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OPINION

A loopy world

A loopy world
August 25, 2015
A loopy world

There are two ways in which this would actually benefit the UK: lower oil prices will raise real incomes; and fears about the health of the world economy might cause the Bank of England to delay raising interest rates. We can quantify these negative feedback effects. The UK consumes around 1.5m barrels of oil a day, which implies that the $15 per barrel fall in its price we’ve seen since June would add 0.3 per cent to GDP. And Bank of England research suggests that if Bank rate is a quarter point lower than expected, GDP should be around 0.15 per cent higher than expected.

Offsetting these small but significant negative feedback effects are some positive feedback effects that could add to instability.

One is an old-fashioned accelerator effect; slower growth in world trade means companies will have more spare capacity than they expected which will depress capital spending. This effect, though, seems to be weak for now. The CBI this week increased its forecast for business investment growth this year, despite China’s troubles hitting UK exporters.

There’s another positive feedback effect we needn’t worry about. In theory, falling share prices depress consumer spending simply by making us poorer. This mechanism, though, is weak. The tech crash of 2000-03 wiped over £800bn off the value of UK shares with very little macroeconomic damage, so it’s hard to see why a smaller loss should be so troubling.

There are, however, potentially more worrying feedback effects. One of these is that oil exporters’ lower revenues mean they will invest less in western assets, thus depressing demand for shares, bonds and London housing. This helps explain why UK and US bond yields have risen since April even though falling share prices, concerns about global growth and a lower inflation outlook should have depressed them.

There’s a further problem - debt. The contrast between the mild effects of the tech crash and the devastation caused by the banking crisis warns us that debt is more destabilizing than equity. Here, we have a short-term and long-term danger.

The short-term danger is that some funds might have leveraged exposure to commodity prices, to commodity producers or to companies hard hit by China’s slowdown and so will get into serious trouble. This creates counterparty risk - he danger that distressed investors will be unable to meet their obligations to other companies - or fire sale risk, the danger that they will sell otherwise good assets to raise cash, thus depressing their prices. It was trouble in emerging markets that triggered the collapse of Long-Term Capital Management in 1998 through these mechanisms.

A longer-term danger is that China’s slowdown will embed deflation or low inflation into western economies, which means debt burdens won’t be eroded by inflation, thus increasing longer-term credit risk.

We don’t know how great these potential positive feedback effects are, because everything depends on the precise distribution of debt and network effects - whether the collapse of one or two investors has serious knock-on effects onto others or not.

I suspect, though, that it is this that is scaring western stock markets; whilst the stabilizing effects of China’s slowdown are quantifiable, the potentially destabilizing ones are not. Leverage plus instability plus opacity is a nasty equation.