By Grant T. Huxham
October 11, 2016
The recent decision by the Governor of the Bank of England, Mark Carney, to support monetary policies that effectively deliver negative real rates of return on U.K. gilts, coupled with Janet Yellen’s consideration of negative interest rate policy (NIRP), suggest that the ‘powers-that-be’ in the West are cautiously revisiting the requisite monetary and fiscal economic policies to be applied against three distinct economic scenarios: recession, deflation, and stagflation.
Key factors to be evaluated in a discussion of this shift include the broader economic malaise that appears to have set into the Eurozone, the fears regarding a “deflationary trap in China”, the possible end of the Japanese recovery under Abe-nomics, and the less than stellar recovery by the U.S. from the events of 2008 and 2009. This article will explore the implications of recession, deflation, and stagflation as they relate specifically to the United Arab Emirates (UAE) and in general to the entire Gulf Cooperation Council (GCC). The three scenarios can be termed “the Good, the Bad – and the Ugly”.
This article will comment on pressures that arise from such scenarios, but is in no way a commentary on actual policies adopted by the Saudi or UAE central banks, nor, to the extent that these central banks are not independent of their governments, on each government’s policy of the day.
“The Good” – Recession
Should the current economic trend be, in fact, a recessionary time (more on that below), such an event has short – and longer term – positive implications for the GCC, and particularly for the UAE.
Recessions, at least under a conventional Keynesian analysis, are thought to reflect an underlying weakness in demand for goods and services. Monetary policy, known as quantitative easing, as applied by the central bank, is an accepted means of stimulating demand.
Under a classical economic system (non-Keynesian approach), prices of goods and services adjust flexibly and quickly to competitive forces. In theory, then, adjustments to the amount of money in the system would have no effect. Though this may be true when observed in the longer term, in the short term, economists generally accept that the “price-stickiness” factor (the inflexibility of current prices) – for example the price of goods or labor – prevents an easy adjustment of prices to reflect shifts in demand or supply. Thus, economists consider the injection of more money into the economy by a central bank (quantitative easing) to be an appropriate response in the short term to an economic recession.
The premise dictates that by having more money available to chase the same number of goods that existed moments before the “new” money was created, competitive forces will raise the nominal prices for those same items, thus directly creating inflationary pressure on prices. In conventional thought, the next domino would fall as follows. Raising prices directly results in an increase in the nominal value of GDP demand. Other parties are prompted to create products and/or provide additional new services in response to the nominal increased price of such services. The economic law known as Says Law suggests that an increase in supply will itself stimulate or create its own demand. New money moves along the demand curve to meet and absorb existing supply at an increased nominal price. The observation by others of this activity then stimulates new supply, which, itself by creating more supply of goods and services, competitively reduces the cost of such goods, which itself induces the consumer to consume at a perceived beneficial price. And so the cycle repeats itself and the “normal” business cycle resumes.
So much for theory. What are the implications for Saudi Arabia and the UAE?
*Grant T. Huxham is a Dubai-based advisor at Gulf State Analytics.