What has 1815 and the Battle of Waterloo got to do with 2016 and the world economy? On 18 June 1815, the Duke of Wellington could feel the battle slipping away, but he also knew the Prussians under General Blucher were coming and that could win the day.
Fast forward to 2016 and there is no General Blucher. By this I mean the huge monetary and fiscal injection into the world economy in the wake of the financial crisis. The fundamental cause of the recent market turmoil – in my view – is the absence of General Blucher. Markets know that if the world economy were to slide back into recession there would be only paltry reinforcements down the road.
Theoretically, of course, central banks could engage in unlimited quantitative easing. But would they do so in practice, given the scale of balance sheet expansion already implemented by the Fed and the Bank of England? We would have entered a world where financial markets wrestled with the potential deflationary risk from contractions in the money supply versus the inflationary consequences of printing yet more money. One might argue that this debate has been ongoing since the introduction of extraordinary monetary policy – which it has – but it would surely be far more intense if massive further increases in QE were required. The debate would be intensified not only by the scale of QE, but also by the shape of monetary policy, with “helicopter money” on the table.
Fiscal policy reinforcements are similarly limited. Any future recession would see budget deficits heading south and public debt way north. Debt and deficit numbers would in themselves be a constraint. One might argue that any future recession would almost certainly become a balance sheet recession – shifting the focus from profit maximisation to debt minimisation – very quickly, and thereby providing an “extreme circumstances” justification for fiscal policy intervention, but this battle would not be fought quickly. Automatic stabilisers would vie with political and ideological skirmishes. And if General Blucher had eventually turned up late, he would have been no use.
Debt and deleveraging, combined with limited monetary and fiscal options, are a toxic mix, given the concern that a 30-year debt super-cycle might be coming to an end. Markets don’t like uncertainty and the uncertainties don’t get much bigger than these.
We are at a truly dangerous point in the battle. It’s early evening at Waterloo, with victory or defeat unclear. Some of Wellington’s best troops (the Chinese economy in this analogy) are being breached by Napoleon’s Imperial Guard. Others are advancing (the US and UK economies), but slower than expected.
But could General Blucher yet intervene in 2016-17? The explosion in debt in China over the past decade risks much slower growth in the downside of the cycle – not a balance sheet recession, but sub-5 per cent growth – and rising social pressures. History teaches that the Communist Party will respond to these pressures. But it will also want to avoid any loss of face, and will surely seek to sell intervention as a service to the world rather than an imperative at home. Could the Chinese deploy massive fiscal and monetary intervention to maintain Chinese GDP growth? Why not? They’re the only big gun with ammunition. Geopolitically, it would also position China as the saviour of the world economy, hardly bad PR for the Communists!