Mark Carney: Uncertainty and the global recovery
Remarks by Mr Mark Carney, Governor of the Bank of Canada and Chairman of the
Financial Stability Board, to the Vancouver Island Economic Alliance, Nanaimo, British
Columbia, 15 October 2012.
* * *
Introduction
It is a pleasure to be in Nanaimo at the Vancouver Island Economic Summit. With British
Columbia serving as Canada's gateway to Asia, you are well aware of the
interconnectedness of the global economy. To the benefit of billions of people, goods, capital
and ideas flow across borders as never before.
Unfortunately, so too does angst. This is my topic today.
While the "Great Recession" is over, what has followed is an unfamiliar process of repairing
public and private balance sheets across advanced economies. The depth and duration of
this deleveraging are unclear. Deleveraging is holding back the global recovery and laying
bare distinct challenges in different parts of the world.
The euro area is stagnating as it struggles with an underlying balance-of-payments crisis.
The United States is at the edge of a fiscal cliff. China and other emerging markets are trying
to sustain rapid growth amid weak demand in their traditional export markets.
There is a synchronous slowdown under way in the global economy. This past weekend in
Tokyo, when the International Monetary Fund (IMF) marked down its growth forecast, no
region or major economy was spared. Further, the IMF warned that downside risks have
risen.1
Against this background, it is not surprising that uncertainty over the global economic outlook
is high. It is being reinforced by concerns over how policy-makers will address these
challenges. This combined uncertainty is further complicating the recovery, prompting firms
and consumers to retrench. There is some evidence of this dynamic here in Canada as
businesses feel the weight of darkening global prospects.
While I will not be able to dispel all of these concerns today, my objective is to explain how
policy-makers are addressing some uncertainties and to put some others in their proper
context.
Uncertainty and Its Impact
It is only human to respond to uncertainty with caution. Faced with a highly volatile
environment, households shy away from spending on big-ticket items such as houses or
cars, and firms put off making large capital investments and hiring new workers. The effect
on business investment can be particularly significant. This is because uncertainty increases
the value of waiting for new information when firms decide whether to undertake big projects,
leading them to reduce current investment.2
That uncertainty has such real effects is clear. However, the precise degree of uncertainty at
any given point in time and its impact on economic activity are themselves uncertain.
According to standard measures of financial market volatility, such as the VIX, or implied
volatilities from options prices in other asset classes, the current environment does not
appear to be particularly uncertain.3 In fact, many of these measures are at post-crisis lows.
The comfort offered by these market-based measures may be misleading. For one, they may
be importantly influenced by the extraordinary liquidity provided by central banks. This
liquidity has supported financial markets and thereby provided insurance against downside
risks. The dampening effect of central bank action may not persist if economic fundamentals
do not ultimately improve, meaning that there could be a discontinuous shift in volatility at
some point in the future.
Moreover, trading volumes across asset classes have generally been low in recent months,
as many market participants with large cash holdings sit on the sidelines. Paralysis, not
confidence, may better account for the observed declines in actual and implied volatility. This
apparent lack of conviction in markets can itself be considered a sign of unusual levels of
uncertainty.
Other indicators, such as surveys of households and businesses, tend to be more consistent
with what many feel. For instance, the most recent Small Business Problems & Priorities
survey of the U.S. National Federation of Independent Business finds that "uncertainty over
economic conditions" ranked second in their list of most "critical" problems. "Uncertainty over
government actions" was fourth.
Another index of economic policy uncertainty for the United States, constructed by
researchers at Stanford, has shown a clear upward trend in recent years.4 They estimate that
the rise in policy uncertainty between 2006 and 2011 reduced the level of real U.S. GDP by
approximately 3 per cent and was associated with a loss of about 2.3 million jobs.
Using a similar methodology, Bank of Canada researchers estimate that the increase in
policy uncertainty observed since the reintensification of the euro-area crisis late last year
may have lowered the level of euro-area GDP by roughly 1 per cent.
Analytically, there is a clear question of causality here - does uncertainty cause slower
growth or is it the other way around, with difficult economic times inducing greater qualms
about the future? Surely it works both ways. Thus, the current combination of economic
weakness and heightened uncertainty may be forming a vicious circle in the global economy.
That there is uncertainty about how the global economy will respond to an unprecedented
period of deleveraging is not surprising. More troubling is the apparent uncertainty about the
stance and perceived effectiveness of economic policy.
The question is what can policy-makers do about it?
Europe
Let me start with Europe.
The euro-area economy is stagnating, with GDP still 2 per cent below its pre-crisis peak and
private domestic demand a stunning 6 per cent below. The causes of this underperformance
are deep-seated.
An adverse feedback loop between weakening economic activity and sovereign and banking
sector vulnerabilities has made the task of fiscal consolidation even more difficult.
Europe's banking losses and fiscal shortfalls are merely symptoms of a more serious
underlying illness - a balance-of-payments crisis. To repay the creditors of Europe's core
economies, the debtors of peripheral economies must regain competitiveness. Although
there has been some progress, this process will be neither easy nor quick.
