The Great Divergence is a term coined by economic historians to explain the sudden acceleration of growth and technology in Europe from the 16th century onward, while other civilizations such as China, India, Japan and Persia remained in their pre-modern state. This phrase has recently acquired a very different meaning, however, more relevant to global economic and financial conditions today.
Early last year, the International Monetary Fund published in its World Economic Outlook an article analyzing “The Great Divergence of Policies” around the globe since the 2008 crisis. The article pointed out that “exceptionally accommodative” monetary policies designed to stimulate recovery were being counteracted by “unusually contractionary fiscal policies” in every advanced economy, first in in the eurozone and Britain, later in the United States and Japan.
More recently, financial markets have become obsessed with another “great divergence.” Allianz Global Investors, parent company of PIMCO, the world’s biggest bond fund, described it like this in “Navigating the Great Divergence”: “With the Fed[eral Reserve] pondering rate hikes and the ECB [European Central Bank] launching new stimulus … investors are faced with divergent influences from [monetary policy]. Investor concerns are diverging on both sides of the Atlantic.”
Why should businesses and investors care about this lexicography? Because by the time an economic trend has become an analytical cliché, it is usually over — and sometimes a counter-trend has already begun.
The Great Divergence — both between fiscal and monetary policy and between the United States and other countries — is a case in point. The important trends today, especially after October policy changes in Japan and Europe, are not divergence but convergence.
This Great Convergence of macroeconomic policies between the United States and the rest of the world will drive financial markets and dominate business conditions in the year ahead. It is not yet reflected, however, in asset prices or market trends. Investors continue to obsess about the tiny gap that may or may not open up between U.S. and European policies sometime next year, when the Fed starts gently raising interest rates.
Far more important than a likely difference next year of a quarter or half a percentage point between short-term interest rates on both sides of the Atlantic, though, is the convergence of economic philosophies and objectives for the first time since the 2008 economic crisis. In the past two months, Japan, Europe and China all moved toward further aggressive monetary stimulus and reversed previous commitments to fiscal austerity.
Though it is true that these global policy shifts coincided with the end of the Fed’s quantitative-easing program, this accident of timing does not imply that the United States is diverging from Europe and Asia. What is really happening is that Europe and Asia are finally — and reluctantly — following Washington’s road map out of the Great Recession.
In the eurozone, Britain and China, hawkish central bankers have been silenced and monetary policy has been reset for full-scale stimulus — most recently by the European Central Bank, which has belatedly accepted the principle of U.S.-style quantitative easing. In Japan, where money-printing presses were already running at full throttle, they have speeded up even more.
The budgetary consolidation planned in Japan and the eurozone has been abandoned — discretely in Italy, France and Britain, where the government will confirm a massive budget slippage next Wednesday, or spectacularly in Japan, where Prime Minister Shinzo Abe has called a snap general election to confirm his political victory over the austerity-minded ministry of finance bureaucrats who were insisting on another tax hike next year. Even though they created a recession this year with the same policy mistake.
The upshot is that every advanced economy is now following broadly the same macroeconomic policies as the United States: maximal monetary stimulus combined with fiscal neutrality and the suspension of counterproductive budget rules. Assuming that Europe and Japan continue to pursue with conviction these Washington-style expansionary policies, they should eventually achieve similar results — gradual improvements in employment and financial conditions, powered by faster economic growth. This trend was confirmed in the United States again this week by the upward revision of 3rd-quarter gross domestic product growth to 3.9 percent.
In addition to the likely improvement in European and Asian economies, convergence of global economic policies toward the U.S. monetary and fiscal model could have several unexpected financial implications.
The euro and the yen, instead of continuing to fall against the dollar as most experts now expect, could stabilize if the European and Japanese economies start improving. By next year, these currencies may even strengthen because the Bank of Japan and the ECB will need to print less money than now expected if their governments reverse self-destructive fiscal austerity.
Similarly, stock markets around the world would start to perform better than Wall Street if investors became convinced that Europe, Japan and China were as committed as Washington is to expansionary policies. The first signs of this sentiment shift could be detected in Japan, after Abe’s reflationary measures in late October, and in China, after the surprise monetary easing last week. If ECB President Mario Draghi can convince investors that he has political support for aggressive monetary stimulus, European equities could also start to outperform.
In bond markets, by contrast, U.S. investors should be the main beneficiaries of global policy convergence. More aggressive quantitative easing in Japan and Europe will likely increase the demand for bonds in the United States, as well as in those economies. As a result, U.S. bond prices will remain higher than normal — instead of falling in response to stronger economic growth.
Better still, the Fed will face less pressure to tighten monetary policy than usual in an economic expansion because quantitative easing in Japan and Europe will keep U.S. bond yields reassuringly low.
In short, the global abandonment of austerity and shift towards the U.S. macroeconomic model is good news all round. Let’s hope the Great Convergence continues.
Anatole Kaletsky is an award-winning journalist and financial economist who has written since 1976 for The Economist, the Financial Times and The Times of London before joining Reuters.