Recession rehearsal

Powell under pressure

The last week has seen many different expressions of adaptive behaviour. First, the Democratic Party establishment and organisation have rallied around Joe Biden, and helped to push him to stunning turnaround in the Party’s campaign for President.

Then there has been widespread adaptation to the coronavirus – people have stopped shaking hands, travel only when necessary and it seems, lead incrementally more healthy lives (though a half-marathon I had entered was cancelled). In some cases however, stoicism wins out – the London Tube is as packed as ever.

In markets, investors – a great deal of whom are unsentimental robots – are adapting to extreme volatility. It has been one of the most extraordinary weeks in markets as investors try to position around the uncertainties introduced by the coronavirus. If and when we get it, a mid-twenties reading on the Vix volatility index would suggest that what might be described as ‘normal’ trading is getting underway. 

Then, policy makers have also been adapting, slowly. My sense is that to a large extent the policy reaction to the coronavirus is a rehearsal for how the next recession is met. So far, it has been a shambles. 

Jerome Powell, in making a 50 basis point cut in interest rates revealed that he is beholden to both equity and bond markets, and it seems, to politics. His action underlined the existence of the Fed ‘put’ – that the central bank will ride to the market’s rescue in times of turbulence.

The delivery of the rate cut was poor.  It focused insufficiently on the sense that this move would provide ‘insurance’ and on the ways it might combat the economic panic (e.g. risk of bankruptcies) associated with the coronavirus.

With the idea of a ‘rehearsal’ in mind, Powell’s move contributed to a feeling that when the ‘real’ recession comes, the Fed will have relatively little monetary ammunition and may, like the ECB and Bank of Japan (BoJ), have to resort to extraordinary measures like negative interest rates. 

If that is where the Fed is headed to, then the lesson for them from the likes of the BoJ, ECB and Riksbank in Sweden is not a happy one. The rush towards very low to negative rates in those monetary jurisdictions undercut banking sectors – a key reason why Europe and Japan have had weak recoveries, and also why to date US banks have outcompeted their international rivals. Sharply cutting rates, in tandem with a compressing yield curve, undercuts the balance sheets of banks, and in some cases can deepen a downturn. The Fed needs to study this carefully.

The second issue with the political response to the economic side-effects of the coronavirus crisis so far, is that despite G7 conference call and very general statement of intent, there is little apparent leadership and coordination.

The fracturing of international politics has made sincere collaboration difficult in practice (America might for example have announced a moratorium on sanctions on China). Moreover, the absence of a serious fiscal response in countries like Italy (the support measures announced come to only 0.3% of GDP), and the notable lack of open thinking on how deregulation might serve to boost business, is worrying.

I may be a little too critical here, but the sum of the week’s policy activity highlights depleted economic arsenals. Debt is too high and few countries have a decent fiscal surplus. Those that do, like Germany, don’t have the will to spend it.

It also points to a depleted international policy community – where the goodwill, leadership and force of mind that existed in the 1980’s or 1990’s (I am thinking of the likes of James Baker or Robert Rubin) is no longer visible. In Europe, Christine Lagarde has been strangely quiet.

There is now a need, an opportunity and hopefully time for someone like Kristalina Georgieva, or even departing Bank of England boss Mark Carney, to so a postmortem on the economic policy response to the coronavirus crisis. With world debt to GDP at its highest level since the Second World War, the next recession will be for real.

Exorbitant privilege endures

Strong then, strong now

Whenever the dollar strengthens noticeably (and it has just risen to a three year high against the trade weighted basket of other major currencies) commentators usually dust off a quote from former US Treasury Secretary John Connally who, when discussing the strong dollar with visiting German politicians in 1971, said ‘its our currency, but your problem’.

Connally had an interesting career – he was seriously injured in the assassination of John Kennedy and he was responsible for breaking the link between the dollar and gold.

In his remarks to the Germans he most likely had in mind the privileged role of the dollar as the world’s reserve currency, and the reality that America’s trading partners had simply to suffer this ‘exorbitant privilege’ as Giscard D’Estaing put it.

In the context of the trade war, and America’s more singular approach to diplomacy, the recent surge in dollar strength deserves some analysis.

Since the time of Connally – the passage of globalization, the emergence of the euro and the economic rise of China – to today, the dollar has been unassailed as the world’s reserve currency.  With 63% of all of the world’s trade settled in dollars, and similarly about two thirds of all the world’s debt denominated in dollars, the US is arguably far, far more powerful financially than it is militarily.

More importantly, as other sources of American power are diminishing – human development is falling, soft or diplomatic power is in recession, China is catching up in naval, missile and drone military capabilities – the dollar is America’s one remaining source of utter dominance.

