Diana Choyleva: the unravelling of globalisation

If you missed any of Merryn's past interviews, you can see them all here.

Merryn: Hi, I'm Merryn Somerset Webb, editor-in-chief of MoneyWeek magazine. Welcome to another one of our MoneyWeek video interviews. With me today is Diana Choyleva, who is the chief economist at Enodo Economics.

Now, we are talking, Diana, just after the results have come out from the American election, so it's quite an important event and I just wonder if we can start by talking about whether it in any way changes your view of global economics; a big question.

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Diana: Absolutely a big question. It's great to be part of your video series, so thank you for inviting me. We are talking during a very important week for where the world economy is headed. It's very clear that with Trump headed for the White House political uncertainty has increased, but actually the one thing that I'm certain about, and that's how my view has changed after the American elections, is that the world economy is heading towards unravelling globalisationho.

Merryn: Okay, so this was the case before the election but the election simply cemented your view that the globalisation of the last four, five, six decades is now going to unwind; this is an anti-globalisation period we're entering.

Diana: Absolutely. The first wake-up call was of course the vote on Brexit, and at the time I argued that ten years from now we are likely to look back and see Brexit as the first nail in the coffin of globalisation. But I still saw a chance for the world economy not necessarily to go in that direction. I think with the election of Trump as US president, that chance is gone.

Merryn: So let's go back then a little bit to the drivers behind this. What has brought us to this point where we're suddenly turning against something that has made the whole world significantly better off?

Diana: Well, a lot of factors, but essentially what we've had is a world that globalised very fast. If we look at the three most important events that accelerated globalisation, the fall of the Berlin wall; funnily enough yesterday on the 9th November was also the anniversary of the fall of the Berlin wall. Also we had China's entry into the World Trade Organisation and as such into the world trade system, and then we've had this rapid technology progress. And you're absolutely right that globalisation improved the livelihood of millions of people out there. The problem is that there seems to be a very fundamental clash between, if you like, globalisation and market forces as we, liberal market forces as we know it, with national sovereignty and identity, and on the other hand with the democratic system, so those three don't seem to be easily coexistent.

Now, I lay the blame at the feet of policymakers across the board because the revolt, the popular revolt against the establishment is understandable. We actually have had large parts in the developed world of the population who felt relatively worse off, but relative to the owners of assets in those economies.

Merryn: So this is the financial crisis really or before that?

Diana: Even before that, because basically the global economy has not been able to internalise, or the world economy has not been able to internalise this globalisation in the best possible way. Whereas I can forgive policymakers for not doing the right policies or following the right policies before the financial crisis, my view is that the financial crisis should have been a huge wake-up call. Unfortunately, eight years since, you're looking at the global economic situation being largely misunderstood by policymakers and then as a result we're not seeing the right policies come through.

Merryn: What do you think the policies should be? I'm giving you an opportunity to rule the world here. You're suddenly in charge; what would you have done after the financial crisis to remedy the problems that globalisation brings?

Diana: It's a very complicated issue. It almost doesn't have a solution because the policy response should have been globally coordinated and that's the problem. If you look at why the financial crisis came about, it was largely not because there were these bunch of people, whether in America or in the UK or in the periphery economies of the Euro area, who wanted to borrow and spend excessively, or if you like think the world was investing excessively. No. Actually the key driver was the desire to save excessively out of income in large parts of the world, notably China, Japan and northern Europe.

And if you're in the shoes of the Federal Reserve during the build up to the global financial crisis, you weren't in the driving seat. These people were willing to throw this money at you at no cost. It's almost too rude to refuse. So in response to the crisis, the Federal Reserve in my view did the right thing when they moved onto quantitative easing because you had the need to deleverage in the economy, which meant that there'll be destruction of money, either by dead default or pay down of debt. That could have threatened demand, deflation, a downward spiral if there wasn't a way of propping up the amount of money in the economy and QE [quantitative easing] served that function from the point onwards when they started buying the assets from the non-banks. The problem is...

Merryn: So this was a correct policy; QE was the right thing to do post crisis?

