Low interest rates contribute to weak labour markets
In the latter part of August, the cream of the world’s central bankers convened at the annual Kansas City Fed gathering at Jackson Hole, Wyoming. Every year the Conference has a theme. Last year’s was Quantitative Easing (QE): when and how it would end. This year’s topic was unemployment, under the rather grandiose title “Re-Evaluating Labour Market Dynamics”.
Ms Yellen, chair of the Federal Reserve, seemed at last to acknowledge one of this Newsletter’s recurring concerns; namely, that official unemployment data mislead because they ignore the number of citizens so disaffected with prospects that they no longer register as looking for work. She is warming towards a new Fed Board developed Labour Market Conditions Index (LMCI) which takes account of workforce participation rates and various other measures. She considers LMCI a better indicator of employment market strength or weakness than the raw unemployment percentage number. By this measure, unemployment is still substantially above the pre-crisis level. Accordingly, Ms Yellen remains concerned about the present strength of the US recovery:
“the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate”;
Nonetheless, she indicated that interest rates would rise if future, stronger than expected, labour market data were reported.
Similar concerns are now paramount among UK central bankers. The Bank of England now overtly links its ‘forward guidance’ about the timing of interest rate increases to evidence of growth in wage levels.
The ECB’s President Mario Draghi had absorbed the summer’s deterioration in European data suggesting that another slowdown is underway. Only this time, it is impacting primarily the core, France and Italy, and even Germany. Finance Minister Schaeuble recently said that ‘the ECB have already done enough’ so Germany is firmly against more stimulus at this stage.
President Draghi’s speech put labour market worries at the forefront of Europe’s problems. In Europe there was a second surge in unemployment 3 years after the financial crisis. From early 2011, when it became apparent that a number of countries would, without bailouts, default or renege on sovereign debt, heavy job losses drove up the Eurozone average to levels that have only recently topped out. Draghi took the opportunity of the profile of this occasion once again to express doubts whether unleashing QE in the Eurozone would make any difference to labour market conditions, because national governments have failed to implement substantive structural reforms. Like a physical trainer addressing a group of failed slimmers after 3 years of group therapy, he berated that he has done all he could do in the group sessions, those dissatisfied with their progress should look to themselves.
Although these presentations reveal doubts among leading central bankers that near zero interest rate policies (ZIRP) may not result in economic stimulus, there is still a gulf between these doubts and the scepticism about ZIRP policies, doubt that have been strongly expressed by the Bank for International Settlements (see our July Newsletter).
An even stronger counter view is beginning to gather mainstream support; namely, that ZIRP is a primary cause of the continuing weak labour market conditions. The reasoning is as follows. By reducing the cost of borrowing money substantially below its ‘market’ level, capital goods for businesses have become disproportionately cheap compared with the cost of employing people. When weighing up the cost/ benefit of, say, installing a machine to sell tickets in train stations compared with employing staff to do the same job, low interest rates reduce the cost of the machine option. Businessmen make such decisions using discounted cash flow analysis, whereby future costs are assessed a present value using average market interest rates over the term. So ZIRP has a double whammy effect; not only is the borrowing cost of the machine lower, but by applying a discount rate of close to zero to the employee option, the present value cost of the stream of wages is increased. This may go some way towards explaining the trend of low to moderate-income jobs being replaced by machines in areas such as supermarket checkout services as well as transport ticketing.
This is a classic “misallocation” as per Austrian economics. It follows that, when rates rise, firms will find their overall operations burdened by excessive (now expensive) capital equipment. What they will then want are more productive employees. However, the lack of skilled workers–those out of the labour force for several years tend to be less productive–will make competition for skilled labour intense, wage pressures will rise, and the combination of excess capital capacity and rising wage pressures will intensify the stagflation we have already seen to date (see our July Newsletter).
Concerns about Repo Market Disruptions.
In August, concerns were reported that the US repo market, one of the largest engines of liquidity in global capital markets, was experiencing disruptions to its otherwise smooth functioning owing to a reduction in repo activity by banks. Banks explained this by citing increased capital costs under the recently introduced Leverage Ratio (see our February Newsletter).
Before considering this further, since repo transactions can be confusing, let us set out an example. A repo counterparty, say an investment fund, might hold a 5-year US Treasury bond. There has traditionally been a deep and liquid market enabling the fund to enter into a contract with, say, a bank to sell and buy back the bond, usually on a very short-term basis (overnight). However, medium term funding can be obtained by rolling the position every day. The sale and repurchase price are pre-agreed, the differential constitutes the return to the provider of cash. Banks have been encouraged to play the role of repo cash provider (otherwise known as Reverse repo Counterparty) as the market for derivatives, particularly interest rate swaps (IRS), has grown.
Thus it can be seen that not only have banks been lured to the repo market by the modest net interest income generated by being the repo cash provider against very low credit risk, but also because repos provide a steady source of government bonds that are useful for other hedging activities of the bank itself.
So why are they now pulling back? Even though the Basel Capital weighting applied to banks’ holdings of non-defaulted government bonds is zero, such holdings are indeed caught by the Leverage Ratio. Therefore, there will be a cost from the new rule’s effective date of 1 January 2015.
But is the pullback entirely attributable to new regulations, as claimed in the mainstream press? We are not so sure. There also appears to be a shortage of available collateral (Treasury bonds) in the maturities most popular with market participants. Perhaps this results from the Federal Reserve’s mopping up of so much of the US Treasury security market via its QE programme. The result is that banks providing cash into the transaction in which the underlying security is becoming scarce (e.g. 5 years), now expect to make a negative return on the loan of the cash. The loss would materialize if the price they will have to pay in the market to buy back the bond for delivery back to the counterparty has risen owing to scarcity. In these circumstances, it is hardly surprising that banks would prefer to deposit their cash with the Federal Reserve at a better rate of return and without the negative Leverage ratio consequences.
Under normal market conditions, repo provides a cheap and easy way to releverage an asset. If trend described in the previous paragraph persists, does it presage the start of wholesale reductions in systemic leverage? We doubt it. The thrust of ‘legal’ financial innovation, especially since the outbreak of the crisis, has been for banks to find new ways of leverage through collateral transformation, swapping collateral with each other in ways that either slip by, or are tacitly approved by regulators. One such example is asset rehypothecation, which we discussed in our January Newsletter.
Finally, is this repo market disruption an ‘unintended consequence’ of the new Leverage Ratio regulations? The prevailing view appears to be negative. A small number of senior US Reserve bank governors have long memories of the 2008 crisis, and fear a recurrence of the repo market seizure. Sceptics may take the view that those bank governors are overly focussed on the symptoms of that crisis rather than on its cause. As has been amply documented, at the peak of the crisis (before any talk of bailouts), repo and other markets froze up because a number of insolvent counterparties reneged on obligations to deliver cash or collateral, triggering a collapse in confidence upon which these interbank markets rely. Shrinking the repo market will not prevent a recurrence of system wide crisis when such insolvency worries resurface.
[Editor's note: Please find the IREF Newsletter here]
[Editor's note: this article, by Robert Batemarco, first appeared at Mises.org]
John Tamny recently wrote a piece at Forbes titled, “The Closing of the Austrian School’s Economic Mind” in which he critiqued certain claims made in Frank Hollenbeck’s Mises Daily article, “Confusing Capitalism with Fractional Reserve Banking.”
Tamny goes far beyond taking Hollenbeck to task, asserting that many modern Austrian economists have certain views of monetary policy that are at odds with much of the rest of the contribution of the Austrian School. Tamny’s biggest point of disagreement with Austrians is over the low regard with which many Austrians hold the practice of fractional reserve banking. In so doing, he makes several arguments which cannot stand up to critical scrutiny.
The crux of the Austrian position is that the practice of fractional reserve banking gives ownership claims to the same funds to more than one person. The person depositing the funds clearly has a property claim to those funds. Yet when a loan is made from those funds, the borrower now has a claim to the same funds. Two or more people owning the same funds is what makes bank runs possible. The existence of deposit insurance since the 1930s has minimized the number of these runs, in which multiple owners sought to claim their funds at the same time. The deposit insurance that prevents bank runs really amounts to a pre-emptive bailout of the banks. As this is a special privilege, rather than a natural development of the market, it follows that restrictions on fractional reserve banking would be a libertarian validation of the market rather than the statist interference that Tamny claims it to be.
His inability to see that fractional reserves lead to two or more people having claim to the same funds at the same time leads him to deny the logic of the money multiplier. To quote him:
The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. … To the Austrians, money can be multiplied. Bank A takes in $1,000, lends $900 to Bank B, then Bank B lends $810 to Bank C, only for Bank C to lend $729 to Bank D, etc. Pretty soon $1,000 has been “multiplied” many times over as the credit is passed around.
