the fiscal surge that accompanied pre-WWII rearmament offered an economic boost of the sort that it’s hard to imagine being endorsed today. There is very little political will for a similar stimulus (hopefully not for an enormous conflict) today, even before considering how much more heavily indebted the advanced world is.
If it all goes wrong for the Fed this time, they can’t say history didn’t warn them.