Diana: In the US and in the UK, but they were doing it... In the UK they were doing it for the right reasons but in the US they kept talking about credit easing, and they continue to talk about credit easing, failing to realise that why would you want to stimulate credit in an economy that is actually suffering from excess debt?

The good thing in America was that quite outside of policymakers causing this, there was an actual deleveraging, largely because the housing market there is different, they have mortgages that are fixed rate mortgages, not variable rate mortgages, and also loans that are, I think it was non-recourse or recourse - I keep mixing them - but basically it means that you can throw the keys behind you and you are not responsible for the loan.

So we did see a lot of deleveraging and America also allowed the banking sector to cleanse itself; a lot of banks went bust, and that was a good structural development, the deflationary effects of which were alleviated by quantitative easing. The problem is that beyond that we have now entered a situation where monetary policy or quantitative easing in particular is turning from being benign to malign.

Merryn: Malign in what sense?

Diana: I will give you the example of the Bank of Japan. They engaged in very aggressive, a new round if you like of quantitative easing a couple of years ago, but in the case of Japan there isn't any private sector debt problem. Japan suffers from two key structural imbalances; one is that too much income flows to the corporate and too little to the household sector, and the other one is that actually there has been a very fundamental deterioration on the supply side of its economy, so much so that they have lost half their export market share in the last 20 years and not because of an overvalued exchange rate. So in their predicament, deflation was mildly positive. It wasn't actually the problem because it gave some real income to households.

Now, to go outright to try and achieve an inflationary target and to do that through quantitative easing, the only reason that they haven't actually achieved it just yet is because they were buying the assets mostly from the banks and the banks weren't lending, no-one was willing to borrow, so it wasn't hitting the real or the non-bank economy if you like.

Merryn: So they were keeping the money quantitative easing inside the banking system because they're buying assets directly from the banks rather than in the type of quantitative easing you've seen elsewhere where people have bought, their banks have bought assets in the market and therefore injected the cash directly in. This is the core difference.

Diana: Yes. But it is applying QE to the wrong problem or applying the wrong medicine to Japan's problem. So QE, so far the damage has been largely through the weakening of the yen. In a sense that if Japan was pursuing that policy and the rest of the world was all fine, it would have been all right, but the rest of the world is not fine. So if all of the major economies are trying to devalue their currencies to get growth, clearly, unless we discover life on Mars, nobody can win. It's a zero sum game.

But the other danger that's around the corner in Japan is that if they keep the rate of asset purchases at current levels, soon they're running out of JGBs to buy from the bank so at that point they have to buy assets from the non-banks, and at that point the money hits. Now, quantitative easing doesn't improve the trend growth rate of an economy. It doesn't solve the structural imbalances. So if you actually have a avalanche of money hitting, yes, you are going to get your inflation but it's not going to be through a sustainable increase in real growth and you then create an inflationary problem.

Merryn: But then what that might do is inflate away the real value of the debt that Japan is owning the public debt. That helps.

Diana: That helps if they weren't the bond market vigilantes. Of course in the case of Japan, the Bank of Japan is now owning 40% of the government bond market. So I think the next big theme over two to three years is going to be the return of inflation for various reasons, not just because now monetary policy, for lack of anything else, and kind of feeling the pressure that central bankers have to do something even though it's out of their hands, we're getting into a negative spiral of too much easing. I mean, look at the Bank of England's response to the Brexit vote. The UK didn't need lower interest rates and they didn't need QE either, especially considering...

Merryn: They got it anyway because it's the only policy that is left for anybody to use.

Diana: It's not the only policy that is left but yes, it's in a way, it's out of central bank's hands and at this point they can do more damage than good. If we look at the US and the Federal Reserve, they should have raised rates much sooner than they did. So they're not necessarily guilty of easing at this point but they're certainly guilty of not normalising faster than they should have.

Merryn: So do you think that the Fed could normalise now, could bring rates up to normal levels without damaging the economy?

Diana: Absolutely, because they have actually done the adjustment. If you look at...