The notion of the money multiplier is by no means uniquely Austrian. I learned it forty years ago from the Paul Samuelson textbook and from the Fed publication Modern Money Mechanics. It is also the centerpiece of the monetary system chapter of virtually every textbook right up to Paul Krugman’s most recent edition. Indeed, the nature of the process is one of the most uncontroversial propositions in economics — a good definition of an uncontroversial economic proposition being one on which both Murray Rothbard and Paul Krugman are in substantive agreement. Indeed, if there were no money multiplier, one would be at a loss to explain why, until QE1 in 2008, M1 was a 1.6 times size of the monetary base, having historically been even higher. Nor would the required reserve ratio, a tool of monetary policy that became too powerful to be used after 1937, have any effect on the money supply in the absence of the money multiplier effect.
What is controversial about the money multiplier is not its existence, but whether or not it creates distortions in the economy. The distortions introduced into the economy by fractional reserve banking, and to an even greater extent by central banking, comprise the central element of Austrian business cycle theory. The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects. This is the real goods sector counterpart of bank runs in the monetary sector. Since there is no real goods sector counterpart to deposit insurance, firms will run short of the resources necessary to profitably complete their investment projects, exposing them as malinvestments and turning boom to bust.
Tamny disputes the above claims, largely on the basis of what seems to me an idiosyncratic definition of credit. He states that, “credit can’t be multiplied. Period. For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.” This statement is informed by the valuable insight that lending money to those who wish to buy goods they could not otherwise afford does not create additional goods. Where the equivocation arises is in his use of the word credit to describe the goods that credit permits one to buy. I believe this eccentric use of that word is what leads to many of Tamny’s disagreements with the Austrians. Here is Exhibit A:
Perhaps another logical response to this line of thinking is the housing boom that took place in the 2000s. Wasn’t the latter most certainly a function of easy credit? Let’s be serious. To believe it was, that low rates set by the Fed were what made housing credit easy is to believe that rent control renders apartments abundant. But it doesn’t, nor were low rates decreed by the Fed the driver of the housing boom.
Austrians agree that making loans more available than the market would make them does not make more goods available. But there is the illusion of more resources in the short run because the credit-creation process does initially commandeer resources from those whose money decreases in value through the Cantillon Effect. Unfortunately, many entrepreneurs seeking to expand their operations act on this illusion. Only when the new money reaches those whose money lost its value initially and they re-assert their demand, does the inability of new credit to create new goods become obvious.
The last critique Tamny makes that I will discuss here is his implication that Austrian support for 100 percent reserves on demand deposits would make it impossible for borrowers to borrow from savers in order to lend those savings out. This is wrong. Austrians have no problem with savers buying the bonds of a firm seeking additional financing, nor with their buying stock, either directly from the company or its investment bank through an IPO or on the secondary market where it helps keep the market liquid, nor with their buying a bank CD or time deposit knowing that they will not have a claim on the funds they have entrusted to the bank until maturity. In all of these cases, intermediaries are borrowing from savers in order to lend those savings out (this is not exactly a loan in the case of stocks). What Austrians object to is banks telling depositors they still have an instantaneous claim on the funds deposited when they have given someone else a claim on the same funds.
Under the elimination of fractional reserve banking, investment spending would be reduced, not to zero, but to a more sustainable level. This would not eliminate entrepreneurial errors, which are part and parcel of having to act in the face of uncertainty, but it would eliminate the cluster of errors generated by the inconsistent plans that would be made on the basis of falsified market signals of interest rates below their natural rate, thus moderating, or in the best-case scenario, eliminating the business cycle.
What is Super Mario up to?
First, he gave an unexpectedly dovish speech at the Jackson Hole conference, rather ungallantly upstaging the host, Ms Yellen, who was widely anticipated to be the most noteworthy speaker at the gathering (talking about the labor market, her favorite subject). Having thus single-handedly and without apparent provocation raised expectations for more “stimulus” at last week’s ECB meeting, he then even exceeded those expectations with another round of rate-cuts and confirmation of QE in form of central bank purchases of asset-backed securities.
These events are significant not because they are going to finally kick-start the Eurozone economy (they won’t) but because 1) they look rushed, and panicky, and 2) they must clearly alienate the Germans. The ideological rift that runs through the European Union is wide and deep, and increasingly rips the central bank apart. And the Germans are losing that battle.
As to 1), it was just three months ago that the ECB cut rates and made headlines by being the first major central bank to take a policy rate below zero. Whatever your view is on the unfolding new Eurozone recession and the apparent need for more action (more about this in a minute), the additional 0.1 percent rate reduction will hardly make a massive difference. Yet, implementing such minor rate cuts in fairly short succession looks nervous and anxious, or even headless. This hardly instils confidence.
And regarding the “unconventional” measures so vehemently requested by the economic commentariat, well, the “targeted liquidity injections” that are supposed to direct freshly printed ECB-money to cash-starved corporations, and that were announced in June as well, have not even been implemented yet. Apparently, and not entirely unreasonably, the ECB wanted to wait for the outcome of their “bank asset quality review”. So now, before these measures are even started, let alone their impact could even be assessed, additional measures are being announced. The asset purchases do not come as a complete surprise either. It was known that asset management giant BlackRock had already been hired to help the ECB prepare such a program. Maybe the process has now been accelerated.
This is Eurozone QE
This is, of course, quantitative easing (QE). Many commentators stated that the ECB shied away from full-fledged QE. This view implies that only buying sovereign debt can properly be called QE. This does not make sense. The Fed, as part of its first round of QE in 2008, also bought mortgage-backed securities only. There were no sovereign bonds in its first QE program, and everybody still called it QE. Mortgage-backed securities are, of course, a form of asset-backed security, and the ECB announced purchases of asset-backed securities at the meeting. This is QE, period. The simple fact is that the ECB expands its balance sheet by purchasing selected assets and creating additional bank reserves (for which banks will now pay the ECB a 0.2 percent p.a. “fee”).
As to 2), not only will the ECB decisions have upset the Germans (the Bundesbank’s Mr. Weidmann duly objected but was outvoted) but so will have Mr. Draghi’s new rhetoric. In Jackson Hole he used the F-word, as in “flexibility”, meaning fiscal flexibility, or more fiscal leeway for the big deficit countries. By doing so he adopted the language of the Italian and French governments, whenever they demand to be given more time for structural reform and fiscal consolidation. The German government does not like to hear this (apparently, Merkel and Schäuble both phoned Draghi after Jackson Hole and complained.)
The German strategy has been to keep the pressure on reform-resistant deficit-countries, and on France and Italy in particular, and to not allow them to shift the burden of adjustment to the ECB. Draghi has now undermined the German strategy.
The Germans fear, not quite unjustifiably, that some countries always want more time and will never implement reform. In contrast to those countries that had their backs to the wall in the crisis and had little choice but to change course in some respect, such as Greece, Ireland, and Spain, France and Italy have so far done zilch on the structural reform front. France’s competitiveness has declined ever since it adopted the 35-hour workweek in 2000 but the policy remains pretty much untouchable. In Italy, Renzi wants to loosen the country’s notoriously strict labour regulations but faces stiff opposition from the trade unions and the Left, not least in his own party. He now wants to give his government three years to implement reform, as he announced last week.
Draghi turns away from the Germans
German influence on the ECB is waning. It was this influence that kept alive the prospect of a somewhat different approach to economic challenges than the one adopted in the US, the UK and, interestingly, Japan. Of course, the differences should not be overstated. In the Eurozone, like elsewhere, we observed interest rate suppression, asset price manipulations, and massive liquidity-injections, and worse, even capital controls and arbitrary bans on short-selling. But we also saw a greater willingness to rely on restructuring, belt-tightening, liquidation, and, yes, even default, to rid the system of the deformations and imbalances that are the ultimate root causes of recessions and the impediments to healthy, sustainable growth. In the Eurozone it was not all about “stimulus” and “boosting aggregate demand”. But increasingly, the ECB looks like any other major central bank with a mandate to keep asset prices up, government borrowing costs down, and a generous stream of liquidity flowing to cover the cracks in the system, to sustain a mirage of solvency and sustainability, and to generate some artificial and short-lived headline growth. QE will not only come to the Eurozone, it will become a conventional tool, just like elsewhere.
I believe it is these two points, Draghi’s sudden hyperactivity (1) and his clear rift with the Germans and his departure from the German strategy (2) that may explain why the euro is finally weakening, and why the minor announcements of last Thursday had a more meaningful impact on markets than the similarly minor announcements in June. With German influence on the ECB waning, trashing your currency becomes official strategy more easily, and this is already official policy in Japan and in the US.
Is Draghi scared by the weak growth numbers and the prospect of deflation?
Maybe, but things should be put in perspective.
Europe has a structural growth problem as mentioned above. If the structural impediments to growth are not removed, Europe won’t grow, and no amount of central bank pump priming can fix it.
Nobody should be surprised if parts of Europe fall into technical recessions every now and then. If “no growth” is your default mode then experiencing “negative growth” occasionally, or even regularly, should not surprise anyone. Excited talk about Italy’s shocking “triple-dip” recession is hyperbole. It is simply what one should expect. Having said this, I do suspect that we are already in another broader cyclical downturn, not only in Europe but also in Asia (China, Japan) and the UK.
