Markets & Economy
Big debt and easy money
May 22, 2013
Catherine Gordon: Hi, I'm Catherine Gordon at Vanguard's headquarters in Pennsylvania. Welcome to today's program where we'll discuss the impact of the fiscal and monetary policies of key countries around the world. Joining us is Joe Davis, Vanguard's chief economist. We'll also hear from Peter Westaway, our chief economist in Europe, who is in our London office.
Joe, thanks for being here today.
Joe Davis: Thank you, Catherine.
Catherine Gordon: So let's first talk about monetary policies of the major developed economies, especially the United States and Japan. As we know, the Federal Reserve in the U.S. and Japan Central Bank are aggressively injecting more cash into their economies to stimulate growth. Do you think they're on the right track and what do you think the impact is around the world?
Joe Davis: Sure, Catherine. Well, clearly the efforts and recent actions of the U.S. Federal Reserve, the Bank of Japan, and also the European Central Bank, as well as the Bank of England, so a lot of the major economies around the world, central bankers have been extraordinarily aggressive of so-called quantitative easing to expand the size of their balance sheet. And I would argue that we have never seen this in human history in terms of both size and scope. So it clearly is extraordinarily aggressive actions. The question is, to your point, is it on the right track? I think we do have to appreciate some of the forces that have been counteracting and hence the reason for extraordinary monetary expansion throughout the world.
I mean, consumers having to pay down debt; governments having to address that, all these are inherently deflationary or put downward pressure on prices, wages and economic growth, and so it is a matter of calibrating from central banks' perspective, some of those forces. Some nations, some central banks have been more effective than others. I would point to the United States as actually being in the front. Bank of Japan only more recently have become more aggressive I think in some extent in response to how more successful the United States has been.
Now, they've clearly helped the financial markets and some investors take on more risk and have been supportive of, I would say, investor psychology and business psychology to some extent, but I do have concerns that just given the sheer size and response of central banks that it could be distortionary. Now again, central bankers would say that is the very point for all of us to take on more risk, but we do have reservations at Vanguard, that we're in uncharted territory. We may not fully appreciate some of the distortions that this may entail.
Catherine Gordon: So turning to Europe, we talked recently with Vanguard's economist in London, Peter Westaway. He was unable to join us today, but we did get to discuss with him the situation in Europe where officials have been more focused on restraining deficits and keeping peripheral nations solvent. We asked him how long Europe will be struggling to get its economy growing again.
Peter Westaway: I think the European economy could remain stuck in neutral or worse for a little while yet. I mean, if you look at the euro area as a whole, it's still in recession. We're probably not expecting positive growth until the fourth quarter and then probably slightly positive growth in 2014 as some of the fiscal headwinds ease, but that overall growth picture hides a range of experiences. I mean, you've got Germany who are actually in positive growth already. They're growing at just under 1%, but then if you look at the other end of the spectrum at some of the periphery countries, you've got Spain and Italy. They're probably not going to grow positively until 2014 and then Greece, who's in the deepest recession of all. They're unlikely to grow in positive territory until 2015. Indeed of all the periphery countries, only Ireland is actually experiencing increasing output at the moment.
I should probably also mention the U.K. We heard that they've managed to avoid a triple-dip recession, but it's still the case standing back from that that the U.K.'s effectively had flat stagnant output for the last two years and again, we're probably not going to get very strong growth next year here, either. I mean, the final point to make I think is that a lot of the structural reforms in Europe are, in the long run, designed to boost the growth rate, but the trouble is that those reforms are going to take a very long time to kick in, which is why the immediate prospect is quite gloomy.
Catherine Gordon: Europe continues to see very high unemployment. We asked Peter how the stubborn unemployment problem is complicating Europe's economic challenges.
Peter Westaway: Yes, I mean, unemployment is still very high in Europe across the board really, and it matters for two main reasons. First, it matters because when unemployment's high, it means that the fiscal challenges are just that much harder to face because the revenues aren't coming into government, more money has to be spent on unemployment benefits and other types of benefits, and so when you're trying to bring your spending down, governments are actually having to spend more money. So that's hard enough.