Merryn: So why have they not?

Diana: Because they're petrified... Raising interest rates will have to involve a correction in the equity market. There's no way around it. And they're too focused on that being somehow negative, more so than the cost of not doing it.

Merryn: They will have to do a question [?] and there's been a lot of talk already about how Trumpism is going to bring back inflation; so many of his policies are inflationary. At some point, relatively soon the Fed will have to give in and raise rates and do you think that then the American equity market will suffer?

Diana: Yes, it will have to re-price one way or another but that, I don't view that necessarily as a negative thing. If we put Trump to the side for a second, and I'll comment on that; if the Federal Reserve had said well actually the real economy has adjusted, if you look at the household sector there's no excess debt, if you look at the corporate sector debt has gone up relative and the debt servicing costs have gone up, but not to crisis levels, and the public sector has also arrested the increase in the public debt to GDP ratio. So they could have said okay, we're normalising interest rates. Yes, asset markets would have to correct, but if they saw through that rather than trying to see through in the future, I'm sure, inflation, if they saw through that they could have said well actually we are confident that the real economy is doing well.

And a lot of the improvement in the economy was because of improvement in employment, not purely wage growth, which is a much more sustainable kind of support to consumer spending because you definitely spend more if you move from being unemployed, spending your savings, to employed spending your income, than if for example we had the adjustment where wages were pushed up. At that point it's less of a support for consumption because you might decide to save more rather than spend more, if you see what I mean.

So then they could have at least given the market that confidence that we're back to normal and we would have seen more consumption and more investment as a result, is my view. We didn't do that and of course you're right, that now a lot of Trump's policies are inflationary, not just for America. If we are going to be building walls, whether it is between the US and Mexico - by the way, that's one wall I think he will not build - so there is opportunity for the Mexican peso to recover and the equity market to recover and that is...

Merryn: He will not build that wall; you don't think he'll just put up a token section of it or something like that? He's going to have to save face somehow.

Diana: Well, if I look at the way globalisation is likely to fracture, I mean clearly politicians promise a lot of things before they get elected and then what they do after they get elected tends to be a very different story. I think from all the promises that he has made, probably that one is less likely to materialise, not least because my view is that globalisation will unravel into localisation.

Now, in this environment, big and stable economies have an advantage over small and open ones. Clearly China, US, India fall in that bracket; the Euro area, unfortunately, doesn't fall in the stability bracket because we still have the German, the French elections, a lot of political instability there. They are a trading bloc, that's great, but the politics is going to trump that in the coming year.

Merryn: Europe is probably the place where we're going to see the next leg of globalisation collapse.

Diana: Well, if you like the next leg of the popular revolt. Now, America is big but I think they will look to expand their regional reach and the natural look is obviously Canada and Mexico. So I do think that that will be one promise that's not going to be followed on or followed through on. And my suspicion is that Trump's hard rhetoric vis-a-vis China is probably more likely to be followed through, and that's extremely bad news.

Merryn: Let's talk about that because China is already not in the best of places, is it?

Diana: No. It's one of the saver economies. But actually to their credit, in the last three years of the new leadership they have gone down the right policy route of saying okay, we threw money at the economy after the financial crisis, we did a lot of wasteful investment, it's not worked because all we got for it was inflation and a huge build up of debt, let's reform.

They have been opening up the financial system and liberalising at a rate that in a way is even unprecedented for China. Peculiarly though, at the same time on the political side, actually going very much the other way around in curtailing personal freedom even more, using Mao style measures to go on the anti-corruption drive, return of the party secretary to the state owned enterprises as the main decision makers, self-criticisms. So politically they've gone very much the other way around but economically, bizarrely, they have been liberalising.

Merryn: Trying to rebalance.

Diana: Yes. And if you look at the global currency war, the only major currency that is over-valued is China, is the yuan. And in fact in a world where interest rates are near zero, the monetary policies of each economy have been played out largely via the exchange rate. And China had accepted this; they've even intervened to support the currency shedding foreign exchange reserves, not allowed it to depreciate too fast because they wanted this more stringent policy to be the impetus towards reform.