The deflation debate in the newspapers is bordering on the ridiculous. Here, the impression is conveyed that a drop in official inflation readings from 0.5 to 0.3 has substantial information content, and that if we drop below zero we would suddenly be caught in some dreadful deflation-death-trap, from which we may not escape for many years. This is complete hogwash. There is nothing in economic theory or in economic history that would support this. And, no, this is not what happened in Japan.
The margin of error around these numbers is substantial. For all we know, we may already have a -1 percent inflation rate in the Eurozone. Or still plus 1 percent. Either way, for any real-life economy this is broadly price-stability. To assume that modest reductions in any given price average suddenly mean economic disaster is simply a fairy tale. Many economies have experienced extended periods of deflation (moderately rising purchasing power of money on trend) in excess of what Japan has experienced over the past 20 years and have grown nicely, thank you very much.
As former Bank of Japan governor Masaaki Shirakawa has explained recently, Japan’s deflation has been “very mild” indeed, and may have had many positive effects as well. In a rapidly aging society with many savers and with slow headline growth it helped maintain consumer purchasing power and thus living standards. Japan has an official unemployment rate of below 4 percent. Japan has many problems but deflation may not be one of them.
Furthermore, the absence of inflation in the Eurozone is no surprise either. There has been no money and credit growth in aggregate in recent years as banks are still repairing their balance sheets, as the “asset quality review” is pending, and as other regulations kick in. Banks are reluctant to lend, and the private sector is careful to borrow, and neither are acting unreasonably.
Expecting Eurozone inflation to clock in at the arbitrarily chosen 2 percent is simply unrealistic.
Draghi’s new activism moves the ECB more in the direction of the US Fed and the Bank of Japan. This alienates the Germans and marginally strengthens the position of the Eurozone’s Southern periphery. This monetary policy will not reinvigorate European growth. Only proper structural reform can do this but much of Europe appears unable to reform, at least without another major crisis. Fiscal deficits will grow.
Monetary policy is not about “stimulus” but about maintaining the status quo. Super-low interest rates are meant to sustain structures that would otherwise be revealed to be obsolete, and that would, in a proper free market, be replaced. The European establishment is interested in maintaining the status quo at all cost, and ultra-easy monetary policy and QE are essentially doing just that.
Under the new scheme of buying asset-backed securities, the ECB’s balance sheet will become a dumping ground for unwanted bank assets (the Eurozone’s new “bad” bank). Like almost everything about the Euro-project, this is about shifting responsibility, obscuring accountability, and socializing the costs of bad decisions. Monetary socialism is coming. The market gets corrupted further.
In recent months talking heads, disappointed with the lack of economic recovery, have turned their attention to wages. If only wages could grow, they say, there would be more demand for goods and services: without wage growth, economies will continue to stagnate. It amounts to a non-specific call to stimulate aggregate demand by continuing with or even accelerating the expansion of money supply. The thinking is the same as that behind Bernanke’s monetary distribution by helicopter. Unfortunately for these wishful-thinkers the disciplines of the markets cannot be bypassed. If you give everyone more money without a balancing increase in the supply of goods, there is no surer way of stimulating price inflation, collapsing a currency’s purchasing power and losing all control of interest rates.
The underlying error is to fail to understand that economising individuals make things in order to be able to buy things. That is the order of events, earn it first and spend it second. No amount of monetary shenanigans can change this basic fact. Instead, expanding the quantity of money will always end up devaluing the wealth and earning-power of ordinary people, the same people that are being encouraged to spend, and destroying genuine economic activity in the process.
This is the reason monetary stimulation never works, except for a short period if and when the public are fooled by the process. Businesses – owned and managed by ordinary people – are not fooled by it any more: they are buying in their equity instead of investing in new production because they know that investing in production doesn’t earn a return. This is the logical response by businesses to the destruction of their customers’ wealth through currency debasement.
Let me sum up currency debasement with an aphorism:
“You print some money to rob the wealth of ordinary people to give to the banks to lend to business to make their products for customers to buy with money devalued by printing.”
It is as ridiculous a circular proposition as perpetual motion, yet central banks never seem to question it. Monetary stimulus fails with every credit cycle when the destruction of wealth is exposed by rising prices. But in this credit cycle the deception was so obvious to the general public that it failed from the outset.
The last five years have seen all beliefs in the manageability of aggregate demand comprehensively demolished by experience. The unfortunate result of this failure is that central bankers now see no alternative to maintaining things as they are, because the financial system has become horribly over-geared and probably wouldn’t survive the rise in interest rates a genuine economic recovery entails anyway. Price inflation would almost certainly rise well above the 2% target forcing central banks to raise interest rates, throwing bonds and stocks into a severe bear market, and imperilling government finances. The financial system is simply too highly geared to survive a credit-driven recovery.
Japan, which has accelerated monetary debasement of the yen at an unprecedented rate, finds itself in this trap. If anything, the pace of its economic deterioration is increasing. The explanation is simple and confirms the obvious: monetary debasement impoverishes ordinary people. Far from boosting the economy it is rapidly driving us into a global slump.
The solution is not higher wages.
“When Nobel Prize-winner Joseph Stiglitz was asked in Germany this week if the country and its neighbours would suffer a lost decade, his response was unequivocal. “Is Europe going the same way as Japan ? Yes,” Mr Stiglitz said in Lindau at a meeting for Nobel laureates and economics students. “The only way to describe what is going on in some European countries is depression.”
‘Spectre of Japan-style lost decade looms over eurozone’, Claire Jones, The Financial Times, August 22, 2014.
Few films have managed to convey the feeling of approaching menace more effectively than Jeff Nichols’ 2011 drama, ‘Take Shelter’. Its blue collar protagonist, Curtis LaForche, played by the lantern-jawed Michael Shannon – whose sepulchral bass tones make his every utterance sound like someone slowly dragging a coffin over a cello – begins to suffer terrifying dreams and visions; he responds by building a storm shelter in his back yard. It transpires that his mother was diagnosed with schizophrenia at a similar stage in her own life. Are these simply hallucinations ? Or are they portents of darker things to come ?
Nichols, the film’s writer and director, has gone on record as stating that at least part of the film owes something to the financial crisis:
“I think I was a bit ahead of the curve, since I wrote it in 2008, which was also an anxious time, for sure, but, yeah, now it feels even more so. This film deals with two kinds of anxiety. There’s this free-floating anxiety that we generally experience: you wake in bed and maybe worry about what’s happening to the planet, to the state of the economy, to things you have no control over. In 2008, I was particularly struck with this during the beginning of the financial meltdown. Then there’s a personal anxiety. You need to keep your life on track—your health, your finances, your family..”
There’s a degree of pretention in claiming to have a reliable read on the psychology of the marketplace – too many participants, too much intangibility, too much subjectivity. But taking market price index levels at face value, especially in stock markets, there seems to be a general sense that since the near-collapse of the financial system six years ago, the worst has passed. The S&P 500 stock index, for example, has just reached a new all-time high, leaving plenty of financial media commentators to breathlessly anticipate its goal of 2,000 index points. But look at it from an objective perspective, rather than one of simple-minded cheerleading: the market is more expensive than ever – the only people who should be celebrating are those considering selling.
There are at least two other storm clouds massing on the horizon (we ignore the worsening geopolitical outlook altogether). One is the ‘health’ of the bond markets. Bloomberg’s Mark Gilbert points out that Germany has just issued €4 billion of two year notes that pay no interest whatsoever until they mature in 2016. The second is the explicitly declining health of the euro zone economy, which is threatening to slide into recession (again), and to which zero interest rates in Germany broadly allude. The reality, which is not a hallucination, is that years of Zero Interest Rate Policy everywhere and trillions of dollars, pounds, euros and yen pumped into a moribund banking system have created a ‘Potemkin village’ market offering the illusion of stability. In their June 2014 letter, Elliott Management wrote as follows:
“..Stock markets around the world are at or near all-time nominal highs, while global interest rates hover near record lows. A flood of newly-printed money has combined with zero percent interest rates to keep all the balls suspended in the air. Nonetheless, growth in the developed world (US, Europe and Japan) has been significantly subpar for the 5 ½ years following the financial crisis. Businesses have been reluctant to invest and hire. The consumer is still “tapped out,” and there are significant suppressive forces from poor policy, including taxes and increased regulation. Governments (which are actually responsible for the feeble growth) are blaming the shortfall on “secular stagnation,” purportedly a long-term trend, which enables them to deny responsibility..
“The orchestra conductors for this remarkable epoch are the central bankers in the US, UK, Europe and Japan. The cost of debt of all maturities issued by every country, corporation and individual in the world (except outliers like Argentina) is in the process of converging at remarkably low rates. In Greece (for goodness sake), long-term government debt is trading with a yield just north of 5%. In France, 10 year bonds are trading at a yield of 1.67%.