One very interesting original, approach to examining the durability of dollar strength comes from Professor Barry Eichengreen, the academic authority on currencies. In a paper entitled “Mars or Mercury? The Geopolitics of International Currency Choice” written Eichengreen and with two economists at the Euro- pean Central Bank (ECB) describes two approaches to valuing currencies.

First, there is the more conventional “Mercury” approach, which gauges currency strength by analyzing variables like interest rates and currency reserves. The second approach, “Mars,” sees a currency as reflecting the standing of a country in the world—the quality of its institutions and its alliances.

Using data going back to the First World War, the paper finds that military and geopolitical alliances are a significant factor in explaining currency strength. The rationale is that a country that is geopolitically well placed is engaged with and trusted by its allies through trade and finance.

Eichengreen and his coauthors have set up a framework to capture the impact on the dollar of US diplomatic disengagement with the world. One of the main implications the “Mars or Mercury?” paper finds is that, in a scenario where the United States withdraws from the world and becomes more isolationist, its strategic allies no longer become enthusiastic buyers of US financial assets and long-term interest rates in the United States could rise by up to 1 percent because there would be fewer buyers of American government debt.

At a strategic level, what is interesting is that despite the chaos being wrought on US diplomacy and America’s diplomatic relationships – Latin America is forgotten, Europe chastised and Asia provoked – there is no sign yet that Eichengreen’s thesis is playing out. Perhaps it is too early to tell.

Perhaps it also has something to do with the fact that much of the rest of the world economy is stagnant – recent data point to the fact that Japan may be in recession and some large European economies are flirting with it. This, and the overeager activism of the Fed make dollar denominated assets attractive keeps the dollar bid. At the same time this draws capital out of emerging economies, a trend manifest in the weakness of emerging market currencies.

In the long run, there are maybe four factors to watch that could make inroads into the dollar’s dominance of finance.

The first two will only become evidence in the aftermath of the next recession, whenever that is. One is the ability of the euro-zone to prove that its financial system can stand up to another downturn (in many ways it is less indebted than the US and China) and grow its economy.

The other, is similarly the financial shape China finds itself in after a period of negative growth, and the kind of steps it takes to build out its financial markets (such as deepening of its bond market and developing its pension system). If it can do so in a way that encourages liquidity and transparency then the share of Chinese assets in international (and Chinese) portfolios will rise significantly, drawing capital out of the dollar.

There are two other wildcards. Should the US continue to disenchant its allies, neighbours and trading partners then the Eichengreen hypothesis will play out, with the Middle East, India and parts of Latin America prone to diversify their currency reserves.  

Then finally, the prospect that central banks may someday introduce digital currencies. This may shake up financial flows, central bank reserves and economic structures, and in turn, might shake the dollar. But, not yet.

Have a great week ahead,

Mike

Gone fishing – Jackson hole in 2039

Trout, an important fish in the history of central banking

Two years ago I wrote an oped for the Financial Times (https://www.ft.com/content/9089eaf8-83fe-11e7-a4ce-15b2513cb3ff ) the byline of which ran ‘Jackson Hole offers a chance for central banks to hand over baton – It is time for central banks to let governments take on more of the burden of economic policy’. That I could reprint the same article today says much less about my foresight and much more about the stopped clock of international economics and finance.

Central banks should long ago have stepped back from generously providing stimulus to economies and markets, particularly as the economic impact of quantitative easing (QE) is diminishing, if not negative in terms of the effect of negative interest rates in banking systems.

Moreover, clever fiscal policy should be been deployed some time ago, especially in Europe where growth is stubbornly low. More broadly, the reality is that many governments do not have the fiscal capacity to stimulate their economies and more importantly to cushion the effects of a coming recession. President Trump’s economy is a case is point, with a historically high budget deficit (5%) and near record level of debt (to GDP).

Many of these issues will have been discussed at the Kansas Federal Reserve ‘offsite’ at Jackson Hole, Wyoming. The event has become one of the more important platforms for central bankers, due in little part to its proximity to decent fishing. Legend has it that up to the early 1980’s the Kansas Fed struggled to attract participants to its annual conference but came up with the idea of hosting it in Jackson Hole, because the prospect of excellent trout fishing might lure then Fed Chairman Paul Volcker (a keen fisherman) to the conference. The strategy worked and Jackson Hole gathering is now internationally famous and attracts many professional central bankers, whose pronouncements are closely followed by markets. Never before has trout played such an important role in central banking.

The title of this year’s symposium was ‘Challenges for Monetary Policy’. Whether on purpose or not, this title echoes with the Jackson Hole symposium of twenty years earlier. In 1999, the likes of Mervyn King, Alan Greenspan and late economists and central bankers like Wim Duisenberg, Rudiger Dornbusch and Martin Feldstein gathered to discuss ‘New Challenges for Central Banking’.

