One Reason for Our Global Economic Puzzle—Slack Needs to Dissipate

10/15/2015 9:00 am EST

Focus: FOREX

Are markets running out of steam? Can the US economy be strong enough to pull the rest of the world out of its doldrums? Why have a number of experts been unable to explain the current conundrum? To address these global concerns from a forex perspective, Tom Cleveland, on, relies on one word...slack.

While optimists and pessimists debate the near-term outcomes of our financial markets, analysts and economists are unable to agree on why the global economy is only sputtering along, refusing to shift into higher gears. Equity markets, however, are peaking with bubble-type valuations. Investors are getting edgier by the day, but everyone seems to be looking for one smoking gun that will capsize the ship and send everyone rushing for safe havens. By their measure, it is not if, but when.

Our current situation has been deemed a puzzle or whatever term you might choose to denote a larger-than-life question mark. The doomsayers among us have been screaming for three years, advising investors to cash out and sit on the sidelines until bargains reappear. For those that followed this advice, they would have missed out on one of the longest bull markets in history and a great opportunity to recover losses sustained during the Great Recession. Forex traders, however, have been patiently waiting for volatility to return, a time when easy fortunes can be made are there for the taking.

A plethora of technical charts have been presented that support this reverse Big Bang Theory in our capital markets. The implosion, if you will, should now occur in late 2015 or in 2016 for sure. The scramble for the exits will result in a liquidity crunch like never before seen, including 2008 and 1929. This time around, we are talking about cross-border capital flows that will drive huge Bid/Ask wedges into major and minor forex pairings in a mad dash to repatriate illiquid foreign investments. Some analysts claim that this dash started some time ago, especially in emerging markets. Gold enthusiasts have yet to benefit, but their time is coming...maybe.

No one has yet to find this reliable smoking gun or killer chart that proves their argument. Our markets have buckled under the onslaught of these pessimistic sentiments, but they have returned with gusto each time. Earnings season is upon us once again and so the die is cast in some quarters. Forecasts abound from quite a few respected experts that the momentum from 2008, as slight and gradual as it has been, must decline going forward. Are markets running out of steam? Can the US economy be strong enough to pull the rest of the world out of its doldrums?

Why have our esteemed experts been unable to explain the current conundrum?

NEXT PAGE: So, What's at the Core of the Problem?


In a recent article, Roger Mitchell, the Managing Editor for the CFA Institute Magazine, opined that the issue is more one of managing expectations. He wrote, “Most of us are poised to believe that markets will do something erratic. That is our implicit null hypothesis. An overvalued market will be corrected. An irrationally exuberant market will crash. A slowing economy will cause a bear market. A rapidly expanding economy will drive a boom. But the only reason we believe in this null hypothesis is because we can look back at a single historical sequence that seems to confirm our bias.”

This reliance upon “a single historical sequence” is at the core of the problem. Peter L. Bernstein, known as “the grand historian of modern investment theory,” expounded further, more than a decade ago, that, “In real life, past data constitute a sequence rather than a set of independent observations…We have only one sample of the economy and the capital markets, not thousands of separate, autonomous, and stochastic numbers. Probabilities calculated from frequency distributions of events that have already occurred assume that those data enjoy a kind of independence that cannot exist in real-time information.”

And therein lie the errors in judgment. Academic models and technical charts are based upon prior interrelated sequences of data. If there is no independence in the data points, then there can be no reliance derived from statistical inferences. Nearly all of economic pricing theory is then based upon an incorrect presumption. Putting odds around the forecast might make it more acceptable, but who reads the fine print?

We do not have to search very far in the historical record for evidence of this phenomenon. The pricing behaviors of arcane OTC swaps and options during the financial debacle of 2008 were attributed to “fat-tail anomalies,” a fancy way of saying that the distribution of data points was not as expected. The breakdown in prices occurred with a frequency that was much closer to the mean than two standard deviations, suggesting that abnormal risk was much closer to being a normal observation than anyone had ever realized or prepared for in advance.

Market forces will be held hostage until current slack dissipates.

Analysts and economists have been all over the map recently, looking for the one last straw that would make the market camel break a knee. Are they suffering from myopia? Can they not see the forest for the trees? If we pull back for a moment, we can recall that the major items impacting the global economy for the past few decades have been central bank policies, globalization strategies, shifting demographics, and technological advances. Of the four, the latter is, perhaps, the least understood.

NEXT PAGE: What Ties the Four Major Factors All Together?