“..Sadly, financial market conditions are not the result of the advancement of human knowledge in these matters. Rather, they are the result of policymaker groupthink and a mass delusion. By reducing interest rates to zero and having central banks purchase most of the debt issued by their governments, they think that inflation can be encouraged (but without any risk that it will spin out of control) and that economic activity consequently can be supported and enhanced. We are 5 ½ years into this global experiment, which has never been tried in its current breadth and scope at any other time in history.. the bald fact is that the entire developed world is growing at a sluggish pace, if at all. But governments, media, politicians, central bankers and academics are unwilling to state the obvious conclusion that their policies have failed and need to be revised. Instead, they uniformly state, with the kind of confidence only present among the truly clueless, that in the absence of their current policies, things would be much worse.”
Regardless of the context, stock markets at or near all-time highs are things to be sceptical of, rather than to be embraced with both hands. Value investors prefer to buy at the low than at the high. The same holds for bonds, especially when they offer the certainty of a loss in real terms if held to maturity. But as Elliott point out, the job of asset managers is to manage money, and not to “hold up our arms and order the tide to roll back”. (We have written previously about those who seem to believe they can control the tides.) So by a process of logic, selectivity and elimination, we believe the only things remotely worth buying today are high quality stocks trading at levels well below their intrinsic value.
We recently wrote about the sort of metrics to assess stocks that can be reliably used over the long run to generate superior returns. Among them, low price / book is a stand-out characteristic of value stocks that has generated impressive, market-beating returns over any medium term time frame. So which markets currently enjoy some of the most attractive price / book ratios ?
The four tables below, courtesy of Greg Fisher and Samarang Capital, show the relative attractiveness of the Japanese, US, Vietnamese and UK markets, as expressed by the distributions of their price / book ratios. Over 40% of the Japanese market, for example, trades on a price / book of between 0.5 and 1. We would humbly submit that this makes the Japanese market objectively cheap. The comparative percentage for the US market is around 15%.
Various stock markets as expressed in price / book ratios
Source: Bloomberg LLP
Even more strikingly, nearly 60% of the Vietnamese stock market trades on a price / book of between 0.5 and 1. The comparative figure for the UK market is approximately 20%.
Conversely, nearly 60% of the US market trades on a price / book of above 2 times. We would humbly submit that this makes the US market look expensive. There is clearly a world of difference between a frontier market like Vietnam which is limited by way of capital controls, and a developed market like that of the US which isn’t. But the price / book ratio is a comparison of apples with apples, and US stock market apples simply cost more than those in Japan or Vietnam. We’d rather buy cheap apples.
As clients and longstanding readers will appreciate, we split the investible universe into four asset classes: high quality credit; value equity; uncorrelated funds; and real assets, notably precious metals. As a result of the extraordinary monetary accommodation of the past six years or so, both credit markets and stocks have been boosted to probably unsustainable levels, at least in the West. Uncorrelated funds (specifically, trend-following funds) and gold and silver have recently lagged more traditional assets, though we contend that they still offer potential for portfolio insurance when the long-awaited storm of reality (financial gravity) finally strikes. But on any objective analysis, we think the merits of genuine value stocks are now compelling when set against any other type of investment, both on a relative and absolute basis. Increasingly desperate central banks have destroyed the concept of safe havens. There is now only relative safety by way of financial assets. The mood music of the markets is becoming increasingly discordant as investors (outside the euro zone at least) start to prepare for a turn in the interest rate cycle. There is a stark choice when it comes to investment aesthetics. Those favouring value and deep value investments are, we believe, more likely to end up wearing diamonds. Those favouring growth and momentum investments are, we believe, more likely to end up wearing the Emperor’s new clothes. We do not intend to end up as fashion victims as and when the storm finally hits.
Despite all the massive monetary pumping over the past six years and the lowering of interest rates to almost zero most commentators have expressed disappointment with the pace of economic growth. For instance, the yearly rate of growth of the EMU real GDP fell to 0.7% in Q2 from 0.9% in the previous quarter. In Q1 2007 the yearly rate of growth stood at 3.7%. In Japan the yearly rate of growth of real GDP fell to 0% in Q2 from 2.7% in Q1 and 5.8% in Q3 2010.
In the US the yearly rate of growth of real GDP stood at 2.4% in Q2 against 1.9% in the prior quarter. Note that since Q1 2010 the rate of growth followed a sideways path of around 2.2%. The exception is the UK where the growth momentum of GDP shows strengthening with the yearly rate of growth closing at 3.1% in Q2 from 3% in Q1. Observe however, that the yearly rate of growth in Q3 2007 stood at 4.3%.
In addition to still subdued economic activity most central bankers are concerned with the weakness of workers earnings.
Some of them are puzzled that despite injecting trillions of dollars into the financial system so little of it is showing up in workers earnings?
After all, it is held, the higher earnings are the more consumers can spend and consequently, the stronger the economic growth is going to be, so it is held.
The yearly rate of growth of US average hourly earnings stood at 2% in July against 3.9% in June 2007.
In the EMU the yearly rate of growth of weekly earnings plunged to 1.3% in Q1 from 5.4% in Q2 2009.
In the UK the yearly rate of growth of average weekly earnings fell to 0.7% in June this year from 5% in August 2007.
According to the Vice Chairman of the US Federal Reserve Stanley Fischer the US and global recoveries have been “disappointing” so far and may point to a permanent downshift in economic potential. Fisher has suggested that a slowing productivity could be an important factor behind all this.
That a fall in the productivity of workers could be an important factor is a good beginning in trying to establish what is really happening. It is however, just the identification of a symptom – it is not the cause of the problem.
Now, higher wages are possible if workers’ contribution to the generation of real wealth is expanding. The more a particular worker generates as far as real wealth is concerned the more he/she can demand in terms of wages.
An important factor that permits a worker to lift productivity is the magnitude and the quality of the infrastructure that is available to him. With better tools and machinery more output per hour can be generated and hence higher wages can be paid.
It is by allocating a larger slice out of a given pool of real wealth towards the buildup and the enhancement of the infrastructure that more capital goods per worker emerges (more tools and machinery per worker) and this sets the platform for higher worker productivity and hence to an expansion in real wealth and thus lifts prospects for higher wages. (With better infrastructure workers can now produce more goods and services).
The key factors that undermine the expansion in the capital goods per worker are an ever expanding government and loose monetary policies of the central bank. According to the popular view, what drives the economy is the demand for goods and services.
If, for whatever reasons, insufficient demand emerges it is the role of the government and the central bank to strengthen the demand to keep the economy going, so it is held. There is, however, no independent category such as demand that drives an economy. Every demand must be funded by a previous production of wealth. By producing something useful to other individuals an individual can exercise a demand for other useful goods.
Any policy, which artificially boosts demand, leads to consumption that is not backed up by a previous production of wealth. For instance, monetary pumping that is supposedly aimed at lifting the economy in fact generates activities that cannot support themselves. This means that their existence is only possible by diverting real wealth from wealth generators.
Printing presses set in motion an exchange of nothing for something. Note that a monetary pumping sets a platform for various non-productive or bubble activities – instead of wealth being used to fund the expansion of a wealth generating infrastructure, the monetary pumping channels wealth towards wealth squandering activities.
This means that monetary pumping leads to the squandering of real wealth. Similarly a policy of artificially lowering interest rates in order to boost demand in fact provides support for various non-productive activities that in a free market environment would never emerge.
We suggest that the longer central banks world wide persist with their loose monetary policies the greater the risk of severely damaging the wealth generating process is. This in turn raises the likelihood of a prolonged stagnation.
All this however, can be reversed by shrinking the size of the government and by the closure of all the loopholes of the monetary expansion. Obviously a tighter fiscal and monetary stance is going to hurt various non-productive activities.
The data was not really surprising and neither was the response from the commentariat. After a run of weak reports from Germany over recent months, last week’s release of GDP data for the eurozone confirmed that the economy had been flatlining in the second quarter. Predictably, this led to new calls for ECB action. “Europe now needs full-blown QE” diagnosed the leader writer of the Financial Times, and in its main report on page one the paper quoted Richard Barwell, European economist at Royal Bank of Scotland with “It’s time the ECB took control and we got the real deal, instead of the weaker measure unveiled in June.”
I wonder if calls for more ‘stimulus’ are now simply knee-jerk reactions, mere Pavlovian reflexes imbued by five years of near relentless policy easing. Do these economists and leader writers still really think about their suggestions? If so, what do they think Europe’s ills are that easy money and cheap credit are going to cure them? Is pumping ever more freshly printed money into the banking system really the answer to every economic problem? And has QE been a success where it has been pursued?