Their debates, which occurred in the wake of the Emerging Market and LTCM crises, just tell us much about the persistence of financial market phenomena such as asset price bubbles and the ways in which the central banking community has a tendency to fight ‘yesterday’s monetary wars’ rather than those of the future. A couple of things struck me.

One was the focus on price stability – in particular comments from Wim Duisenberg, then the first head of the European Central Bank, whose comments reflected the orthodoxy of central banks like the Bundesbank that price stability was the holy grail of central banking, something that itself had roots in prior decades of inflation.

Inflation, in consumer prices at least, is now well and truly dead, killed off not so much by central bankers but by the residual effects of the global and eurozone financial crises on household balance sheets. In this light and with the euro-zone in mind, it is interesting that (apart from Feldstein) there was very little mention in 1999 of the frailties of the euro-zone system.

The second interesting factor in the 1999 meeting was a discussion on asset prices and monetary policy. There was a firm consensus then that central banks should not tackle asset price bubbles head on. The rest as the say is history – the 2001 dot.com bubble and then the housing and derivative bubbles of 2007 that led to the financial crisis. Today, there is not enough discussion amongst central bankers about the effect of monetary policy on wealth inequality or on the bubble in fixed income markets. If and when the trillions of bonds in and around negative yield territory sell-off, this will produce a crisis in central banking.

Indeed, if we move forward twenty years and think of what the 2039 Jackson Hole symposium will discuss, I can hazard at least three topics. The first will be an evaluation of central banking credibility following the ‘Great QE Bubble of 2021’. The second might be ‘Does Facial Recognition Improve the Efficiency of Central Bank Digital Currencies’ and a third might be ‘The Effects on the Emirate Economies of Euro-zone Membership’. Much to think about for the future.

Have a great week ahead,

Mike

Who is the stubborn child?

Who is the stubborn child ? President Trump continues to harrangue the Fed, with his latest line being that the Fed is behaving like a ‘stubborn child’. I take a different view, in an oped for DowJones/Marketwatch I argue that over accommodative monetary policy stores up financial risks for the future and gives politicians the cover to engage in bad policy.. https://lnkd.in/eYmWJ7g

As the dust settles on last week’s market-moving, dovish communications from the Federal Reserve and the European Central Bank, commentators continue to debate the Fed’s independence and the ECB’s wisdom.

Yet, beyond the shorter-term noise of markets and the sting of tweets from President Trump, there is a much deeper issue — that the comfort blanket the Fed and other central banks extend to stock and bond markets is enabling reckless politicians to do and say reckless things.

While the majority of central bankers have engaged in quantitative easing and super-low interest rates out of necessity rather than choice, this is a policy experiment that has arguably reached the limits of its usefulness. Politicians are beginning to take advantage.

In particular, quantitative easing is very much like a doctor administering morphine — it will dull pain but won’t cure that patient. Quantitative easing dulled the pain of the aftermath of the global financial crisis, but it has done little to fix the eurozone, and has done much to extend wealth inequality and encourage indebtedness, not just in the U.S., but in Europe, Japan and by extension in some emerging markets.

The Leviathan-like bargain central banks appear to have struck is to buy financial and economic stability in exchange for an inordinate level of influence over world affairs. The costs of this bargain are growing, in the dulling of market sensitivities to economic and financial imbalances, to wealth inequality and to the numbing of the urgency for politicians to address a litany of critical issues.

A much more profound concern relates to the intersection of central banks and politics, against the backdrop of what political scientist Larry Diamond has called a “political recession.” The widespread political volatility, agitation and generalized voter dissatisfaction we witness today are manifestations of lower expectations of income growth caused by the threat of structurally lower growth, and arguably the poorly distributed gains of globalization.

Very few politicians have responded to these threats in a thoughtful way, perhaps because the outsize presence of central banks and their willingness to calm markets removes a vital source of pressure on those politicians. For example, populist parties in Italy would show much less bravado if the European Central Bank hadn’t been buying billions of euros of its debt over the last seven years.

Equally, the White House might be much more careful and strategic in how it dealt with China if there was a sense that the Fed would not automatically respond to the collateral damage created by the trade dispute.

There are growing signs that because central banks are the only game in town, policy makers are less coherent in their thinking. For instance, in the not-so-recent past it might have been expected that a large cohort of Republicans and Democrats would resolutely oppose both a burgeoning fiscal deficit that is expected to total $897 billion this fiscal year, according to the Congressional Budget Office, has and a near-record-level of U.S. debt to GDP. The fashion for MMT (Modern Monetary Theory, or the idea that government debt should be monetized) is another indication of how giddy the policy community become when they contemplate the full range of the monetary toolkit.

