Realignment Is Underway
There are three reasons for the realignment that is already underway. First, the new demography of the United States is dramatically changing party identification and the current Republican Party doesn’t look or think like the new America. Second, the Trump phenomenon has ruptured the Republican political brand and accelerated the party’s fatal weaknesses with the expanding constituencies of this new America. Third, the coincidence of the 2020 decennial census and a presidential election will swell Democratic turnout for down ballot elections of Governors and state legislatures that will subsequently redistrict the House of Representatives for a decade.
Data on the American electorate since 1988 shows a dramatic demographic shift that has now reached critical mass: the white electorate has shrunk from 88% of overall turnout to an anticipated 69% this year. Blacks, Hispanics and Asians are expected to comprise 31% of the 2016 electorate, with Hillary Clinton expected to receive between 80-92% of the non-white vote. Voters under 30 have single digit support for the Republican ticket and single women are repudiating not only Trump, but traditional Republican ideology by dramatic margins. These increasingly powerful demographic constituencies identify and vote significantly Democratic, thus making a Republican national election victory — even if Republicans had a strong, non-controversial candidate — improbable.
The Republican Party conducted an “autopsy” after its 2012 defeat.
That RNC report concluded that the Party must reach out, pragmatically and symbolically, to blacks, Hispanics, Asians, and women. Yet, the only response by Republican State parties to these recommendations has been not to reach out to these growing constituencies, but rather to adopt voter suppression legislation to prevent them from voting. And as the Republican base of old white men dies off, the demographic base of the Democratic Party continues to attract the expanding constituencies of the new American electorate.
Global growth of GDP per working age person slightly outpaced its historical average and unemployment rates generally fell in the year under review. Perceptions of economic conditions, however, were defined by further falls in commodity prices, large swings in exchange rates and lower than expected headline global growth. These developments hint at a realignment of economic and financial forces that have unfolded over many years. In EME commodity exporters, the downturn in the domestic financial cycle mostly compounded the fall in export prices and currency depreciations, with economic conditions becoming weaker. In general, tighter access to dollar borrowing amplified these developments. The anticipated rotation of growth failed to materialise, with activity in advanced economies not picking up as much as needed to offset slower EME growth, despite some upturn in domestic financial cycles in the advanced economies most affected by the Great Financial Crisis. Lower oil and other commodity prices have not yet triggered the expected fillip to growth in importers, possibly because some parts of the private sector are still nursing weak balance sheets. The scars of repeated financial booms and busts and debt accumulation also hang over global potential growth: factor misallocation appears to be holding back productivity, with debt overhang and uncertainty seemingly restraining investment.
The global economy continued to expand in the year under review, with unemployment generally falling and global growth of GDP per capita around its historical average. That said, sharp falls in commodity prices and their subsequent partial recovery, large exchange rate moves and lower than expected headline global GDP growth shaped perceptions. These developments are often seen as the confluence of unrelated negative shocks. But this triplet is, to an important extent, the result of an economic and financial process that has unfolded over many years.1Before reviewing these three developments and the realignment they represent, it is useful to take stock of their connections and the path taken to the current juncture.
The genesis of much of the latest developments lies in the boom years leading up to the Great Financial Crisis. Stable, low-inflation growth in the 2000s encouraged easy monetary and financial conditions in the major economies and ample global liquidity. Easy financing fuelled domestic financial booms in advanced economies, with credit and property prices soaring. Strong growth in emerging market economies (EMEs), particularly in China as it reformed and opened its economy, added to buoyant global demand. Resource-intensive industries in EMEs, including manufacturing and construction, expanded rapidly, pushing demand for commodities ever higher. The surge in commodity prices, and in commodity producers’ exchange rates, encouraged ample and cheap international borrowing, in turn contributing to the vast investment in commodity production capacity.
