I have been trying to fathom why financial analysts and economists like me have been so completely off the mark in some of their recent predictions. The consensus, for instance, just a few months back was that the US economy was headed for a marked slowdown, making a cut in policy interest rates inevitable.
Asset markets across the world had "priced in" this scenario. Things have changed since then. We now seem reconciled to the fact that despite the odd quarter of slow growth, the US economic engine is chugging along fine. In fact, going by the US Fed's periodic reiteration of the fact that inflationary pressures persist makes the probability of a policy rate hike slightly higher than that of a cut.
One of the reasons perhaps for the persistent error of judgement has been the inability among analysts to estimate or forecast the quantum of excess liquidity in the global financial system and the myriad ways in which this has flowed into both asset markets and the real economy.
The proliferation of hedge funds and private equity investors in recent years has meant that leveraged drawing upon this excess liquidity has played a growing role in driving portfolio flows and asset prices.
The Indian markets have not been the exception. If, indeed, flows through participatory notes accounted for over 40 per cent of total FII flows in 2006, the bulk would have been "leveraged" carry trades riding on the back of low-yielding currencies like the yen.
Low leverage cost and high equity prices have also set off a flurry of mergers and acquisitions -- $1.04 trillion apparently in the US alone this year. Indian companies too have followed this tack -- bulking up debt on the balance sheet to acquire assets. Eat before you are eaten up seems to be the driving logic behind this.
This blame or the credit (depending on your perspective) for maintaining these high levels of liquidity must surely rest on the shoulders of the leading central banks. As my colleague Robert Lind points out in a recent piece ("Rate Roulette," ABN-AMRO Research), interest rates across the world have been, over the last five years, much lower than what any systematic monetary policy rule would suggest.
A simple monetary rule, for example, that would enable central bankers to keep a leash on growth would be to let nominal interest rates converge to nominal GDP growth. In almost all the major G-7 markets, there has been a yawning gap between nominal interest and growth rates, a gap that still persists.
This brings me back to the question I started with -- why have forecasters gone wrong?
My sense is that the logic underpinning a number of forecasts has been based on the assumption that the obvious structural imbalances that dot the global economic map would lead to large corrections, initially through changes in asset prices like interest and exchange rates and then ultimately in the real economy.
Interest rate increases and exchange rate revaluation in China, for instance, would compress the country's trade surplus and growth. These assumptions have proved to be flawed because central banks have thought and behaved very differently.
In fact, despite the regular references to global structural imbalances in the speeches of central bank governors, central banks have done precious little to address the structural problems that beset their economies.
If, indeed, US Federal Reserve Chairman Bernanke was concerned about the terrifyingly large household debt in the US (accompanied incidentally by diminishing credit quality) or the current account and budget deficits, the Fed Funds rate would perhaps have been close to 7 per cent.
The People's Bank of China has made a series of feeble attempts to push up lending rates and allow greater flexibility in their exchange. They have typically come either in the wake of protectionist rhetoric from the US, and Treasury Secretary Hank Paulson's visits to China, or have coincided with G-7 meets that have raised the issue of global imbalances.
They have been largely token gestures -- there is nothing to suggest that the Chinese economy is slowing down noticeably or its trade surplus shrinking.
An extreme view would be that central banks have been so obsessed with managing their short-term business cycles (and indirectly their asset markets) that they have actually prevented the structural imbalances from correcting to any noticeable degree.
In their bid to keep growth rates high and asset prices robust, central banks have given issues of long-term macroeconomic sustainability short shrift. The large quantum of global liquidity is simply a manifestation of this behaviour.
What does this mean for the global economy in 2007 or indeed the foreseeable future? The good news is that the global economy is unlikely to slow down significantly -- developed economies will continue to borrow to fund their appetite for exports of the developing markets.
Thus, despite the large structural imbalances that are likely to get worse over time, the global economy will be stuck in a sort of equilibrium where none of the entities reneges and induces large-scale structural adjustments.
The bad news, especially for those who blieve in the tenets of economic theory, will continue to get worse. The circuit-breaker will, of course, have to come from significantly higher yields.
That could happen either if currencies of exporter economies appreciate enough to offset their labour cost advantage or if labour markets in developed and developing countries tighten enough to set off another spree of interest rate hikes.
The rising prices of base metals are another risk to inflation and if these spiral up sharply enough, it could push yield up and compress liquidity. This, according to me, is unlikely to happen in a hurry. Those betting on continued global expansion could put more on the table.