The fact is that money has hardly been tight in years – at least not at the central bank level, at the core of the system. Granted, banks have not been falling over one another to extend new loans but that is surely not surprising given that they still lick their wounds from 2008. The ongoing “asset quality review” and tighter regulation are doing their bit, too, and if these are needed to make finance safer, as their proponents claim, then abandoning them for the sake of a quick – and ultimately short-lived – GDP rebound doesn’t seem advisable. The simple fact is that lenders are reluctant to lend and borrowers reluctant to borrow, and both may have good reasons for their reluctance.
Do we really think that Italian, French, and German companies have drawers full of exciting investment projects that would instantly be put to work if only rates were lower? I think it is a fairly safe bet that whatever investment project Siemens, BMW, Total and Fiat can be cajoled into via the lure of easy money will by now have been realized. The easy-money drug has a rapidly diminishing marginal return.
In most major economies, rates have been close to zero for more than five years and various additional stimulus measures have been taken, including some by the ECB, even if they fell short of outright QE. Yet, the global economy is hardly buzzing. The advocates of central bank activism will point to the US and the UK. Growth there has recently been stronger and many expect a rise in interest rates in the not too distant future. Yet, even if we take the US’ latest quarterly GDP data of an annualized 4 percent at face value (it was a powerful snap-back from a contraction in Q1), the present recovery, having started in 2009, still is the slowest in the post-World-War-II period, and by some margin. The Fed is not done with its bond-buying program yet, fading it out ever so slowly and carefully, fearful that the economy, or at any rate overstretched financial markets, could buckle under a more ‘normal’ policy environment, if anybody still knows what that may look like. We will see how much spring is left in the economy’s step once stimulus has been removed fully and interest rates begin to rise — if that will ever happen.
Then there is Japan, under Abe and Kuroda firmly committed to QE-square and thus the new poster-boy of the growth-through-money-printing movement. Here the economy contracted in Q2 by a staggering 6.8% annualized, mimicking its performance from when it was hit by a tsunami in 2011. This time economic contraction appears to have been mainly driven by an increase in the country’s sale tax (I guess the government has to rein in its deficit at some stage, even in Japan), which had initially caused a strong Q1, as consumers front-loaded purchases in anticipation of the tax hike. Now it was pay-back time. Still, looking through the two quarters, the Wall Street Journal speaks of “Japan’s slow recovery despite heavy stimulus”.
Elsewhere the debate has moved on
In the Anglo-Saxon countries the debate about the negative side-effects of ultra-easy money seems to be intensifying. Last week Martin Feldstein and Robert Rubin, in an editorial for the Wall Street Journal, warned of risks to financial stability from the Fed’s long-standing policy stimulus, pointing towards high asset values and tight risk premiums, stressing that monetary policy was asked to do too much. Paul Singer, founder of the Elliott Management hedge fund and the nemesis of Argentina’s Cristina Fernandez de Kirchner, was reported as saying that ultra-easy monetary policy had failed and that structural reforms and a more business-friendly regulatory environment were needed instead. All of this even before you consider my case (the Austrian School case) that every form of monetary stimulus is ultimately disruptive because it can at best buy some growth near term at the price of distorting capital markets and sowing the seeds of a correction in the future. No monetary stimulus can ever lead to lasting growth.
None of this seems to faze the enthusiasts for more monetary intervention in Europe. When data is soft, the inevitable response is to ask the ECB to print more money.
The ECB’s critics are correct when they claim that the ECB has recently been less accommodative than some of its cousins, namely the Fed and the Bank of Japan. So the eurozone economy stands in front of us naked and without much monetary make-up. If we do not like what we see then the blame should go to Europe’s ineffectual political elite, to France’s socialist president Hollande, whose eat-the-rich tax policies and out-of-control state bureaucracy cripple the country; to Ms Merkel, who not only has failed to enact a single pro-growth reform program since becoming Germany’s chancellor (how long can the country rest on the Schroeder reforms of 2002?) but now embraces a national minimum wage and a lower retirement age of 63, positions she previously objected to; to Italy’s sunny-boy Renzi who talks the talk but has so far failed to walk the walk. But then it has been argued that under democracy the people get the rulers they deserve. Europe’s structural impediments to growth often appear to enjoy great public support.
Calls for yet easier monetary conditions and more cheap credit are a sign of intellectual bankruptcy and political incompetence. They will probably be heeded.
The Federal Reserve increasingly is attracting scrutiny across the board. Now add to that a roller coaster of a thriller, using a miracle of a rare device, shining a light into the operations of the Fed — that contemporary riddle wrapped in a mystery inside an enigma: Matthew Quirk’s latest novel, The Directive.
“If I’ve made myself too clear, you must have misunderstood me,” Fed Chairman Alan Greenspan once famously said. The era of a mystagogue Fed may be ending. Recently, the House Government Oversight Committee passed, and referred to the full House, theFederal Reserve Transparency Act of 2014. This legislation is part of the legacy of the great former Representative Ron Paul. It popularly is known as “Audit the Fed.” How ironic that a mystery novel proves a device to dispel some of the Fed’s obscurantist mystery.
Novelist/reporter Matthew Quirk’s The Directive does for he Fed what Alan Drury did for Senate intrigue with his Pulitzer Prize winning Advise and Consent, what Aaron Sorkin did for the White House in The West Wing and, now, what Beau Willimon, is doing for the Congress with House of Cards. Quirk takes the genre of political thriller into virgin territory: the Fed. Make to mistake. Engaging the popular imagination has political potency. As Victor Hugo, nicely paraphrased, observed: Nothing is as powerful as an idea whose time has come.
Quirk, according to his website,“studied history and literature at Harvard College. After graduation, he spent five years at The Atlantic reporting on crimes, private military contractors, the opium trade, terrorism prosecutions, and international gangs.” His background shows. Quirk’s writings drips with the kind of eye for the telling detail that only a canny reporter, detective, or spy possesses. (Readers will learn, just in passing, the plausible identity of the mysterious “secure undisclosed location” where the vice president was secreted following 9/11.)
If you like Ludlum you are certain to like Quirk. And who isn’t intrigued by such a mysteriously powerful entity as the Fed? Booklist calls The Directive a “nonstop heart-pounding ride in which moral blacks and whites turn gray in the ‘efficient alignment of power and interests’ that is big time politics.” Amen.
The Directive describes an effort to rob the biggest bank in the world. The object of the heist is not the tons of gold secured in the basement of 33 Liberty Street. (As Ian Fleming pointed out, in Goldfinger it logistically is impossible to move the mass of so much gold quickly enough to effect a robbery.) Rather, Quirk uses as his literary device, with a touch of dramatic license, the interception of the Federal Open Market Committee’s directive to the trading desk of the Federal Reserve Bank of New York to raise (or lower) interest rates in order to use that insider information to make a fast killing.
Lest anyone doubt the power of such insider information consider William Safire’s report, from his White House classic memoir Before the Fall, of the weekend at Camp David before Nixon “closed the gold window.”
After the Quadriad meeting, the President remained alone while the rest of the group dined at the Laurel Cabin. The no-phone-calls edict was still in force, raising some eyebrows of men who had shown themselves to be trustworthy repositories of events. but the 6’8″, dour Treasury Under Secretary Volcker explained a different dimension to the need for no leaks: “Fortunes could be made with this information.” Haldeman, mock-serious, leaned forward and whispered loudly, “Exactly how?” The tension broken, Volcker asked Schulz, “How much is your budget deficit?” George estimated, “Oh, twenty three billion or so — why?” Volcker looked dreamily at the ceiling. “Give me a billion dollars and a free hand on Monday, and I could make up that deficit in the money markets.”
Safire provides context making Volcker’s integrity indisputable lest anyone be tempted to misinterpret this as a trial balloon.
This columnist has been inside the headquarters of the Fed, including, many years ago, the boardroom. Quirk:
Every eight weeks or so, a committee gathers near the National Mall in a marble citadel known as the Board of Governors of the Federal Reserve. Twenty-five men and women sit at a long wooden table with an inset of black stone shined to a high gloss. By noon they decide the fate of the American economy.
This columnist never has stepped foot inside the Federal Reserve Bank of New York, much less its trading floor(s). Few have entered that sanctum sanctorum. By taking his readers inside Quirk provides his readers a narrative grasp to how the Fed does what it does.
[T]he Fed is by design very friendly to large New York banks. When the committee in DC decides what interest rates should be, they can’t simply dictate them to the banks. They decide on a target interest, and then send the directive to the trading desk at the New York Fed to instruct them about how to achieve it. The traders upstairs go into the markets and wheel and deal with the big banks, buying and selling Treasury bills and other government debts, essentially IOUs from Uncle Sam. When the Fed buys up a lot of those IOUs, they flood the economy with money; when they sell them, they take money out of circulation.
They are effectively creating and destroying cash. By shrinking or expanding the supply of money in the global economy, making it more or less scarce, they also make it more or less expensive to borrow; the interest rate. In this way, trading back and forth with the largest banks in the world, they can drive interest rates toward their target.
The amount of actual physical currency in circulation is only a quarter of the total monetary supply. The rest is just numbers on a computer somewhere. When people say the government can print as much money as it wants, they’re really talking about the desk doing its daily work of resizing the monetary supply—tacking zeros onto a bunch of electronic accounts—that big banks are allowed to lend out to you and me.