There are two ways to address the uncertainties plaguing Europe.
First, Europe is often said to be suffering an existential crisis - meaning that the very
existence of the euro is being questioned. Recent actions, particularly by the European
Central Bank (ECB), are now directly addressing this risk. The ECB has recently introduced
a new program - the Outright Monetary Transactions (OMT) program - that is specifically
designed to eliminate the risk of euro redenomination.
Simply put, subject to certain conditions, the ECB will act to ensure that yields on any
particular euro-area country's short-term government bonds should reflect only the credit risk
of that sovereign, not the risk that the country will leave the euro.5 By lowering yields in this
manner, the ECB will substantially improve the transmission of monetary policy, and thereby
increase the prospects for economic recovery in Europe.
Second, it would be helpful if European authorities would reframe the expectations of citizens
and market participants regarding the time horizon over which European monetary union will
be refounded. You are no doubt aware that there has been a seemingly endless series of
crisis summits held about the euro in recent years - nineteen meetings at the Leader level in
the past two years. Although there has been important progress, there was never any
chance any one meeting could solve the issue.
For the euro area to be a viable currency union, several reforms over a 3 to 5 year period will
be required. These include:
•
necessary institutional changes, including a banking union;
• a closer fiscal union, including a fiscal transfer system and some form of
mutualisation of sovereign debt;
• reforms to enhance labour market flexibility and mobility, as well as measures to
promote competition and productivity in product markets; and
•
steady reductions in (cyclically adjusted) budgetary deficits.
By reframing expectations to a realistic timeline, and ensuring that any financing assistance
program for countries is sufficient for this period, European authorities could arrest the cycle
of crisis summits, and thereby reduce policy uncertainty.
The slowdown in China
In emerging economies, growth has slowed at a greater-than-anticipated rate in recent
months. In China, real GDP grew 7.6 per cent in the second quarter, its slowest pace in three
years, and recent data suggest continued softening in the third quarter.
The slowdown in China's growth reflects two broad influences. First, external demand for
China's exports has weakened, owing in particular to the recession in Europe, China's
largest trading partner.
Second, past policy actions in China are having an effect. With large vulnerabilities building
in the housing sector, increasing evidence of overinvestment, and inflation above target,
policy-makers appropriately tightened monetary and macroprudential policies once the
economy shook off the effects of the 2008-09 global crisis.
Given these excesses, the reduction in China's growth to more sustainable rates is welcome.
However, recent signs that the slowdown in the Chinese economy may become too intense
have prompted authorities to unwind some of the past policy tightening. This process has
begun, with notable fiscal stimulus measures announced recently.
Nonetheless, there remains significant uncertainty over how quickly China can adjust its
growth model. With the limits of an export-led growth strategy now obvious, rebalancing to
encourage domestic sources of growth is needed. Yet prior rounds of stimulus appeared to
stoke already very high levels of residential and business fixed investment, rather than
consumption, which remains exceptionally low.
The risk is that, once again, the right stimulus will end up in the wrong places.
For outside observers, the uncertainty surrounding the economic outlook in China is
compounded by the difficulty in obtaining reliable information regarding the extent to which
the economy has already slowed.
That said, it is important to put China's recent performance in context. The Bank of Canada
expects growth in China's GDP to average about 7.5 per cent over the next few years. While
this is substantially below the unsustainable double-digit rates seen in recent years, it is still
considerable. In fact, 7.5 per cent real growth in Chinese GDP in 2012 will add roughly
$800 billion to the global economy, an amount equivalent (in real terms) to the 14 per cent
rate of growth in China in 2007, and approximately twice the dollar value of U.S. growth this
year.
The U.S. outlook
The U.S. recovery remains modest, consistent with the experience of other advanced
economies that have faced financial crises. Although the fiscal challenges continue to loom,
the recovery appears to be on a somewhat surer footing.
American households have recovered more than two-thirds of the $16 trillion in net worth lost
in the aftermath of the crisis. While it will take several more years to make up the balance,
the process of household deleveraging appears well advanced, particularly now that the U.S.
housing market is beginning to recover.
In addition, major U.S. banks have substantially increased their capital, and U.S. corporate
balance sheets are very strong.
Despite this progress, aggregate debt across all sectors of the U.S. economy has not budged
from its peak of about 250 per cent of GDP. The burden of deleveraging in the United States
has, in a sense, been transferred from the private to the public sector.
It is clear that the U.S. public debt burden needs to be reined in over the medium term.
Precisely how is less obvious. Existing legislation incorporates automatic tax increases and
spending cuts, set to kick in next January, amounting to roughly 4 per cent of GDP - the
so-called "fiscal cliff." If authorities do not change these provisions, this massive fiscal drag
will likely push the U.S. economy back into recession next year. That is not what we expect,
but like others, we cannot be sure.
There is evidence that uncertainty surrounding the resolution of the fiscal cliff issue is already
having an adverse impact. While the general tone of the U.S. data has improved slightly of
late and financial markets have held up, high-frequency indicators related to U.S. business
investment - where one would expect to see the greatest impact of uncertainty - have
weakened. For example, new orders for capital goods have fallen sharply, declining by
26 per cent over the most recent three months. This is by far the weakest result since the
end of the recession.