The financial crisis brought only a brief pause to these dynamics. The onset of severe balance sheet recessions in the countries at the core of the crisis, prominently the United States and parts of Europe, led to highly expansionary monetary and fiscal policies not only in these economies, but also in those exposed to them through trade and financial channels, including China. The resulting demand boost triggered a resurgence in the commodity boom as resource-intensive industries expanded in key economies, supported by readily available finance. As the crisis-hit countries recovered only slowly from the balance sheet recession, highly expansionary monetary policy remained in place for an extended period even as fiscal policy tightened somewhat. The persistently easy global liquidity conditions induced spillovers to commodity exporters and other EMEs, boosting broad-based domestic financial booms in those countries.
More recently, the commodity “supercycle” has turned and global liquidity conditions have begun to tighten even as crisis-hit economies have continued to grow at a moderate pace. In the past year, weakness in construction and manufacturing slowed the growth of resource demand. This softer demand, coupled with supply expansion, ushered in further commodity price drops, with significant economic consequences. For some countries, maturing or turning domestic financial cycles coincided with tighter external financial conditions linked to an appreciating US dollar. Large exchange rate depreciations have the potential to cushion countries against external developments, but their beneficial effect can be offset by the corresponding tightening of financial conditions, as they boost the foreign currency debt burden. With EMEs accounting for a larger share of the global economy than ever before, their strains can have larger spillbacks on other economies.
This chapter reviews the lower than expected growth, commodity price falls and exchange rate moves in the context of the financial and real forces that delivered this triplet. The first section discusses growth in the global economy, countries’ evolving financial cycles and the elusive realignment. While growth has been lower than expected, particularly in EME commodity exporters, the state of the economy appears much brighter based on growth adjusted for demographic change and labour market outcomes. The subsequent sections examine the commodity price falls – the proximate cause of lower growth in many commodity producers and EMEs – and the associated exchange rate moves. These two relative price changes can set the basis for more sustainable growth in the long run, but the short-run drag may be significant. The potential spillovers from EMEs are discussed next. While EMEs’ increasing share of growth and trade means they are a greater source of spillovers through trade, financial spillovers largely still emanate from advanced economies. Notably, though, such financial spillovers can build up in EMEs, raising the potential for pernicious spillbacks to advanced economies. Finally, the chapter explores the causes and policy implications of slower structural growth. The slowing of working age population growth is weighing heavily on growth potential, but other headwinds from the shadows of financial booms should eventually recede. These headwinds make it all the more important to pursue policies that can deliver sustainable growth.
The missing rotation
Global growth in 2015 was lower than expected, and the near-term outlook weakened (Chapter II). Global GDP expanded by 3.2% in 2015, less than the 3.6% expected as at December 2014, which would have been close to the 1987-2007 average (Graph III.1, left-hand panel). However, taking account of demographic forces, growth of GDP per working age person was actually slightly above its historical average. The anticipated rotation in growth, part of the broader realignment, failed to materialise as the slowdown in some EMEs, in particular commodity exporters, was not fully offset by a pickup in advanced economies. The financial cycle turned down in some economies adversely affected by these economic forces, but remained in an upswing in others (see Box III.A for a discussion of the measurement of the financial cycle). Growth in most economies was underpinned by domestic consumption.
In countries at the centre of the financial crisis, including the United States, the United Kingdom and Spain, growth remained moderate in the wake of the balance sheet recession, but the financial cycle generally turned up. In the United States, growth was 2.4% in 2015 and continued at a similar pace in early 2016, constrained by US dollar appreciation. Real property price and credit growth picked up, gradually closing the credit-to-GDP gap (Graph III.2, left-hand panel). The euro area saw GDP expand by 1.6% in 2015, up from 0.9% in 2014. This pace of growth continued in early 2016 as the financial cycle kept recovering in most euro area economies, with increasing real property prices and credit-to-GDP gaps still negative. With consolidation efforts behind, fiscal headwinds waned.
In other advanced economies, developments varied. The expansion in Japan slowed in the second half of 2015 despite the fall in commodity import prices, with growth of 0.6% for the year. Canada returned to growth in the second half of 2015 after a mild recession triggered by a collapse in resource investment.
