The global economy is ruled by feedback loops, says ING IM economist Verhagen

Willem Verhagen, senior economist at ING Investment Management, says that the virtuous feedback loops involving growth and financial conditions, created by monetary policy such as quantitative easing, face political headwinds and an uncertain future.

The past three years have taught us a lesson: One of the prime reasons that growth is so volatile (and the cycle much shorter than it used to be) is the paramount importance of policy action in a world where both the real and financial sides of the economy are characterised by daunting imbalances. The latter make the system very vulnerable to shocks. In theory, policy should try to smooth the effects of these shocks and in the case of monetary policy this is exactly what happens. Nevertheless, ultimately monetary policy cannot be a substitute for the fundamental changes that are needed (for example, institution building in the Euro area, fiscal reform in both Economic and Monetary Union and the US, EM switch to another growth model).

Unfortunately, policymaking in these areas does not act as a source of stability but rather it serves to create more volatility in markets and the real economy. The reason is essentially that the economic machine is broken and needs to be repaired by the mechanics (policymakers). However, the latter have their hands tied behind their back because their bosses (the electorate) may fire them if they carry out the sometimes painful and costly repairs. Voters lack the prospect of rising future incomes they were used to and they realize that someone will have to pay for the costs of the crisis. As a result, voter preferences have become much more polarized and can also be quite volatile. This makes life very difficult for governments. Nevertheless, if the latter do not take any action, the performance of the economy deteriorates further which causes even more voter discontent.

Next to the direct negative growth effect of this kind of policy paralysis, there is also an indirect negative effect via the financial markets and confidence channel. This is, of course, all too clear in Europe. Yet, this channel is also instrumental in understanding why policymakers do from time to time make a step forward in solving the fundamental problems, albeit always an incomplete one. To continue the analogy: If the heat becomes too much and there is a danger of the machine exploding, the mechanics will carry out some repairs despite the constraints put upon them by their fickle bosses.

This framework is very useful for understanding where we are in the cycle and what the risks are that the impending upturn will be aborted in the next few months. In short one could say that the heat from the financial markets and, in the case of the Fed, dissatisfaction with the results from previous policy actions, induced policymakers to make some important steps forward. This means that the virtuous feedback loop between growth and financial conditions/confidence, should in a sense “take the lead” in the next few months. Nevertheless, in principle the vigour of this feedback loop is always under a potential threat from renewed turmoil in the political arena which, if it becomes big enough, may at some point once again become the overriding factor. These risks include geopolitical developments as well as Economic and Monetary Union and US political brinkmanship.

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