Merryn: But it has been depreciating.

Diana: It has, yes. But it could have been depreciating a lot more, and they need it to be depreciating a lot more because the adjustment that they have to go through is very difficult and it will be that much harder if they have to deal with an over-valued currency on top. The problem is, and that was a problem before Trump but certainly after Trump it becomes even more difficult to imagine how this could happen, for China to have a successful rebalancing, a necessary consequence of that is that weaker currency. And my problem before Trump was that I didn't see how the rest of the world will be prepared to accept that consequence, in particular Japan and the Euro area, but now certainly not America either.

So in Beijing maybe they feel that Trump's election is positive from a political perspective because, you know, maybe they'll get more space to increase their political influence, but it is very ambiguous in terms of its impact on the economy. And in fact the danger is if you think of China and America as key, you could think of them as the wings of the world economy, if one wing is cut off then the whole thing spirals down. So we are entering, unfortunately, a very difficult economic and political time.

Merryn: So when you say you think that Trump will follow through on his threats to do with China, trade policy and branding it a currency manipulator etc, how will that actually happen?

Diana: To be honest, I think in this case it's almost totally unreasonable to make any forecast, especially for someone like me who is not a political analyst but an economist, as to what Trump will do or won't do. I think it's such an unknown quantity and all of us will just have to wait and see what happens. My feeling is, and that's just judging by what has happened so far, he did go to Mexico and did offer a small olive branch. He's not done that at all one bit with relation to China. So I'm not basing that expectation on anything else but the logic of how economics would progress and seeing a little bit of what he has done so far in maybe educating us of what he might do next.

But I think this is the biggest problem for everyone at the moment is that we don't know what Trump will do, and as a secondary move what he can do because obviously he has checks and balances within the American system itself.

Merryn: That's a comfort. Now Diana, I know that you're an economist and not an investment strategist but you've just painted a pretty miserable picture of the global economy. Where does that leave investors? Do you have any sense of how we should or shouldn't be deploying our money around the globe? Definitely not in US equities.

Diana: Well, not necessarily definitely not in US equities in the sense that, you know, if we look for the longer term, so the next three to five years rather than immediately over the next three months or six months, the fracture of globalisation has very clear-cut investment themes. As I mentioned to you, India, China, US are relatively more likely to do better than smaller economies if barriers go up, whether it's capital, trade, movement of labour.

The cost of capital will go up as well. I think inflation is coming, so that's a very clear-cut theme and obviously leads, together with political uncertainty, to me being a gold bull if you like because, well, from both sides gold is generally a hedge against political uncertainty and it's a hedge against inflation, and I think both will be features of what we are facing. It also argues towards maybe more bottom-up investment. If we're going to see a localised global economy, clearly the global players are going to suffer, not just because globalisation is going up but because everyone is after the big corporations in terms of their attempts to hide away the profit in...

Merryn: The political climate is turning against the big corporates, it's one of the villains in the globalisation story and possibly towards smaller companies who are the, not the villains. Everyone loves the small company right; you never hear a government complaining about the activities of small or medium sized companies; they're always after the big corporates.

Diana: And the other thing is that, and it's not useful advice, the majority of the people that I talk to, because they have certain remits, is that actually you'll probably find more value in the non-quoted space than in the quoted space because, for example, if you say or play a domestically demand driven story, in a place like the UK, the US, there is more of that sector represented in the quoted equity space. In the case of the Euro area, that's not the story. It's difficult to play a domestic demand driven story through the quoted equities. At the same time, though I'm not saying go into the private equity space because that one's pretty crowded as well in terms of the returns you get.

Merryn: So be an entrepreneur is what you're saying.

Diana: Well, this is what I decided to do with my own money. As I left Lombard Street Research I thought what should I do? And I thought the best use; the highest likelihood of me making superior returns is to invest in my own business.

Merryn: Diana, thank you very much. I think we come away from that with some excellent advice, buy gold and start your own business. Thank you.