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,


Tall Tales

What’s the story?

When Robert Shiller won the Nobel Prize for Economics in 2013  (shared with Lars Peter Hansen and the great Eugene Fama), I recall being particularly pleased for him. He is, rightly I suspect, a skeptic of the antics of financial markets, having twice called the top in market bubbles (dot.com and housing crisis). He coined the phrase “irrational exuberance,” which was used to powerful effect by Alan Greenspan.

Then, famously during the dot.com crisis, he was derided by many in the financial community and on CNBC for his pronouncements that markets would collapse. He handled himself with grace and had the last laugh. In addition, he is an economist with a practical interest in markets and asset prices, and many of his housing and stock market metrics are now widely used.

Well before academics shared data publicly, Shiller made his long-term market valuation series available on the internet. This open source approach is perhaps one of the reasons why his long-term data is now widely referred to. The key metric here is what is called the Shiller P/E (price to earnings ratio) or, as he himself puts it, the CAPE, the cyclically adjusted price to earnings ratio. What this essentially does is normalize earnings across the economic cycle.

The CAPE is now at a level only previously reached in 1929 and 1999/2000. We know what happened next in both of those cases. This doesn’t seem to worry investors, largely because the market narrative is built around the notion that ‘a trade deal will be done any day now’ and that the Federal Reserve will continue to dose markets with liquidity.

Interestingly, the idea of the macro ‘narrative’ is the focus of Shiller’s most recent work (he has a book out entitled ‘Narrative Economics’ as well as several papers on the topic). Essentially, he investigates the ways in which we (households, investors, economists) tell stories about the behavior of economic events and market trends. I would argue that ‘The Levelling’ is a narrative on what is happening to the old world order and on how it would evolve.

Shiller’s ‘narrative’ based strand of research is not new. Pop economists have for a long time made sense of the world by coining understandable terms like ‘white van man’, and for an even longer time, stockbrokers have told stories around stocks and markets, and their clients have readily swallowed these stories.

I tend to classify the spectrum of the finance industry as having two ends – storytelling and quant. Story tellers are not good quants, and quants are not good storytellers. What is interesting now is that quant, be it through the provision of new and better datasets, is providing the narrative ammunition for storytellers to tell more elaborate, and possibly convincing, macroeconomic stories.

Storytelling is also a neat way of bunching together the various trends in markets. For instance, there is a notable divergence between what we might call drugged assets (assets that are under the spell of central bank liquidity) such as the Dax, quality corporate bonds, euro-zone debt and the S&P 500 index, and those like emerging market currencies, some commodities and crypto currencies (see last week’s missive) that do not have the outright benefit of central bank asset purchases, and that as a result tell a cleaner picture about the relatively weak global economy.

As we head into December expect many to continue the narrative that central bank liquidity will suppress volatility, and I suspect that in general this narrative will continue to hold into 2020.

One narrative that may pick up pace, is the idea I explored a few weeks ago of ‘Demonstration Contagion’ (link). Under this narrative, the panoply of protests around the world are both distinct and have common perceived causes such as inequality and climate damage. In particular, events in Hong Kong cut across many of these issues, and there is a great deal at stake economically and politically.

The new developments are that President Trump’s (by the way Shiller describes him as a ‘master of narratives’…Shiller is a master of irony) signing of the Hong Kong Human Rights and Democracy Act and the overwhelmingly pro-democracy tenor of last week’s council elections in Hong Kong, provide two threads to tie events in Hong Kong to the trade dispute between the US and China, and to January’s Presidential elections in Taiwan.

As such, protestors in Hong Kong have every incentive to continue to protest, and the Chinese authorities cannot but feel more uncomfortable. As crowds in Hong Kong this weekend hold aloft the image recently tweeted by Donald Trump of his head superimposed on the body of ‘Rocky’, the Demonstration Contagion narrative is only just warming up.

Have a great week ahead,


Open economics and hard decisions

Ada Smith would know what to do

Two related stories from the engine room of economics struck me this week. One was the underlining by members of the European Parliament of the lack of female representation on the ECB Governing Council and the other was the news that the Federal Reserve is broadening its hiring process to recruit more women and people with more ethnically diverse backgrounds, though disappointingly this initiative seems only to be focused only on research assistant roles.