Every morning, on the ninth floor of the New York Fed, the desk gets ready to go out and manipulate the markets according to the instructions laid out in the directive. Its traders are linked by computer with twenty-one of the largest banks in the world. When they’re ready to buy and sell, in what are called open market operation, one trader presses a button on his terminal and three chimes — the notes F-E-D — sound on the terminals of his counterparties. Then they’re off to the races.
There are usually eight to ten people on that desk, mostly guys in their late twenties and early thirties, and they manage a portfolio of government securities worth nearly $4 trillion that backs our currency. Without it, the bills in your wallet would be as worthless as Monopoly cash. The traders on that floor carry out nearly $5.5 billion in trades per day, set the value of every penny you earn or spend, and steer the global economy.
As Quirk recently told Matthew Yglesias, at Vox.com:
I was casting about for the biggest hoards of money in the world, and you get to the Federal Reserve Bank in New York fairly quickly. But that’s been done. Then I learned more and more about the trading desk, and my mind was blown.
You get to have this great line where you say, “There’s $300 billion worth of gold in the basement, but the real money is on the ninth floor.” …
I was a reporter in Washington for a while, and I thought, “Oh, the Fed sets interest rates,” because that’s always what people say. But as you dig into it, you realize that the Fed just has to induce interest rates to where they want to be. They have to trade back and forth with these 19 or 20 banks, and they have 8‑10 guys at this trading desk, trading about $5.5 billion a day. That’s actually how the government prints money and expands and contracts the monetary supply.
It’s this high wire act. You explain it to people and they say, “Oh, it’s a conspiracy thriller.” You say, “No, no. That’s the real part. I haven’t gotten to the conspiracy yet.” But it’s a miracle that it works.
Quirk’s own dual mandate? Combine fast-paced drama with a peek behind the scenes of the world’s biggest bank, providing vivid entertainment while teaching more about the way that one of the most powerful and mysterious institutions in the world works. In The Directive Matthew Quirk shakes, rather than stirs, his readers brilliantly.
Originating at Forbes.com: http://www.forbes.com/sites/ralphbenko/2014/08/04/signs-of-the-feds-era-of-secrecy-coming-to-an-end/
At the end of July global equity bull markets had a moment of doubt, falling three or four per cent. In the seven trading days up to 1st August the S&P500 fell 3.8%, and we are not out of the woods yet. At the same time the Russell 2000, an index of small-cap US companies fell an exceptional 9%, and more worryingly it looks like it has lost bullish momentum as shown in the chart below. This indicates a possible double-top formation in the making.
Meanwhile yield-spreads on junk bonds widened significantly, sending a signal that markets were reconsidering appropriate yields on risky bonds.
This is conventional analysis and the common backbone of most brokers’ reports. Put simply, investment is now all about the trend and little else. You never have to value anything properly any more: just measure confidence. This approach to investing resonates with post-Keynesian economics and government planning. The expectations of the crowd, or its animal spirits, are now there to be managed. No longer is there the seemingly irrational behaviour of unfettered markets dominated by independent thinkers. Forward guidance is just the latest manifestation of this policy. It represents the triumph of economic management over the markets.
Central banks have for a long time subscribed to management of expectations. Initially it was setting interest rates to accelerate the growth of money and credit. Investors and market traders soon learned that interest rate policy is the most important factor in pricing everything. Out of credit cycles technical analysis evolved, which sought to identify trends and turning points for investment purposes.
Today this control goes much further because of two precedents: in 2001-02 the Fed under Alan Greenspan’s chairmanship cut interest rates specifically to rescue the stock market out of its slump, and secondly the Fed’s rescue of the banking system in the wake of the Lehman crisis extended direct intervention into all financial markets.
Both of these actions succeeded in their objectives. Ubiquitous intervention continues to this day, and is copied elsewhere. It is no accident that Spanish bond yields for example are priced as if Spain’s sovereign debt is amongst the safest on the planet; and as if France’s bond yields reflect a credible plan to repay its debt.
We have known for years that through intervention central banks have managed to control the prices of currencies, precious metals and government bonds; but there is increasing evidence of direct buying of other financial assets, including equities. The means for continual price management are there: there are central banks, exchange stabilisation funds, sovereign wealth funds and government-controlled pension funds, which between them have limitless buying-power.
Doubtless there is a growing band of central bankers who believe that with this control they have finally discovered Keynes’s Holy Grail: the euthanasia of the rentier and his replacement by the state as the primary source of business capital. This being the case, last month’s dip in the markets will turn out to be just that, because intervention will simply continue and if necessary be ramped up.
But in the process, all market risk is being transferred from bonds, equities and all other financial assets into currencies themselves; and it is the outcome of their purchasing power that will prove to be the final judgement in the debate of markets versus economic planning.
“I say to all those who bet against Greece and against Europe: You lost and Greece won. You lost and Europe won.” –Jean-Claude Juncker, former prime minister of Luxembourg and president of the Eurogroup of EU Finance Ministers, 2014
“We have indeed at the moment little cause for pride: As a profession we have made a mess of things.” –Friedrich Hayek, Nobel Laureate in Economic Science, 1974
Jean-Claude Juncker is a prominent exception to the recent trend of economic and monetary officials openly expressing doubt that their interventionist policies are producing the desired results. In recent months, central bankers, the International Monetary Fund, the Bank for International Settlements, and a number of prestigious academic economists have expressed serious concern that their policies are not working and that, if anything, the risks of another 2008-esque global financial crisis are building. Thus we have arrived at a ‘Crisis of Interventionism’ as the consequences of unprecedented monetary and fiscal stimulus become evident, fuelling a surge in economic nationalism around the world, threatening the end of globalisation and the outbreak of trade wars. Indeed, a tech trade war may already have started. This is is perhaps the least appreciated risk to financial markets at present. How should investors prepare?
THE FATAL CONCEIT
Friedrich Hayek was the first Austrian School economist to win the Nobel Memorial Prize in Economic Science. Yet Hayek took issue with the characterisation of modern economics as a ‘science’ in the conventional sense. This is because the scientific method requires theories to be falsifiable and repeatable under stable conditions. Hayek knew this to be impossible in the real world in which dynamic, spontaneous human action takes place in response to an incalculable number of exogenous and endogenous variables.
Moreover, Hayek believed that, due to the complexity of a modern economy, the very idea that someone can possibly understand how it works to the point of justifying trying to influence or distort prices is nonsensical in theory and dangerous in practise. Thus he termed such hubris in economic theory ‘The Pretence of Knowledge’ and, in economic policy, ‘The Fatal Conceit’.
History provides much evidence that Hayek was correct. Interventionism has consistently failed either to produce the desired results or has caused new, unanticipated problems, such as in the 1920s and 1930s, for example, an age of particularly active economic policy activism in most of the world. Indeed, as Hayek wrote in his most famous work, The Road to Serfdom, economic officials tend to respond to the unintended consequences of their failed interventions with ever more interventionism, eventually leading to severe restrictions of economic liberty, such as those observed under socialist or communist regimes.
Hayek thus took advantage of his Nobel award to warn the economics profession that, by embracing a flawed, ‘pseudo-scientific method’ to justify interventionism, it was doing itself and society at large a great disservice:
The conflict between what in its present mood the public expects science to achieve in satisfaction of popular hopes and what is really in its power is a serious matter because, even if the true scientists should all recognize the limitations of what they can do in the field of human affairs, so long as the public expects more there will always be some who will pretend, and perhaps honestly believe, that they can do more to meet popular demands than is really in their power. It is often difficult enough for the expert, and certainly in many instances impossible for the layman, to distinguish between legitimate and illegitimate claims advanced in the name of science…
If we are to safeguard the reputation of economic science, and to prevent the arrogation of knowledge based on a superficial similarity of procedure with that of the physical sciences, much effort will have to be directed toward debunking such arrogations, some of which have by now become the vested interests of established university departments.
Hayek made these comments in 1974. If only the economics profession had listened. Instead, it continued with the pseudo-science, full-steam ahead. That said, by 1974 a backlash against traditional Keynesian-style intervention had already begun, led by, among others, Milton Friedman. But Friedman too, brilliant as he no doubt was, was seduced also by the culture of pseudo-science and, in his monetary theories, for which he won his Nobel prize in 1976, he replaced a Keynesian set of unscientific, non-falsifiable, intervention-justifying equations with a Monetarist set instead.
Economic interventionism did, however, fall out of intellectual favour following the disastrous late-1970s stagflation and subsequent deep recession of the early 1980s—in the US, the worst since WWII. It never really fell out of policy, however. The US Federal Reserve, for example, facilitated one bubble after another in US stock and/or property prices in the period 1987-2007 by employing an increasingly activist monetary policy. As we know, this culminated in the spectacular events of 2008, which unleased a global wave of intervention unparalleled in modern economic history.
