Interpreting Increased Volatility in Financial Markets
The recent volatility in the stock market has raised
questions about its causes and its consequences for asset prices and economic
growth. With the 2008 global financial crisis in mind, investors and the
broader public want to know whether such corrections are simply part of the
process of normalization in the global economy following a prolonged period of
unusually low interest rates, or whether they might be symptoms of more worrying
trends, signaling a range of other weaknesses in the economy. This article will
argue that beyond the challenges created by the global financial crisis and the
concomitant rapid rise in levels of public indebtedness in the United States
and other advanced economies, policymakers will also face a number of
medium-term challenges linked to aging populations and the likely fiscal impact
of climate change and that much more needs to be done to establish a firmer
foundation for sustainable economic growth.
One area of concern pertains to the current stance of fiscal
policy in the United States. Fiscal policy during much of the postwar period
has largely been countercyclical, that is, the government has traditionally
played a stabilizing role, providing stimulus whenever private demand was
weak—such as during the 2008 crisis. Fiscal stimulus was applied globally in
response to that crisis, and resulted in a sharp widening of national deficits
in the years immediately following. As economies entered a period of gradual
recovery, the deficits came down. In recent months, the U.S. government
approved large tax cuts and signaled boosts to public spending, at a time when
unemployment is at the lowest level in more than a decade (4.1%) and the
outlook for economic growth appears positive. These measures raised questions
about the appropriateness of fiscal stimulus as a policy tool, considering U.S.
public debt levels are at their highest since the end of World War II,
reflecting the immense costs of the 2008-09 interventions.
There are other sources of concern in the US. As budget
deficits need to be financed, there will be a fairly robust supply of treasury
bills to the market in the period ahead. In particular, the US Treasury will
have to fund a $1 trillion deficit over the next year. Moreover, monetary
authorities already began to unwind their balance sheets, which grew rapidly as
a result of the unorthodox policies they were forced to implement – such as
quantitative easing – in order to deal with the aftermath of the crisis.
Indeed, the European Central Bank and the Bank of England are similarly
committed to unwinding their crisis-era stimuli and shifting their role as
“babysitters” of the financial markets through the provision of unusually easy
financial conditions after the crisis to a more traditional role of guardians
of low inflation.
As interest rates in Europe edge up, U.S. debt is likely to
be less attractive in relative terms. This effect will be reinforced by the
weakness of the U.S. dollar against the euro and other currencies. This is
important because the financing of the U.S. budget deficit is very much
dependent on foreigners, who own about half of all U.S. debt. In light of this,
it has been hardly surprising to see interest rates climb in recent months. This
climb has pushed the yield on 10-year treasury bills to a 4-year high. The
fiscal outlook is further complicated by these higher borrowing costs. Other
geopolitical risks—trade wars, various security shocks—have the potential to
boost perceptions of risk and push interest rates higher.
A main concern in the period ahead is not so much about
volatility in financial markets linked to a gradual rise in interest rates, or
central banks being less accommodating than in recent years. The concern is
over fiscal pressures which are projected to build in coming years – for which
highly indebted economies are ill-prepared.
As the chart below shows, many countries’ public debts
currently stand at levels last seen in the mid-1940s. The problem with high
public indebtedness in a context of rising interest rates is that it creates
painful tradeoffs for governments. Scarce public resources which could be
allocated to areas that help to improve competitiveness have to be increasingly
dedicated to debt service. Instead of worrying about reforms aimed at boosting
productivity, governments tend to focus more on debt dynamics, market
sentiment, credit ratings, and where the money will come from in order to cope
with the next crisis.
Regrettably, for a variety of reasons, a number of
challenges in the coming years will emerge, which will likely put heavy
pressures on the public finances of countries the world over. To start with,
unlike the favorable demographic dynamics of the 1950s and ‘60s that featured
major increases in the working age population, today, because of increases in
life expectancy and decreases in fertility, we face the problem of an aging
population. The cost of pensions, healthcare, and other social benefits is
projected to rise rapidly over the next several decades. In the United States,
for instance, 78 million people were born between 1946 and 1964 (the “baby
boomers”), a cohort that has started to retire since 2011. In France and
Germany, pension and health spending by 2050 is expected to be well above the
17 percent of GDP registered in 2000. This is not only a problem in rich
industrial countries; many of the larger emerging countries have an aging
population problem of their own. In coming years, there will be fiscal
pressures unseen in past decades, which will significantly add to budgetary
burdens and erode the ability of governments to simply “grow out of debt.”
Furthermore, governments have generally shied away from implementing the sorts
of reforms that are necessary to deal with these fiscal pressures. Increasing
the retirement age, for instance, can be a highly effective way to set the
public finances on a more sustainable path, though this policy tends to be
politically difficult to implement.
Further, climate change will be a feature of the global
environment in the years ahead. Increases in sea levels could well require
heavy investments in infrastructure, including sea barriers, or, as many
regions become drier, irrigation networks and other investments to deal with
water scarcity. In some cases, it may be necessary to resettle populations no
longer able to live in low lying areas; currently, roughly 1.2 billion people
live within 100 km of the shore globally. The increasing incidence of extreme
weather events—as we saw dramatically in the United States and the Caribbean in
2017—will also require budgetary allocation that will, by definition, be
difficult to plan for. To the extent that weather-related catastrophes put a
dent on economic growth, there will be adverse repercussions for government
revenue as well, putting additional pressures on budget deficits.
The risk is that markets will not wait until a government is
insolvent before significantly increasing the costs of borrowing. 2010 showed
how systematically destabilizing the prospect of default could be even for
small countries like Greece, and how losses of confidence in the debt-carrying
capacity of the country can, through an increase in risk premia, dramatically
reduce the government’s room for fiscal maneuver. The point is that the fiscal
consequences of climate change and aging populations could at some point
interact with financial markets in highly destabilizing ways, significantly
worsening an already difficult fiscal situation.
Sustainable economic recovery—essential when addressing the
debt problem—will only come when governments implement reforms which will help
remove supply-side barriers that have long undermined competitiveness and
reduced potential growth. We need to wean ourselves away from central banks’
generosity and courageously tackle the precarious fiscal outlook.
Augusto Lopez-Claros is Senior Fellow at the School of
Foreign Service. He is on leave from the World Bank.
Augusto Lopez-Claros