The Bank assumes that the United States will, in the end, step back from the fiscal cliff. Even
with that assumption in place, the Bank projected in its July Monetary Policy Report that
fiscal tightening in the United States will remove 1 percentage point from U.S. growth in
2012, and 1.5 percentage points in each of 2013 and 2014. Under such a scenario, the
near-term hit to the economy is largely avoided, but the need for fiscal consolidation persists
- as indeed it does under any plausible scenario.
A clear, consistent and committed medium-term U.S. fiscal plan, one that demonstrates how
this consolidation will be achieved, would be helpful in mitigating a major uncertainty that
would otherwise endure.
More positively, recent Fed actions have actually reduced uncertainty. Specifically, the Fed
has provided greater certainty by indicating that its policy rate could be expected to remain at
extremely low levels until mid-2015. It has also provided more certainty with respect to its
reaction function, linking future unconventional monetary policy to substantial improvements
in the outlook for the U.S. labour market. In addition, the Fed has indicated that it will leave
highly accommodative policy in place "for a considerable time after the economic recovery
strengthens."
If conditions were to deteriorate and further easing were required, the U.S. central bank
could provide even greater certainty with further refinements, such as precise numerical
targets and a time frame for achieving these targets.
The Fed did not just sharpen communication, it also announced its intention to purchase
$40 billion in securities per month - a strategy nicknamed "QE3." As with previous rounds of
monetary stimulus, QE3 can be expected to support the American recovery, both directly by
lowering interest rates, and more broadly, through the so-called portfolio-balance effect. This
channel tends to lift asset prices and reduce the value of the U.S. dollar. The overall impact
of QE3 for Canada is estimated to be modestly positive, reflecting its supportive implications
for U.S. and global activity and the resulting boost to commodity prices.
What does all this mean for Canada?
Elevated global uncertainty is holding back global economic growth and, thus, the demand
for Canadian exports. In addition, there is some evidence that global uncertainty is affecting
domestic activity. According to the Bank's most recent quarterly Business Outlook Survey,
released this morning, Canadian firms have become more circumspect about new capital
expenditures and less inclined to hire new workers.6 In this environment of slow global
economic growth and uncertainty about demand, firms have also tempered their sales
expectations for the next 12 months.
However, while Canada's economy is being affected by the global angst, the key areas of
uncertainty abroad are all points of justifiable confidence here at home. Canada's public
finances are sound. Monetary policy is clear and credible. Canada's financial system showed
itself to be among the most resilient in the world through the crisis. Since then, it has
strengthened further. One thing Canadian businesses can expect is that their financial
system will be there if times get tough again.
In this uncertain world, then, Canada is rightly viewed as an attractive investment destination.
This is having an important effect on Canadian financial conditions. Capital inflows are
tending to push up the value of our dollar, thus acting as a headwind to the Canadian
economy. However, foreign capital is also tending to push domestic asset prices up and
longer-term interest rates down, which has a supportive effect on domestic growth. The Bank
takes all of this into account when setting monetary policy.
The Bank provides as much certainty as it can in the conduct of monetary policy. While we
obviously cannot determine events over which we have no control, we can be transparent
about what we expect and how we would react to different scenarios. That includes being
clear about the role of monetary policy in supporting financial stability in Canada. For
example, if we were to lean against emerging imbalances in household debt, we would
clearly declare we are doing so and indicate how long we expect it would take for inflation to
return to the 2 per cent target.7
Conclusion
Let me conclude.
Eighty years ago, faced with a more dire set of economic circumstances than we are today,
Franklin D. Roosevelt famously told Americans that "the only thing we have to fear is fear
itself." But this is not the Great Depression. The IMF expects the global economy to grow by
more than 3 per cent this year and next, or just under the average of the past 10 years. What
we face now is better described as uncertainty rather than fear. Nonetheless, the spirit of
FDR's comment applies - we must take care not to allow uncertainty to dominate our
actions, letting profitable opportunities slip away and, more generally, compounding the very
real, but still manageable, challenges facing the global economy.
At times of extreme economic and policy uncertainty, it pays to be quick and bold, as the
central banks of the United States, the United Kingdom, and the euro area have been.
As Canadians, we need to focus on what we can control. We can't save the euro, fix
America's fiscal cliff or restart the U.S. housing market. Should we just wait out a
decade-long deleveraging process in the crisis economies? Should we lower our
expectations? Or should we control our destiny by building on our strengths in the new global
environment? We can improve Canada's low productivity growth and sharpen our focus on
emerging markets. And we can continue to invest in our greatest resource - our people.
Monetary Policy Report
Against this backdrop, next week's will provide a full update on the
Bank's outlook for economic growth and inflation in Canada. It will take into account the
impact of the uncertainty that I have been discussing today. The Bank will take whatever
action is appropriate to achieve the 2 per cent CPI inflation target over the medium term.
That certainty is our contribution to ensuring that Canadians can invest and plan with
confidence.