Over the past eight years or so, the world has been flooded with money. Many countries, but especially the United States, through three rounds of quantitative easing, pumped trillions of new dollars into the world economy. Commodity prices took off.
Now, with commodity prices slumping and equities markets following them down, it may not look like the past years' partying was such a good idea.
Martin Wolf, the noted economic commentator, writes in the Financial Times that "The adjustment ahead for a world economy so addicted to credit bubbles is going to be difficult."
Listen to Wolf: "The most important shift (in world markets) is in the perceived economic and financial prospects for emerging economies. As a result, capital in now flowing out of emerging economies."
What is allowing this to take place is unlimited ability of the sophisticated investor to move money around the world at a moment's notice.
Wolf reports, "Global investors withdrew about $52 billion from emerging market equity and bond funds in the third quarter of 2015. This was the largest quarterly outflow on record." Going further, Wolf reports, "Net capital outflows to emerging and frontier economies even fell to zero, the lowest level since the 2008-09 crisis."
Theoretically, economists argued that having no controls on capital flows would be taken care of by flexible exchange rates. That is, movements in exchange rates would handle imbalances in the performance of independent economies, to bring nations back into equilibrium with one another.
In the real world, this has not happened. It takes time for these changes to take place due to limits on trading or due to interventions by central banks. As a consequence, massive amounts of funds can move around internationally and disrupt financial markets and global trade patterns.
Although economists and others recognized that the free flow of capital around the world had increased dramatically in the early 2000s, I don't think that economic policy makers and central bankers recognized the full impact of this fact and at the time the Great Recession came about. Nor was the extent of it was recognized as the Federal Reserve went through its three rounds of quantitative easing.
The book written by former Federal Reserve chairman Ben Bernanke, The Courage to Act: A Memoir of a Crisis and Its Aftermath, discusses, more than any other book on monetary policy, the international interactions that took place during his tenure. Yet, I still don't get the sense that Bernanke and the Fed realized how the money it was pumping into the economy might go elsewhere in the world and not just stay in the United States.
Bernanke and the Fed did exactly what the economist Milton Friedman, perhaps the person Bernanke learned the most from in his research into the Great Depression, suggested to do when facing a severe economic downturn. They erred on the side of putting too much liquidity into the financial markets, and pumped billions and billions of dollars into the banking system. A good portion of these funds went "off-shore" and helped to create the credit bubbles, cited by Wolf above, in commodity markets and the stock markets of emerging nations.
Well, the Fed's quantitative easing ended in late October 2014 and financial markets have not been the same since. On October 31, 2014 the S&P GSCI, an index that measures commodity prices, closed just under 54. The Reuters-Jeffries CRB, another index of commodity prices, closed at about 272. On Tuesday, January 12, 2016, the S&P GSCI closed just under 28, showing a decline of 48% from the earlier date, while the Reuters-Jeffries CRB closed at 162, down 40%.
The credit bubble has burst and now the world economy has to adjust for it.
Wolf discusses some remedies. For one, China has played a big role in the rise in commodity prices and is also playing its role in the decline. In order to help stop the decline, it is suggested that China allow for its own capital flows and further depreciate the renminbi. This, however, Wolf argues, would "threaten the stability of the rest of the world economy." Not such a good remedy.
The other factor here is the Federal Reserve. The Fed put the last nail in the coffin, so to speak, as it raised its policy rate in December, causing the value of the U.S. dollar to rise, putting even more pressure on commodity prices and international capital flows.
And officials at the Fed are discussing four more increases in its policy rate in 2016. This is not helping in that it has added reasons for investors to take money out of emerging markets.
Whatever is done, it is obvious that the freely flowing capital throughout the world has changed things and policy makers are going to have to take account of this fact, something they have avoided up to this point.
Wolf does not have a real optimistic view of how this all will be resolved. "Cleaning up the aftermath of financial mistakes is just a part of the challenge the world confronts." And, he closes by writing "The adjustment ahead for a world economy so addicted to credit bubbles is going to be difficult. It will probably be no outright disaster. But it is not going to be much fun either."
In other words, hang onto your hats.
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.