Both stories tell us much about gender, diversity and decision making and the direction of the economics profession.

On gender, all of the research I have been involved in this area underlines a couple of themes, that good data on gender representation is still hard to get (my friend Richard Kersley’s ‘Gender 3000’ database is one of the leading datasets), and that better (gender) balanced teams and boards make better decisions (or is it that men only ones make more bad decisions?).

In that way it makes great sense for organizations and institutions to recruit women to professional roles, but these institutions also need to facilitate the upward progress of women. I have known many female colleagues who have suffered the tyranny of ‘flexi-time’ – working a four day week, suffering career ‘stigma’ for doing so, and ultimately having to work 20% harder.

As it concerns central banking specifically, there is a much broader question of diversity of thought. By the time a man or women, from any given nationality has made it through an economics PhD programme of a major US university (Handelsblatt carried a news item last week which showed that only 4 of the top 30 German speaking economists are employed in German universities), published in leading economics journals, gained a faculty place or worked in the Fed/IMF/World Bank system, they have become creatures of the system, increasingly losing the incentive and ability to question the status quo.

Very few have the courage to challenge orthodoxy. A good example was the address that Rajan Raghuram gave to the Jackson Hole Symposium in 2005 (‘Has financial development made the world riskier?’) where (as later outlined in his book ‘Faultlines’) he warned of the dangers posed by the mountain of derivatives that had been built upon the US housing market. The response to his speech was frosty to say the least, and for a time many leading economists castigated him (Larry Summers called him a Luddite).  

The tendency of major academic economics departments to ‘form’ economists is dangerous because the creation of group think in central banking has produced a habitual, backward looking approach to monetary policy that usually ends up producing asset price bubbles and economic imbalances (e.g. negative yields, broken banks).

One response to this is to call for ‘new economics’. A recent example is entrepreneur Nick Hanauer’s impassioned TED Talk on the need to change capitalism. While I have sympathy for this view, I do not think that we need new economic theories but rather a better mix of formal economic theory with other sciences, and generally a much greater focus on the science of decision making (the US military and many sports teams such as the leading teams in the Rugby World Cup are innovators here).

One avenue is to pursue much more of a ‘Santa Fe’ approach to economics (I am thinking of the Santa Fe Institute which fosters a cross disciplinary approach to policy and science problems). Within economics, economists and analysts may in the future be better served by taking more the approach of a sleuth than of an econometric modeler.

Specifically, they should employ a wider variety of skills, ferret out facts and use firsthand experience to better understand them, and be more wide-ranging in their choice of the factors they choose to study. For instance, anthropology and sociology can sometimes better help understand the behavior of bankers and markets than can finance theory. If the pendulum of the economics profession is swinging away from a modeling-based approach, better that it swings toward development economics, for instance, which very often requires a more granular appreciation of how policy formulation works in practice.

Development economics is also the field where can be studied the impact on economic growth of a relative change in the quality of institutions or in rule of law, simply by virtue of the fact that the potential incremental change in both variables is much larger in developing than developed countries. I

In more detail, the policies, actions, and actors that affect development in emerging nations are complex, both individually and in the ways they interact with each other. In the Trump/Brexit/ Macron age, politics and institutional quality are exerting a very significant role on markets and economies, and a multipronged, more bottom up approach may be required to open the black box of how policy decision making is undertaken, how it might be improved, and, as I discuss in The Levelling how politicians can make good use of it.

In that respect the ECB and Fed should focus on hiring more senior female experts, in areas like law, banking, psychology as well as those with experience working in large organisations. Christine Lagarde is both the exception and the role model here.

The last issue is decision making. Surely, with debt levels growing, human development levels receding and the climate warming, we need to better understand why policymakers are so prone to avoiding big decisions?

Have a great week ahead,


Beyond Brexit – a plan for Northern Ireland

Light ahead for Northern Ireland?

I am trying hard not to write about Brexit, partly because it is so unpredictable and partly because so much else has been written and said about it. There are however two economics related angles that are worth mentioning. The first relates to the challenge of reviving the British economy after Brexit, and I covered this in a Times oped earlier this week (Times.html). The other is the longer socio-economic future of Northern-Ireland.