THE KEYNESIANS’ NEW CLOTHES
Long out of fashion, Keynesian theory and practice returned to the fore as the 2008 crisis unfolded. Some boldly claimed at the time that “we are all Keynesians now.” Activist economic interventionism became the norm across most developed and developing economies. In some countries, this has taken a more fiscal policy form; in others the emphasis has been more on monetary policy. Now six years on, with most countries still running historically large fiscal deficits and with interest rates almost universally at or near record lows, it is entirely understandable that the economics profession is beginning to ask itself whether the interventions it recommended are working as expected or desired.
While there have always been disputes around the margins of post-2008 interventionist policies, beginning in 2012 these became considerably more significant and frequent. In a previous report, THE KEYNESIANS’ NEW CLOTHES, I focused on precisely this development:
In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particular, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Now, nearly two years later, the IMF has been joined in its doubts by a chorus of economic officials and academics from all over the world increasingly concerned that their interventions are failing and, in some cases, putting forth proposals of what should be done.
Let’s start with the Bank of England. Arguably the most activist central bank post-2008, as measured by the expansion of its balance sheet, several members of the Banks’ Monetary Policy Committee have expressed concern about the risks to financial stability posed by soaring UK property prices, a lack of household savings and a financial sector that remains highly leveraged. In a recent speech, BoE Chief Economist Charlie Bean stated that:
[T]he experience of the past few years does appear to suggest that monetary policy ought to take greater account of financial stability concerns. Ahead of the crisis, Bill White and colleagues at the Bank for International Settlements consistently argued that when leverage was becoming excessive and/or asset prices misaligned, central bankers ought to ‘lean against the wind’ by keeping interest rates higher than necessary to meet the price stability objective in the short run. Just as central banks are willing to accept temporary deviations from their inflation targets to limit output volatility, so they should also be willing to accept temporary deviations to attenuate the credit cycle. Essentially it is worth accepting a little more volatility in output and inflation in the short run if one can thereby reduce the size or frequency of asset-price busts and credit crunches.
In other words, perhaps central bank policy should change focus from inflation targeting, which demonstrably failed to prevent 2008, and instead to focus on money and credit growth. This is clearly an anti-Kenyesian view in principle, although one wonders how it might actually work in practice. In closing, he offered these thoughts:
I opened my remarks tonight by observing that my time at the Bank has neatly fallen into two halves. Seven years of unparalleled macroeconomic stability have been followed by seven years characterised by financial instability and a deep recession. It was a salutary lesson for those, like me, who thought we had successfully cracked the problem of steering the economy, and highlighted the need to put in place an effective prudential framework to complement monetary policy. Policy making today consequently looks a much more complex problem than it did fourteen years ago.
Indeed. Policy making does look increasingly complex. And not only to the staff of the IMF and to Mr Bean, but also to the staff at the Bank for International Settlements, to which Mr Bean referred in his comments. In a recent speech, General Manager of the BIS, Jaime Caruana, taking a global view, expressed fresh concern that:
There is considerable evidence that, for the world as a whole, policy interest rates have been persistently below traditional benchmarks, fostering unbalanced expansions. Policy rates are comparatively low regardless of the benchmarks – be these trend growth rates or more refined ones that capture the influence of output and inflation… Moreover, there is clear evidence that US monetary policy helps explain these deviations, especially for small open and emerging market economies. This, together with the large accumulation of foreign exchange reserves, is consistent with the view that these countries find it hard, economically or politically, to operate with rates that are considerably higher than those in core advanced economies. And, alongside such low rates, several of these economies, including some large ones, have been exhibiting signs of a build-up of financial imbalances worryingly reminiscent of that observed in the economies that were later hit by the crisis. Importantly, some of the financial imbalances have been building up in current account surplus countries, such as China, which can ill afford to use traditional policies to boost domestic demand further. This is by no means new: historically, some of the most disruptive financial booms have occurred in current account surplus countries. The United States in the 1920s and Japan in the 1980s immediately spring to mind.
The above might not sound terribly controversial from a common-sense perspective but to those familiar with the core precepts of the neo-Keynesian mainstream, this borders on economic heresy. Mr Caruana is implying that the Great Depression was not caused primarily by the policy failures of the early 1930s but by the boom preceeding it and that the stagnation of Japan in recent decades also has its roots in an unsustainable investment boom. In both cases, these booms were the product of economic interventions in the form of inappropriately easy monetary policy. And whence does current inappropriate policy originate? Why, from the US Federal Reserve! Mr Caruana is placing the blame for the renewed, dangerous buildup of substantial global imbalances and associated asset bubbles specifically on the Fed!
Yet Mr Caruana doesn’t stop there. He concludes by noting that:
[T]he implication is that there has been too much emphasis since the crisis on stimulating demand and not enough on balance sheet repair and structural reforms to boost productivity. Looking forward, policy frameworks need to ensure that policies are more symmetrical over the financial cycle, so as to avoid the risks of entrenching instability and eventually running out of policy ammunition.
So now we have had the IMF observing that traditional policies aren’t working as expected; BoE Chief Economist Bean noting how policy-making has become ‘complex’; and BIS GM Caruana implying this is primarily due to the boom/bust policies of the US Federal Reserve. So what of the Fed itself? What have Fed officials had to say of late?
Arguably the most outspoken recent dissent of the policy mainstream from within the Fed is that from Jeffrey Lacker, President of the regional Richmond branch. In a recent speech, he voiced his clear opposition to growing central bank interventionism:
There are some who praise the Fed’s credit market interventions and advocate an expansive role for the Fed in promoting financial stability and mitigating financial system disruptions. They construe the founders of the Federal Reserve System as motivated by a broad desire to minimize and prevent financial panics, even beyond simply satisfying increased demand for currency. My own view, which I must note may not be shared by all my colleagues in the Federal Reserve System, favors a narrower and more restrained role, focused on the critical core function of managing the monetary liabilities of the central bank. Ambitious use of a central bank’s balance sheet to channel credit to particular economic sectors or entities threatens to entangle the central bank in distributional politics and place the bank’s independence at risk. Moreover, the use of central bank credit to rescue creditors boosts moral hazard and encourages vulnerability to financial shocks.
By explicitly referencing moral hazard, Mr Lacker is taking on the current leadership of the Federal Reserve, now headed by Janet Yellen, which denies that easy money policies have had anything to do with fostering financial instability. But as discussed earlier in this report, the historical evidence is clear that Fed activism is behind the escalating boom-bust cycles of recent decades. And as Mr Caruana further suggests, this has been a global phenomenon, with the Fed at the de facto helm of the international monetary system due to the dollar’s global reserve currency role.
EURO ‘MISSION ACCOMPLISHED’? UH, NO
As quoted at the start of this report, Jean-Claude Juncker, prominent Eurocrat and politician, recently claimed victory in the euro-crisis. “Greece and Europe won.” And who lost? Why, those who bet against them in the financial markets by selling their debt and other associated assets.
But is it really ‘mission accomplished’ in Europe? No, and not by a long shot. Yes, so-called ‘austerity’ was absolutely necessary. Finances in many EU countries were clearly on an unsustainable course. But other than to have bought time through lower borrowing costs, have EU or ECB officials actually achieved anything of note with respect to restoring economic competitiveness?
There is some evidence to this effect, for example in Ireland, Portugal and Spain, comprising some 15% of the euro-area economy. However, there is also evidence to the contrary, most clearly seen in France, comprising some 20% of the euro-area. So while those countries under the most pressure from the crisis have made perhaps some progress, the second-largest euro member country is slipping at an accelerating rate into the uncompetitive abyss. Italy, for many years a relative economic underperformer, is not necessarily doing worse than before, but it is hard to argue it is doing better. (Indeed, Italy’s recent decision to distort its GDP data by including estimates for non-taxable black-market activities smacks of a desperate campaign to trick investors into believing its public debt burden is more manageable than it really is.)
There is also a surge in economic nationalism throughout the EU, as demonstrated by the remarkable surge in support for anti-EU politicians and parties. It is thus far too early for Mr Juncker to claim victory, although politicians are naturally given to such rhetoric. The crisis of interventionism in the euro-area may is not dissipating; rather, it is crossing borders, where it will re-escalate before long.
THE SHORT HONEYMOON OF ‘ABENOMICS’
Turning to developments in Japan, so-called ‘Abenomics’, the unabashedly interventionist economic policy set implemented by Prime Minister Abe following his election in late 2012, has already resulted in tremendous disappointment. Yes, the yen plummeted in late 2012 and early 2013, something that supposedly would restore economic competitiveness. But something happened on the way, namely a surge in import prices, including energy. Now Japan is facing not just economic stagnation but rising inflation, a nasty cocktail of ‘stagflation’. Not that this should be any surprise: Devaluing your way to prosperity has never worked, regardless of when or where tried, yet doing so in the face of structural economic headwinds is guaranteed to produce rising price inflation, just as it did in the US and UK during the 1970s.
