Time to nip next bubble in the bud

Allister Heath
REGULAR readers will know that I’m reasonably optimistic when it comes to short-term growth – I believe that the economy will slow to an uncomfortably modest pace over the next few months but that we won’t tip into a double-dip recession. Yesterday’s manufacturing figures, which showed that the recovery in factory production accelerated further in August, with output growing six per cent over the past year, the best performance since 1994, confirmed this view.

But whereas the overall UK?economy will continue to grow, albeit at a slowing rate, there are plenty of worrying developments that mean that longer-term prospects are looking increasingly bleak. The first is the continued onslaught on the City, as demonstrated by the EU’s bid to limit bonuses to a certain multiple of base pay. But there are also other, more macroeconomic threats. One that almost keeps me awake at night is the continuing growth in emerging economies’ forex reserves, a trend which shows that central banks have learnt nothing from the boom and bust of the noughties.

One of the main drivers of the bubble had nothing to do with bonuses or commercial bankers: it was caused by the fact that Asian and Middle Eastern economies recycled their vast export earnings into huge reserves of dollars, snapping up trillions of dollars worth of government bonds. This helped fund the massive US trade and budget deficits, pushed down yields on all debt and helped to promote the mad credit binge of the noughties. It is a shame that instead of trying to make sure that these vast imbalances – the West spends too much and saves too little, while China deliberately undervalues its currency to boost exports and forex reserves – are tackled, governments have preferred to resort to populist City-bashing.

Meanwhile, the imbalances are getting worse, not better, guaranteeing another disaster at some point. The IMF says that the current account surplus of developing Asian economies will reach $731.2bn in 2015. That is 67 per cent more than the 2008 peak, as Societe Generale points out. The US is forecast to have a current account deficit of $600bn, only marginally less than the 2006 peak of over $800bn. This implies that the reserves of these developing Asian countries will surge from an already massive $3.4 trillion in 2010; global reserves may eventually exceed $10 trillion. Most of these will be parked in bonds; while handy for profligate western governments that are racking up ridiculously large budget deficits, the result will once again be to keep interest rates and yields at permanently low levels. Eventually, this is bound to rekindle bubbles across asset classes, including property and in emerging markets, as well as put upwards pressure on consumer price inflation.

The answer is not to declare a trade war on China, as short-sighted American politicians are threatening; this would trigger tit-for-tat protectionism and plunge the world into a depressionary spiral. Instead, we must boost savings rates in the West, while negotiating with China to induce it to allow the renminbi to rise gently to a more reasonable level. This would reduce its trade surplus and its accumulation of forex reserves. The best way to make the West less dependent on imported capital would to introduce properly funded retirement schemes. Unless we urgently deal with these issues the next crash, when it inevitably comes, will be truly devastating. allister.heath@cityam.com