The concept and measurement of the financial cycle
The broad concept of the financial cycle encapsulates joint fluctuations in a wide set of financial variables, including both quantities and prices (see also Box IV.A in the 84th Annual Report). An obvious analogy is to the business cycle. The business cycle is often identified with movements in GDP, yet despite many years of research there is no universal agreement on which method to use. These can include an analysis of the unemployment rate or identifying turning points in a range of monthly indicators (as done by the NBER Business Cycle Dating Committee). Identifying the financial cycle is more challenging as there is no single aggregate measure of financial activity, even though a consensus has started to emerge that credit aggregates and asset prices, especially property prices, play a particularly important role. Methodologically, two different approaches have been proposed to measure the financial cycle more formally (the first two methods described below). In addition, insights from other strands of the literature can be used to pinpoint peaks and troughs (the third and fourth methods below). While the exact dates of turning points differ, the four methods discussed in this box generally coincide in identifying periods of expansion and contraction.
The turning point method dates the financial cycle with the same technique used by the NBER to date business cycles. Cyclical peaks and troughs are identified in real credit, the credit-to-GDP ratio and real property prices. Drehmann et al (2012) identify a turning point in the financial cycle if all these three series turn within a three- to six-year window.
The filter method uses a statistical filter to extract cyclical fluctuations of real credit, the credit-to-GDP ratio and real property prices and combines them into a single series. Specifics differ, but Drehmann et al (2012), for instance, rely on a bandpass filter to extract cyclical fluctuations between eight and 32 years in each of the series. They then take an average of the medium-term cycles in the three variables.
The early warning indicator (EWI) method builds on the financial crisis early warning indicator literature. In particular, large deviations of the credit-to-GDP ratio from a long-run trend have been found to provide a reliable single early warning signal. And the financial cycle is seen to turn once real residential property prices start to fall. On the flip side, a trough occurs when the credit-to-GDP gap is negative and property price growth turns positive, even though there is more uncertainty as property price growth sometimes fluctuates around zero for some time.
The gap method exploits insights from Juselius and Drehmann (2015) to decompose the financial cycle into two key variables that jointly pin down sustainable levels in the credit-to-GDP ratio. The first is the leverage gap, which is the deviation from the long-run equilibrium relationship between the credit-to-GDP ratio and key asset prices (real residential and commercial property prices and equity prices). The second is the debt service gap, which is the deviation from the long-run equilibrium relationship between the credit-to-GDP ratio and the average lending rate on outstanding debt. By embedding the gaps in a vector autoregressive system, the authors find that they are the key link between financial and real developments. Most importantly, a high debt service gap – when a high fraction of income is used to pay interest and amortise debt – significantly reduces expenditure. The leverage gap, on the other hand, is the key determinant of credit growth, boosting it when it is negative, ie when asset prices are high relative to credit-to-GDP ratios. Given that it embeds both credit and asset price dynamics, a negative (positive) leverage gap is associated with the expansion (contraction) of the financial cycle.
As an illustration, the expansion and contraction phases of the financial cycle for Spain, the United Kingdom and the United States generally coincide based on the four methods outlined above (Graph III.A). While close, the exact timing of turning points differs across methodologies. Otherwise, the only difference between methodologies emerges during the dotcom bust, after which the gap method identifies a contraction in the financial cycle in the United Kingdom and the United States, in contrast to the other approaches. This most likely arises because this is the only method that also includes information from equity prices, which were more volatile at the time.
While the four different methods provide a coherent picture of the financial cycle, in particular in retrospect, it is clear that none is sufficient to perfectly classify countries into different phases. For instance, currently all methods suggest that the financial cycle is expanding in the United States, but there remains more ambiguity for Spain and the United Kingdom. Given the heterogeneity in financial booms and busts, including owing to structural developments, it could be useful to rely on a broader range of indicators, including credit spreads, risk premia, default rates and proxies for risk perceptions and risk appetite.