Please find below former Reserve Bank of New Zealand advisor and multiple CEO, Terry “Macca” McFadgen’s, latest ‘Maccanomics’ article, which tackles the current malaise affecting the global economy and examines why the large-scale ‘money printing’ by the world’s central banks isn’t working. Enjoy!
I can handle the despair…it’s the hope that I can’t deal with!”
(John Cleese on the subject of the English football team…..or maybe it was monetary policy? )
Fear is again flooding through financial markets, as well it might.
Barring some fortuitous intervention from above, the developed world will soon be flirting with another recession, maybe as early as the end of the year. Moreover, there is little evidence of a convincing path for resuming growth quickly thereafter.
There is some good news. US housing has probably bottomed and residential construction should add to GDP next year. But absence of demand is the overriding problem everywhere. Aggressive fiscal tightening is now underway in Europe and will on current plans be pursued there for some years. In parallel, budget cuts and tax increases are about to be imposed in the USA unless the new Congress can agree otherwise. China and the other emerging markets appear to have neither the will nor the means to do more than keep their own ships of state steady.
There are solutions, on paper at least. The USA could safely borrow more today if it could articulate a credible plan for reducing its fiscal deficit over coming decades. But politics means it cannot do so now and is unlikely to be able to do so even after this November’s elections. Germany too could borrow more-but history and political constraints mean that it will not. Japan is at the end of its fiscal rope, with an aging population and a shrinking domestic savings pool from which to fund its deficits, so it finds itself in a tightening noose. Its net public debt burden, at 113% of GDP, is rivaled only by Italy amongst the large economies. To put this in an historical context, Japan’s net public debt was 11.5% of GDP in 1991.
A gentle slide back into anemic growth is probably the best that can be hoped for. In the Euro-zone, Spain and Italy have financing problems which appear to be beyond the capabilities of their political systems to cure. Italy’s cost competitiveness now sits at a disadvantage of about 38% to Germany’s and Spain’s at about 28%. Italy’s ability to achieve the necessary rebalancing by “internal devaluation” (wage reductions and productivity improvements) seems fanciful and at best would lock the Italian people into a decade of misery. Far more likely is an Italian political revolt and Euro-zone exit.
Despite countless Euro summits and many declarations that the zone’s problems have been solved, current bond yields tell a different story. Yields for both Spain and Italy in are in the 6-7% range and are unaffordable if sustained. Citibank (Willem Buiter), recently speculated that Spain will have to submit to a Troika program (aka receivership) later this year, and Italy next year. No-one is scoffing at this outlook.
In truth the world is probably in worse shape than it was immediately post Lehman because since then nothing of substance has been achieved in terms of policy reform, and meanwhile debt has increased everywhere. The long term sustainability of the US fiscal deficit remains unaddressed, as it does in Japan. In Europe, no one can explain how a common currency and monetary policy can work in the absence of an (unwanted) fiscal union, and in China no progress has been made rebalancing the economy away from fixed investment.
Caught in a pincer between political paralysis and their inflation and employment mandates, central banks have flooded the world with ultra cheap money. Bond yields now sit at an astonishing 1.49%pa for US 10 year Treasuries, 1.26%pa for German bunds and .80%pa for JGB’s. Bond investors will likely receive negative real yields on their money for the next 10 years simply for the privilege of having their capital returned “intact”
How long they will tolerate this treatment is an open question.
The world’s banking system is now awash with cash after the central banks of the USA, Japan, the UK and Euro-zone have pursued monetary easing strategies under an overwhelming array of acronyms including the Fed’s ZIRP,MBS, QE and Twist programs and the ECB’s SMP and LTRO. Corporate Treasurers, wary of the bubble in bond pricing, have also fled to cash despite the zero yields on offer.
But all this has been to little avail. Trillions of dollars of dormant money now sit in the banking systems of the developed world doing nothing, whilst economies remain in chains with growth rates too low to allow debt to be paid down swiftly or to support jobs growth. In the USA, unemployment remains stuck at 8.2%:
Youth unemployment is particularly alarming. Approximately 24% of the 16 to 19 year olds in the US labor force are unemployed and, without any work experience since graduation, face the risk of becoming unemployable for life. In Southern Europe the problem is far worse with youth unemployment close to 50% in Spain and 36% in Italy.
As the above chart from Calculated Risk illustrates, something very different is going on here relative to previous recessions.
What is different is that monetary policy has reached its limits. It can do no more-and possibly may now be doing harm.
The Limits of Monetary Policy
In a normal business cycle recession lowering the cost of money reboots demand. About that there is no doubt as the chart attests. So why hasn’t it worked in this recession? The superficial answer is that “there is just too much debt”. The pessimists rightly point out that total debt levels today (sovereign, corporate and household) are actually higher than when the crisis hit in 2008 (340% of GDP versus 332% of GDP according to Jamil Baz of Man Group).
But lurking behind the bushes are some more fundamental problems which impede the effectiveness of ultra cheap money:
It’s Just a Wealth Transfer Pure and Simple
Much is made of how cheaper credit has improved the position of over- indebted households, and rightly so. But a lot less is heard about the cost to savers who now see their funds yielding a pittance. In this respect, ultra cheap money is just a tax which transfers wealth from the prudent who have worked and saved, to the profligate who have over- borrowed.
It normally works because the propensity of the beneficiaries of cheap money to spend some of their extra disposable income exceeds the propensity of the savers to cut back on their spending. Why do savers keep spending? Probably because they see the whole process as temporary, and a price worth paying for a recovery. But what happens when the years tick over and the economy doesn’t fire? And then to add to the pain the Federal Reserve says that low rates will be needed for several more years?