One of the frustrating and revealing aspects of Brexit is the way it has shown a lack of real interest in the North from some British politicians. For instance, in the recent past Boris Johnson has compared the border between Ireland and Northern Ireland to the boundaries of London’s congestion charge zone.

This  level of ignorance is a pity because the reality is that Northern Ireland is one of the poorest economic regions of the UK, falls well behind the level and rate of growth of Ireland the Irish Republic and continues to suffer social, political and economic rigidities. Social divisions are being mended all too slowly, local politics at Stormont is inadequate and the economy remains embarrassingly overdependent on government spending.

Brexit has shone a light on many of these issues and has illuminated the lack of appreciation many in Westminster have for Northern Ireland in particular and Irish history in general. Arguably, a film (‘Titanic’) and tv series (‘Game of Thrones’) have done more for Northern Ireland’s fortunes than its local and London based leaders.

In particular Theresa May’s Brexit strategy was fatally snared by a shoddy understanding of the complexities presented by the border between Northern Ireland and the Republic. Indeed, there is a risk for Britain that Brexit is replaying the divisions and debilitating bitterness of the Ireland’s separation from Britain in the 1921 Anglo-Irish treaty.

Yet, while there have been very few if any winners in the Brexit process so far, it does represent a valuable opportunity for London, Washington, Dublin and Brussels to recognize that Northern Ireland needs a second wind in terms of its socioeconomic development. Irish America can add an important voice of support here. Northern Ireland should not be parked as a political issue but should be cultivated economically and socially.

A provocative but potentially fruitful suggestion is that a portion of Britain’s Brexit exit ‘settlement’ to the European Union be set aside as the basis or seed capital for a Marshall Plan–type fund for Northern Ireland. This could then become a joint UK-EU financed fund with further funding from the UK, the EU and its institutions like the European Investment Bank. The fund would not substitute for spending in Northern Ireland by London but would have the long-term aims of increasing socio-cultural harmony, human development and the economic potential of Northern Ireland’s economy.

Another interesting source of funding is the growing appetite in capital market for social impact investment opportunities. This potential supply of funding is not yet met with a large, coherent supply of impact investment projects, partly because this kind of investing is not yet well understood and partly because it is difficult to create large scale projects here. Northern Ireland could be a model for doing social impact investing in a meaningful way.

The really interesting part of the proposal is that neither London, Dublin, Brussels or even Washington would be involved in planning and running such a program. This would be done by a group of small, advanced economies – the likes of Sweden, Singapore and Switzerland.

This approach would have political and economic attractions. The first is that few if any of these small, advanced countries has political ‘baggage’ with respect to Northern Ireland and would be therefore less likely to fall foul of the distrust that bedevils politics in the North (for example, the advice of New Zealand technocrats might be easier to take, and more credible than policies crafted in London or Washington). 

Secondly, and more tellingly, small advanced countries are the source of the secret sauce of economic, social and human development. They tend to dominate the league tables of socio-economic success, from ‘most globalized’ to “most innovative nation” or most “prosperous nation.” Indeed, the small advanced country model is acknowledged in Northern Ireland’s ‘Economy 2030’ plan.

What small, advanced and open economies have in common are drivers like education, strong institutions, the rule of law, and the deployment of technology—their intangible infrastructure. Northern Ireland needs better ‘intangible infrastructure’, applied in an imaginative and constructive way.

A few examples of what a small state led fund might tangibly focus on include the kind of skill-based apprentice schemes found in Austria and Switzerland, rezoning of housing from deeply politically entrenched areas using the social-impact-investing model found in Belgium, investment in cultural projects that are common to all communities (such as is done in Scandinavia and Switzerland), and the establishment of poles of excellence in certain professions, such as legal financial services.

Such a fund might draw on the expertise and governance capabilities of small states. This might well add energy and transparency to policy decisions and the employment of detailed rolling five-year plans might help speed up what is at times a sclerotic policy process.

Given the frequent and urgent manner in which parties to the Brexit process annunciate the risks to Northern Ireland in general and the Peace Process in particular, it is time they do something to set it on a positive course. It is also high time that Brexit produces at least one good news story.