The longer the major central banks worry about the economic consequences of poor policy the longer populistic policy will continue. That inflation is dead in many countries, and 20% of the world’s bonds have zero to negative yields should alert central bankers to the growing faultiness in the world economy and the futility of using monetary policy to fix these. For investors, it is hard to escape the sense that asset prices are over inflated, and that we are at peak wealth and that the long-run returns   will be lower than we have seen in the last 10 years.

Central bankers must push the risks and responsibility associated with inequality, indebtedness, a half-baked eurosystem and low productivity back to elected politicians. If they don’t, then akin to the rising risk of global climate damage, the long-term negative consequences of these faultlines will grow.

Long-run financial stability is badly served by overgenerous central banking. The world’s major central banks should agree to use extraordinary measures like quantitative easing only under preset conditions (great market and economic stresses).

In reality, today’s central bankers risk caring more about data dips, market volatility and bad trade policy than the threat of burgeoning financial imbalances and the eventual damage these imbalances will do to the economy.

From the Banquet at Hongmen to Hong Kong

…as I was saying…regular readers of the Sunday letter will know that I have taken a break from it in recent weeks to recast the note around my forthcoming book ‘The Levelling’, and I hope that some will be happy it is back.

For those of you who are new to my list (please let me know if I should not have you on the list, or if you have colleagues or friends who would like to join it) I will send out a letter each Sunday morning (the one time people have a chance to read something) that mixes history, politics, markets, geopolitics and economics.

Given the intersection of these factors a good place to start this week is the Banquet at Hongmen, which occurred in China in 206 BC. In an age that is in Game of Thrones overdrive the story of Hongmen will appeal to many (indeed there is already a film about it called White Vengeance (2012)). In China, the tale is short-hand for duplicity and assassination and it featured in the Chinese press last week as part of the more popular response to President Trump’s tariff increase on China.

As an anchor point, ‘Hongmen’ serves a number of purposes that of course effortlessly dovetail into the themes of The Levelling. The first is that internal politics matter – Hongmen occurred at a time when the Qin and Han dynasties were contesting power. In this regard, for all that we hear today about the 2020 Presidential election campaign, we hear equally little about political debate within the Communist Party on topics like trade and relations with the USA.

Second, the cycles of the rise and fall of nations matter a lot. China has had many such cycles and America has effectively to complete a full cycle. Some may feel that this comes across in the bravoura of America’s interaction with other countries, but we should also bear in mind the context and patience that China’s history affords its leadership.

A third related point here is that China’s long history has given it a deep culture and sense of civilization. This is lost on some. Kiron Skinner a State Department official has recently tried to cast US-China relations as a ‘Clash of Civilisations’.  This is a lazy use of Samuel Huntington’s work. A better parsing of the situation is multipolarity, where the world moves away from globalization towards a system driven by three large regions (US, EU and China) who do things in distinctly different ways.

In this context, the trade dispute is a marker of China’s rise and the belated realization of America’s elite as to how it should curb this. Tariffs are not at all the apt tool. There are better avenues. For example, America is extremely powerful financially, in terms of the usage of the dollar, depth and centrality of its markets and the power of its banks. Indeed, one could argue that the US is more hegemonic in finance than it is militarily.

Another avenue is leadership in international rules and standards. Many new fields such as artificial intelligence, genetic editing and cyber war have grown so quickly that they have bypassed international laws, philosophies and norms regarding them. One challenge for the US is to take the lead in outlining new standards and laws in these areas. Unfortunately this is something it does not appear prepared to do, especially in areas like climate change. If anything the US is ceding soft power to China.

To jump to finance, the market view of the trade dispute is that some form of resolution will be forthcoming. The drop in volatility on Friday suggested that US markets are moving from being positioned for a risky outcome, to one that is more sanguine. Other Asia centric ones like the KOSPI index South Korea and the Australian dollar will need to strengthen in order to give the all clear.

If a trade deal is struck, it will mark the beginning of a formal rivalry between the US and China, the start of more ‘nation first’ patterns in consumption and corporate investment and the end of bodies like the World Trade Organisation. There may be many more flash points.

Here, many tend to focus on great naval battles of the future in the South China Sea. In my view, one looming touchpoint is Hong Kong, where there is a fierce debate ongoing around a proposal to permit the imprisonment in China of those sentenced by courts in Hong Kong. For a city-state with a very expensive housing market, dollar currency peg and large stock market, this may be one area where geopolitics again ripples through markets.  

Have a great week ahead,

Mike