But the second reason why unemployment is such a challenge is that it tends to undermine the very social cohesion that's necessary to persuade governments to carry out these difficult fiscal policies and structural measures that are necessary to take place. So when you see unemployment that gets concentrated in the youth or in particular regions, there's a lot of opposition to policies and it makes it all the more difficult for governments to carry them out, and [at] the limit, those governments may actually be thrown out of office.
Catherine Gordon: Joe, turning back to the United States, unemployment here is obviously still a concern, but future inflation is also a worry for some investors because of the Fed's aggressive monetary policies and yet we haven't seen a jump in inflation so far, and why not, and do you think it is still lurking right around the corner?
Joe Davis: Sure, Catherine. I recall you and I having this very conversation almost two years ago and to our credit, to be fair, we suggested that more likely than not we were not going to see a rampant rise in inflation, and I still—we still have that view today and primarily, that's because the fundamental driver of inflation over any two, three, or five year period tends to be associated with credit growth, bank credit growth, most importantly, wage growth which gets your clear observation around the elevated unemployment rate. So I don't foresee a rampant rise in inflation near-term despite the aggressive efforts of central banks or the U.S. Federal Reserve.
I mean, in fact, if anything, we may see throughout this summer continued or renewed concerns at the margin around deflation as commodity prices could very well continue to ebb and most importantly wage growth is below 2%. So it doesn't surprise me at all that measured rates of inflation, such as the consumer price index, are also hovering at or below 2% because wage growth is also very modest.
So for the next several years, it's tough for me to foresee a broad-based, widespread rise in inflation.
Catherine Gordon: Joe, last question. Given what we've been through and all of the risks that are still out there, many investors are wondering if they should take a different approach to asset allocation. Any thoughts on that?
Joe Davis: Sure. I think if we step back and just think what we've all been through the past five or six years, even going back to 2006, 2007 before the onset of the global financial crisis, it's been a very volatile and challenging environment for all of us as investors, perhaps business owners, and just living through this, at times, difficult economic environment and yet when I look back, I think we should also all be applauded, quite frankly, because it hasn't been easy to stick to one's asset allocation, to one's portfolio decisions, and yet when you look at, as just a hypothetical example, a balanced portfolio's return since 2007, by most measures they're above and the return has been positive despite a very, very challenging economic and financial environment.
And so in my mind, the tenets of broad diversification and maintaining that long-term perspective have been rewarded, and it has not been easy. I mean, if you look at, in 2009, some of the prominent, some very smart individuals in the investment community were convinced that because of low economic growth, we were going to have an investment new normal, that the only way to regenerate stock market returns was to say invest exclusively in emerging markets and that the outlook for U.S. stocks was extremely poor.
In 2010, there were concerns everywhere from hyperinflation to a wide rash of municipal bond defaults here in the United States. In 2011, it was interest rates were going to rise markedly and bonds were in a bubble, and so I think when you play back the tape, I'm not here to say that Vanguard is smarter than anyone else in that. It's just that there is always headline risk to try to influence ones to really change direction, and so I think that investors who have stayed the course have been remarkably rewarded through a challenging period. And so even today, as we sit here in this remarkable tension between high government debt in some parts of the world and extraordinary easy money, it is somewhat unclear the timing with which those forces will modify and ameliorate. So I think again, that tells me the approach to investing around balance and diversification is still incredibly important and I would hope will be well-served and well-rewarded over the next five or ten years.
Catherine Gordon: Thanks, Joe, and we appreciate hearing from Peter Westaway in London. And thanks to all of you for watching. We hope that you'll join us again for our discussion of economic trends around the world.
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A conversation with Vanguard economists Joe Davis and Peter Westaway
Central banks continue to try to stimulate growth through aggressive monetary policies, even as their governments debate how to lower excessive sovereign debt levels.
Vanguard Chief Economist Joseph H. Davis, Ph.D., and Chief European Economist Peter Westaway explain the quandary facing economic policymakers and what investors can expect in the months ahead.
- All investing is subject to risk, including the possible loss of the money you invest.