For World Economy, Is it 1937 All Over Again?

Even before Britain's vote to exit the EU shook global markets, 2016 was shaping up to be the fifth consecutive year of tepid global growth. Inflation expectations in many key economies are flirting with new lows, productivity is weak and private capital expenditures are slipping.

After a short-lived recovery, the world economy teeters between a sustainable turnaround and relapse into recession. “If global growth remains weak for longer, the corporate sector will have to adjust down its return expectations, leading to a negative feedback loop," says Chetan Ahya, Morgan Stanley's co-head of global economics.

We've seen this before. In fact, today's macroeconomic environment bears many similarities to the 1930s, when the economy recovered just enough, only for policy makers to rein in money supply and tip the world back into recession. Just as that premature and sharp pace of tightening led to a double-dip in the U.S. economy in 1938, so too have policy decisions today contributed to the slowdown in recent quarters, argues Ahya and fellow co-head of global economics, Elga Bartsch, in “1937-1938 Redux?", a recent Morgan Stanley Research report that looks at the parallels between economic stagnation in the years following the Great Depression and the stagnation plaguing the world economy today.

What's needed now is more, not less, fiscal stimulus. “The effective solution to prevent a relapse into recession would be to reactivate policy stimulus," Ahya and Bartsch write in the report, adding: “The need of the hour is to ensure that aggregate demand is supported by boosting public demand." 

A quick recap of what happened in the 1930s can help put current conditions in perspective. Debt buildup and monetary tightening were key triggers for both the Great Depression and the more recent Great Recession. Following the stock market crash of 1929, however, the Federal Reserve was slow to react—the consequence of which was four consecutive years of deflation, from 1930 through 1933.

Expansionary monetary and fiscal policies in 1934 helped the U.S. economy achieve positive growth—but the recovery was short-lived, as policy makers were too quick to take up policy tightening. Indeed, the Fed back then doubled the reserve requirements for banks, while the Treasury Department sterilized gold inflows, and Social Security collected payments for the first time ever. Consequently, U.S. GDP growth slipped from 5.1% in 1936 to 0.1% in 1938.

Policy makers reversed course yet again, and the combination of monetary and fiscal easing paved the way for recovery in 1939 and growth by 1940.

Just as the lead up to the Great Recession bore many similarities to the Great Recession, today's stagnant global growth may be due in part to policy makers prematurely pumping the breaks. “While they have kept rates low, the key developed markets have all taken up fiscal tightening in recent years and particularly so in the U.S., Europe and the UK," says Ahya.

While many factors contribute to economic vitality, the relationship between less fiscal support and slowing growth is one that cannot be ignored. Gross domestic product growth, which is projected to be 3% for 2016, is on track to come in below the 30-year average for the fifth consecutive year. Consumer price inflation for the Group of 10 nations was just 0.2% in 2015, and is projected to be 0.7% for 2016, according to Morgan Stanley's global economics team.

Relatively strong consumer spending and low rates are helping to offset weaker corporate capital expenditure and slower trade growth. Meanwhile, emerging markets have begun to stabilize. Nevertheless, “the risks remain skewed to the downside, particularly in light of recent political events," says Bartsch. Indeed, on the back of the UK vote to leave the EU, Morgan Stanley’s global economics team raised its subjective probability of a global recession starting in the next 12 months to 40%, up from its previous 30%.

With interest rates still near historic lows, and in some cases below zero, most nations are at their rope limit on monetary policy; additional rate cuts at this point aren’t likely to make much impact. A better strategy would be for leaders to reactivate fiscal policies enough to solidify economic recovery. "Doing so, particularly now when rates are still low, could lead to a virtuous cycle, where the corporate sector takes up investment, thus sustaining job creation and income growth," says Ahya.

Policy makers are, understandably, hesitant to reinstate quantitative easing, which would entail pumping more money into the economy by buying government bonds, as there are growing doubts over its effectiveness. Yet, taking on a path of fiscal austerity could have even greater consequences.

For more Morgan Stanley Research on the global economic outlook, ask your Morgan Stanley representative or Financial Advisor for the full reports, “1937-1938 Redux" (Jun 15, 2016) and “Beyond Brexit” (Jun 27, 2016). Plus, more Ideas.