The answer is that the savers cut back on spending. They also start to get angry about the wealth confiscation being imposed upon them.
That is where we are now. Ultra cheap money is burning itself out as an economic accelerant, and the political temperature is rising as savers ask where the Federal Reserve and other central banks obtained the authority to confiscate and redistribute citizen’s wealth. To that question, there is no ready answer.
It Discourages Investment
Imagine you the CFO if a Fortune 500 company and that you have a new project in the pipeline with a 15 year life which awaits your approval. It appears attractive but you are struggling with a number of fundamental questions.
You need to know your company’s cost of capital over the life of the investment. How to find out? Well for starters the current “risk free rate” of 1.47% doesn’t look right and you know that rate is being manipulated by the Fed. So that’s a dead end.
What about your equity risk premium? Well in theory that can be calculated from share prices but you know that they are being held artificially high by Fed policy also. So no luck there either.
What about your customer’s spending power? How will it evolve over the next decade or two? You know new taxes will be required-but what sort and when? What will the impact be on spending patterns? And what about corporate taxes? No, sorry-no answers are available here.
You get my point. Understandably most CFOs just say, “Enough- my company should stay liquid until all this fog clears.”
But it gets worse. If your company or public sector body has a defined benefit pension plan then you are likely to have been using a 7% pa future earnings assumption to calculate your entity’s pension liability. But if Treasuries are yielding only 1.5%, and the outlook is for nominal GDP growth of 2-3% for a long time, hasn’t your pension plan (and a lot of others) got a major problem on its hands? Yes indeed.
It Creates Bubbles
As central banks have pumped their financial systems full of free money much of it has flooded into assets which offer portfolio diversification, inflation risk protection and speculative upside. The favorites have been oil, precious metals, traded commodities like copper and the high yield currencies of the commodity producers like Brazil, Australia and New Zealand.
In parallel, funds have flooded into “safe haven” bonds (US Treasuries, German Bunds and the Swiss Franc) from investors who fear a global financial collapse.
The immediate impacts of this asset switch have been negative in terms of job creation (none whatsoever), and diminished household incomes which have been eroded by elevated prices for gasoline and other commodities. Beyond these immediate negatives lies the prospect of a value implosion when these inflated prices correct themselves.
Please ask yourself why the surplus countries of the world should continue indefinitely to fund deficit countries’ balance sheets at negative real yields? I have no idea, do you?
If US Treasury yields normalize at around the 4% level then investors buying at current levels will see at least half their capital destroyed. That is a potentially a bigger bust than US housing.
The Inflation Risk
No-one disputes that if the vast sums now sitting idle in the banking system were to move into circulation, we would have a serious inflation problem. But in relation to this risk central banks (primarily the Federal Reserve) have said “don’t worry- we can stop the train before it runs out of control.” We can start offering interest on bank funds on deposit with us to retain those funds within the banking system and we have an array of other tools as well.
The problem here is that this is all uncharted territory. Money creation hasn’t been done on this scale before and there are plenty of skeptics who see an inflationary outbreak as a serious risk either because of a miscalculation by central banks, or a deliberate policy of using inflation to “eliminate” some debt.
And if you see inflation as a risk then off you go and buy commodities or other real assets pumping the price balloon full of yet more air. And so around the bubble circuit we go.
All of these costs and risks are well understood by central bankers, at least in principle[1]. But they are trapped by their mandates and by their past actions. Once started, the free money game has to be kept going-like a Ponzi scheme. If asset prices start to wilt then confidence, and any hope of recovery, is put at risk. Only more free money can keep the balloon afloat and Wall Street knows this very well.
There are rocks, and there are hard places.
Where To From Here?
It is possible that the banks’ ultra cheap money policy may yet work. But the evidence supporting that outcome is weak and we should be prepared for failure, not because of errors by central banks but because they are being asked to do too much.
The developed world is in a bind; free money without parallel policy reforms isn’t working and is losing whatever power it has by the day. But the political will to pursue fundamental reforms is absent. Until one of those conditions changes our economies will remain frozen-unable to grow by reason of too much debt and too much uncertainty regarding future policy, but insulated from total collapse by free money.
In pursuing cheap money policies the main central banks handed politicians and policymakers a lifeline which provided time and space to deal with underlying structural problems. But universally (with the honorable exception of the UK), politicians have failed to grasp the lifeline because they have feared the consequences of telling their electorates the truth.
That truth has three core elements: the first is that we have a ten year problem on our hands (the unpicking and re-stitching of the Euro-zone will alone take five years at best); the second is that some combination of higher taxes and lower benefits is going to be required everywhere with a resultant fall in living standards; and the third is that a radical restructuring of global debt through debt to equity conversions and negotiated debt releases may ultimately be needed.
None of this is what electorates want to hear, or politicians have the courage to say.
Fund manager Hugh Hendry (of Eclectica) recently made the comment that the politicians of the developed world fully understand the excess debt problem and are simply frozen in terror; He said of our politicians, “the truth is that the scale and magnitude of the problem is larger than their ability to respond-and it terrifies them” Maybe. Or is the problem that over the last generation our democracies have morphed into instruments incapable of medium-term perspectives and in which the main parties, obsessed with preserving their “brand”, hold to positions that cannot accommodate cooperation and compromise?
Make no mistake about it-democracy is now on trial and the current approach is not going to cut the mustard.
We had better get it right quickly.
Macca
[1] See El-Erian,” Evolution, Impact and Limitations of Unusual Central Bank Activism”, Homer Jones Memorial Lecture, Reserve Bank of St Louis, April 2012.
