Recession Rehearsal

Powell troubled by low rates

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.

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.

Paul Volcker

Voclker, the anti-populist

This important week has been marked by the passing of Paul Volcker. Many commentators have already paid tribute to a remarkable man. Martin Wolf in the Financial Times referred to him as the ‘greatest man I have known’.

I have never met Volcker (though am privileged to share an excellent editor with him in John Mahaney at PublicAffairs who has edited ‘Keeping at it’) but I wanted to write about him because his legacy touches on the themes in ‘The Levelling’, and more importantly on the state of the world today.

In that context, Volcker stands for many of the things that are missing in our international political economy – a willingness to take unpopular though telling policy actions, the independence of central banks from markets and politicians, and the integrity of those in public life.

His accomplishments as a central banker, his role in helping survivors of the Holocaust recover their savings from the Swiss banks and his views on banking (i.e. the Volcker Rule) underline these qualities.

When he was appointed as Chair of the Federal Reserve, the central bank was nothing as powerful as it is today. Arthur Burns, the Chair from 1970 to 1978, was widely seen as being close to President Nixon, and had later been undermined by the Nixon White House. William Miller who followed Burns, had a short and inglorious career as a central banker (March 1978 to August 1979) and was promoted ‘out of the way’ to become Treasury Secretary. His legacy, a sharply weaker dollar and inflation barreling towards 15%, is beyond the imagination of many people today. Bluntly, high inflation became the policy problem of the day.

Volcker took the reins at the Fed with a clear view as to what needed to be done (‘This is going to be tough, but we are going to stick with it and the inflation rate is going to come down’). To the credit of President Carter who appointed Volcker, Carter also understood the consequences of what Volcker would do. During Volcker’s ‘job interview’ with Carter, Volcker thrice stressed the magnitude of the policy task at hand, to which Carter acquiesced.

By the mid 1980’s Volcker’s medicine was taking effect. Inflation was falling, but the personal costs of his role were also growing. Homebuilders regularly sent him blocks of wood to remind him of the burden that high rates were having on the housing market, and threats to his safety meant that Volcker needed a bodyguard.

Political resistance was also growing. In his book, Volcker mentions a meeting with President Reagan and his chief of staff, James Baker, where Baker reportedly insisted that Volcker not raise interest rates at a forthcoming Fed rate setting committee. Volcker’s response was to get up and leave the meeting.

Thus he cemented the independence of the Fed (Reagan later appointed several White House ‘friendly’ board members to the Fed to stymie Volcker), drove down inflation and in doing so triggered perhaps the most important macro trend of the past thirty years in the shape of the permanent, lower resetting of interest rates and inflation.

This enabled the economic boom in Reagan’s America and provided the structural basis for globalization. Globalization could not have happened and survived if the US economy, and by extension the rest of the world, had had to endure bouts of high inflation and sharp rises in interest rates. Many people today will know little about Volcker, but in a fundamental way, his actions have impacted their lives.

In the sense of the way in which we read our world today, Volcker could be described as an ‘anti-populist’. He was a humble technocrat, or expert, who confronted very tough decisions, with unpopular side-effects. There are at least two reasons as to why he should be studied.

The first is that the world is beset by the accumulation of near existential risks – indebtedness is the highest it has been since the second world war and the Napoleonic Wars before that and, the climate is warming at a rate never seen in the past two hundred years and many cities suffer paralyzing pollution. These and other risks badly need a Volcker type character to resolve them, or else they will be patched up in a crisis. Policy makers need courage, rather than new frameworks.

This is doubly true in a world where the ECB and the Fed are experimenting with new ways of encroaching into the political economy and by extension, of distorting markets. Quantitative easing and negative interest rates have not created organic economic growth. Instead they drive asset bubbles, build wealth inequality and give reckless politicians the cover to engage in poor policy (i.e. Trump’s trade war). Developed world monetary policy risks fatally compromising itself. Volcker would not approve, neither should we.

From Bitcoin to no coin

Falling down

Things are stirring in the cryptocurrency world. There is a burgeoning debate about central bank issued digital currencies, and in the past month bitcoin has fallen by over twenty percent.

In its short life as a trading asset, bitcoin has appeared to move in sync with equities, so this recent move may spark some concern. A more intriguing, related question is whether bitcoin is an indicator of risk appetite or a beneficiary of risk aversion. Indeed, within the less ‘independent’ crypto currency community there is a view abroad that bitcoin and crypto currencies are a ‘safe haven’ in the same way people might for instance, regard gold.

My own sense is that crypto currencies in general and bitcoin specifically are not safe havens. They have failed the purpose they were intended to fulfill in that they are not actively used as a means of exchange. Few retailers accept them, fewer consumers actively use them and transaction costs are still very high.

The technology associated with cryptocurrencies is also complex enough to dissuade most households from using them. For many people the process of setting up a crypto wallet, and mentally translating crypto prices into everyday currencies is too demanding to bother with. This ‘ease of use’ is a cognitive barrier to entry and something that will take time for many to overcome, even Millennials.

In addition, the infrastructure around cryptocurrencies is fragile in at least two respects. Parts of that system, such as exchanges are prone to hacking and ransoming, and can also be shut down at the whim of governments.

From the point of view of cryptocurrencies as assets, very basic data analysis suggests that optically bitcoin has a low correlation with safe havens like gold. This does not mean that bitcoin is a good diversifier or a safe haven. It has been highly volatile over the past two years and is subject to trading and liquidity risks not normally associated with safe havens.

A further clue as to the true nature of cryptocurrencies as investable assets comes from the community of people who hold and trade them. The micro-structure (or plumbing) of markets, as well as the anthropology and sociology of those who populate them (which will have to be the subject of a future missive) is crucial to the way they behave and subsequently to their risk characteristics.

In this light the fact that the biggest holder of bitcoins is apparently the FBI says a lot. A good deal of trading in cryptocurrencies takes place in Asia, other emerging markets like Russia and in hubs like Zug.

Though admittedly not scientific, nor thorough, I suspect that many bitcoin traders also trade equity futures and currencies and use the same equity trading rules (technical) to buy and sell bitcoin (cryptos now have their own rating system, FCAS). If this generalization holds, it suggests that risk budgeting may drive a positive correlation between cryptocurrencies and equities, especially at market highs and lows.

Another observation is that for its size (the top ten cryptocurrencies barely add up to the market cap of Citigroup) the crypto market attracts an inordinately large amount of attention, which may draw money in at high points. To my mind this points to bitcoin having a pro-cyclical bias in terms of its riskiness as a trading asset.

On a structural basis the fall in bitcoin may also signal trouble in the cryptocurrency world, which effectively exists to create means of exchange beyond the normal frameworks of governments and central banks. Note that bitcoin rallied to its year high in the immediate aftermath of Facebook’s announcement of the Libra project in mid June.

The current disarray surrounding Facebook’s Libra project is a sign of the operating and regulatory complexities facing cryptocurrencies. More powerful still is the incentive that central banks and fiscal authorities around the world have for the bitcoin not to succeed. Witness as an example the vigour with which the Chinese – who tightly control money flows – have clamped down on cryptocurrency exchanges.

The next steps in the crypto or digital currency (they are almost the same in that crypto currencies are digital currencies that use cryptography) industry for central banks to issue their own coins, and for the digital payments industry. More thorough regulation, cleaner cross-border payment processes and more reliable identification mechanisms will be part of the workload of central banks and governments.

It all suggests that instead of being a safe haven, bitcoin may become extinct.

Have a great week ahead

Mike