The difficulty is that one cannot look at either one of the four in pure isolation and then draw conclusions from empirical data. Each of the four is interrelated and interdependent to such a degree that modern systems theory must be applied to rationalize what outcome might result when variables shift, as they do continually in our reality. The proposition here is that each item is tied together by undissipated slack. Think of the global economy as a rope with a large dip in it. Demand will make the rope tight, but only after removing the slack. From that perspective, let’s examine each factor:

#1—Central Bank Policies

This factor is the easiest to understand, since it has been the new normal since 2008. Near-Zero Interest Rate Policies (ZIRP) were instituted by central bankers as a temporary measure to ignite economies across the planet. Critics decried ZIRP as a farce, one that would soon create enormous inflation across the globe. Here we are, seven years later, with no inflation to speak of and no economic growth as intended. Cheap money chased returns, pushed up equity valuations, and inflated bubbles across various markets. The short-term nature of excess funds equates to a low-risk appetite. The problem is that there is enormous slack in the desire to take long-term risks.

#2—Globalization Strategies

For the past four decades, outsourcing and off-shoring activities have brought about what many have described as the greatest shift in wealth distribution that the planet has ever seen. Driven primarily by domestic pressure to reduce prices for goods laden with inherent labor costs, developed countries have exported local jobs overseas to take advantage of lower labor-cost profiles that exist in China, India, and other emerging market nations. New trade agreements, ostensibly adopted to create new jobs, have only exacerbated the problem. As a result, enormous slack exists in developed countries of under- and unemployed workers. Reduced demand from the West is now having the same effect in lesser-developed economies.

#3—Shifting Demographics

These shifts come in two varieties...age and wealth distributions. We will discuss the latter below, but in the western world, including Japan, Australia, and New Zealand, age demographics after World War II have shifted dramatically. After the boom period that followed the war, household sizes in these markets have been in decline. A smaller work force must now cover the costs of a larger retiring base, creating stress and slower GDP growth, especially in Japan where the issues are more severe. Young labor dynamics, however, favor developing countries like China, India, Brazil, Malaysia, Indonesia, Vietnam, and others. Shifting ages of the work force have only added to unemployment slack in all regions.

#4—Technological Advances

The “Best Chart of the Week” award for this week goes to the following diagram:

Click to Enlarge

NEXT PAGE: What Happened in the 1980s?


Click to Enlarge

In the decades that followed WWII, economists were confident in saying that prosperity equated to four indicia moving in tandem: Labor Productivity, Real GDP per Capita, Private Employment, and Median Family Income. From this perspective, technology was viewed in a good light. Yes, technological innovations brought change and disruption to the labor market, but, over time, it was believed that productivity would increase and drag the other indicia along with it to increased prosperity for all.

And then, something happened in the eighties. Median Family Income flattened out and has remained flat. Analysts attributed these changes to the outsourcing and off-shoring revolution, but, from 2000 onward, net job creation went flat, as well. No one had a good explanation for what was happening behind the numbers until Erik Brynjolfsson, a professor at the MIT Sloan School of Management, and his collaborator and coauthor, Andrew McAfee, published an insightful study in 2013.

Their analysis of the data indicated that, over the past 15 years, technological advances have been destroying jobs more quickly than they had been creating them. According to Brynjolfsson, “Productivity is at record levels, innovation has never been faster, and yet at the same time, we have a falling median income and we have fewer jobs. People are falling behind because technology is advancing so fast and our skills and organizations aren’t keeping up.” Once again, slack exists in the ability of labor and business to adapt to new technologies by creating new jobs that co-exist with innovative advances.

They also contend that these new digital technologies create winner-take-all economies that concentrate wealth within a very small population of individuals. Workers’ prospects are generally measured as a percent of GDP, but this benchmark has fallen from 65% to 55% since 2000, while corporate profits have surged from 5% to 10% of GDP. Another recent study revealed that these declines are similar in 42 of 59 countries across the globe, including developing markets. As the rich get richer—as opposed to all of society—more stress can only result.

Concluding Remarks

In more recent interviews, the two professors have complained of a lack of dynamism in companies and this malaise is global in nature. Per McAfee, “We need more entrepreneurship. Young businesses, especially fast-growing ones, are a prime source of new jobs. But most industries and regions are seeing fewer new companies than they did three decades ago.” On an upbeat note, they also believe that, once the slack in the rope dissipates, “one confident prediction is that digital technologies will bring the world into an era of more wealth and abundance and less drudgery and toil.”

Let’s hope that they are correct.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

By Tom Cleveland, Contributor,

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