With reality now having arrived, it will be interesting to see what Mr Abe does next. Will he go ‘all-in’ with even more aggressive yen devaluation? Or will he consider focusing on structural reform instead? Although I am hardly a Japan expert, I have travelled to the country regularly since the late 1990s and my sense is that the country is likely to slip right back into the ‘muddle through’ that characterised the economy during most of the past decade. Of course, in the event that another major global financial crisis unfolds, as I regard as inevitable in some form, Japan will be unable to avoid it, highly integrated as it is.
THE BUCK STOPS HERE: A ‘BRIC’ WALL
In my book, THE GOLDEN REVOLUTION, I document how the BRIC economies (Brazil, Russia, India, China, now joined by South Africa to make the BRICS) have been working together for years to try and reorient themselves away from mercantilist, dollar-centric, export-led economic development, in favour of a more balanced approach. Certainly they have good reasons to do so, as I described in a 2012 report, THE BUCK STOPS HERE: A BRIC WALL:
[T]he BRICS are laying the appropriate groundwork for their own monetary system: Bilateral currency arrangements and their own IMF/World Bank. The latter could, in principle, form the basis for a common currency and monetary policy. At a minimum it will allow them to buy much global influence, by extending some portion of their massive cumulative savings to other aspiring developing economies or, intriguingly, to ‘advanced’ economies in need of a helping hand and willing to return the favour in some way.
In my new book, I posit the possibility that the BRICS, amid growing global monetary instability, might choose to back their currencies with gold. While that might seem far-fetched to some, consider that, were the BRICS to reduce their dependence on the dollar without sufficient domestic currency credibility, they would merely replace one source of instability with another. Gold provides a tried, tested, off-the-shelf solution for any country or group of countries seeking greater monetary credibility and the implied stability it provides.
Now consider the foreign policy angle: The Delhi Declaration makes clear that the BRICS are not at all pleased with the new wave of interventionism in Syria and Iran. While the BRICS may be unable to pose an effective military opposition to combined US and NATO military power in either of those two countries, they could nevertheless make it much more difficult for the US and NATO to finance themselves going forward. To challenge the dollar is to challenge the Fed to raise interest rates in response. If the Fed refuses to raise rates, the dollar will plummet. If the Fed does raise interest rates, it will choke off growth and tax revenue. In either case, the US will find it suddenly much more expensive, perhaps prohibitively so, to carry out further military adventures in the Middle East or elsewhere.
While the ongoing US confrontations with Iran and Syria have been of concern to the BRICS for some time, of acute concern to member Russia of late has been the escalating crisis in Ukraine. The recent ‘Maidan’ coup, clearly supported by the US and possibly some EU countries, is regarded with grave concern by Russia, which has already taken action to protect its naval base and other military assets in the Crimea. Now several other Russian-majority Ukrainian regions are seeking either autonomy or independence. The street fighting has been intense at times. The election this past weekend confirming what Russia regards as an illegitimate, NATO-puppet government changes and solves nothing; it merely renders the dipute more intractable and a further escalation appears likely. (Russia is pressing Kiev as I write to allow it to begin providing humanitarian assistance to the rebellious regions, something likely to be denied.)
US economic sanctions on Russia have no doubt helped to catalyse the most recent BRICS initiative, in this case one specific to Russia and China, who have agreed a landmark 30-year gas deal while, at the same time, preparing the groundwork for the Russian banking system to handle non-dollar (eg yuan) payments for Russian gas exports. This is a specific but nevertheless essential step towards a more general de-dollarisation of intra-BRICS trade, which continues to grow rapidly.
The dollar’s international role had been in slow but steady decline for years, with 2008 serving to accelerate the process. The BRICS are now increasingly pro-active in reducing their dollar dependence. Russia has been dumping US dollar reserves all year and China is no longer accumulating them. India has recently eased restrictions on gold imports, something that is likely to reduce Indian demand for US Treasuries. (Strangely enough, and fodder for conspiracy theorists, tiny Belgium has stepped in to fill the gap, purchasing huge amounts of US Treasuries in recent months, equivalent to some $20,000 per household! Clearly that is not actually Belgian buying at all, but custodial buying on behalf of someone else. But on behalf of whom? And why?)
As I wrote in my book, amid global economic weakness, the so-called ‘currency wars’ naturally escalate. Competitive devaluations thus have continued periodically, such as the Abenomics yen devaluation of 2012-13 and the more recent devaluation of the Chinese yuan. As I have warned in previous reports, however, history strongly suggests that protracted currency wars lead to trade wars, which can be potentially disastrous in their effects, including on corporate profits and valuations.
THE END OF GLOBALISATION?
Trade wars are rarely labelled as such, at least not at first. Some other reason is normally given for erecting trade barriers. A popular such reason in recent decades has been either environmental or health concerns. For example, the EU and China, among other countries, have banned the import of certain genetically modified foods and seeds.
Rather than erect formal barriers, governments can also seek ways to subsidise domestic producers or exporters. While the World Trade Organisation (WTO) aims to prevent and police such barriers and subsidies, in practice it can take it years to effectively enforce such actions.
Well, there is now a new excuse for trade barriers, one specific to the huge global tech and telecommunications industry: Espionage. As it emerges that US-built and patented devices in widespread use around the world contain various types of ‘backdoors’ allowing the US National Security Agency to eavesdrop, countries are evaluating whether they should ban their use. Cisco’s CEO recently complained of losing market share to rivals due to such concerns. Somewhat ominously, China announced over the past week that it would prohibit public entities from using Microsoft Windows version 8 and would require banks to migrate away from IBM computer servers.
There has also been talk amongst the BRICS that they should build a parallel internet infrastructure to avoid routing information via the US, where it is now assumed to be automatically and systematically compromised. Given these concerns, it is possible that a general tech trade war is now breaking out under an espionage pretext. What a convenient excuse for protecting jobs: Protecting secrets! What do you think the WTO will have to say about that?
Imagine what a tech trade war would do to corporate profits. Name one major tech firm that does not have widely dispersed global supply chains, manufacturing operations and an international customer base. Amid rising trade barriers, tech firms will struggle to keep costs down. Beyond a certain point they will need to pass rising costs on to their customers. The general deflation of tech in recent decades will go into reverse. Imagine what that will do to consumer price inflation around the world.
Yes, a tech trade war would be devastating. Household, ‘blue-chip’ tech names might struggle to survive, much less remain highly profitable. And the surge in price inflation may limit the ability of central banks to continue with ultra-loose monetary policies, to the detriment also of non-tech corporate profits and financial health. This could lead into a vicious circle of reactionary protectionism in other industries, a historical echo of the ‘tit-for-tat’ trade wars of the 1930s that were part and parcel of what made the Great Depression such a disaster.
Given these facts, it is difficult to imagine that the outbreak of a global tech trade war would not result in a major equity market crash. Current valuations are high in a historical comparison and imply continued high profitability. Major stock markets, including the US, could easily lose half their value, even more if a general price inflation led central banks to tighten monetary conditions by more than financial markets currently expect. Of all the ‘black swans’ out there, a tech trade war is not only taking flight; it is also potentially one of the largest, short of a shooting war.
A SILVER LINING TO THE GLOOM AND DOOM
With equity valuations stretched and complacency rampant—the VIX volatility index dipped below 12 this week, a rare event indeed—now is the time to proceed with extreme caution. The possible outbreak of a tech trade war only adds to the danger. Buying the VIX (say, via an ETF) is perhaps the most straightforward way to insure an equity portfolio, but there are various ways to get defensive, as I discussed in my last report.
Where there is risk, however, there is opportunity, and right now there is a silver lining: With a couple of exceptions, metals prices are extremely depressed relative to stock market valuations. Arguably the most depressed is silver. Having slipped below $20/oz, silver has given up all of its previous, relative outperformance vs other metals from 2010-11. It thus appears cheap vs both precious and industrial metals, with silver being something of a hybrid between the two. Marginal production capacity that was brought on line following the 2010-11 price surge is now uneconomic and is shutting down. But the long slide in prices has now attracted considerable speculative short interest. If for any reason silver finds a reason to recover, the move is likely to be highly asymmetric.
Investors seeing an opportunity in silver can, of course, buy silver mining shares, either individually or through an ETF. A more aggressive play would be to combine a defensive equity market stance—say buying the VIX—with a long position in the miners or in the metal itself. My view is that such a position is likely to perform well in the coming months. (Please note that volatility of the silver price is normally roughly double that of the S&P500 index, so a market-neutral, non-directional spread trade would require shorting roughly twice as much of the S&P500 as the purchasing of silver. Also note, however, that correlations are unstable and thus must be dynamically risk-managed.)
As famed distressed-debt investor Howard Marks says, investing is about capturing asymmetry. Here at Amphora we aim to do precisely that. At present, there appears no better way to go about it than to buy silver, either outright or combined with a stock market short/underweight. From the current starting point, this could well be one of the biggest trades of 2014.