Lords of Finance or Sorcerer’s Apprentices

The Fed meets the Bank of England

In 1927, in the context of economic weakness, Benjamin Strong the President of the New York Federal Reserve suggested to a counterpart in the Banque de France that a rate cut might give the stock market a ‘petit coup du whisky’. The subsequent rate cut set in train a fierce market rally which, boosted by margin debt, ballooned into a stock market bubble. 

According to Liaquat Ahamed’s superb book ‘Lords of Finance’ Federal Reserve officials had considered the ‘coup de whisky’ to be the Fed’s ‘greatest and boldest operation’. Yet, the collapse of this stock market bubble was one of the factors that set in motion the Great Depression.

By comparison to the actions of today’s Fed, Strong’s ‘coup de whisky’ is insignificant when compared to the huge and sustained quantities of monetary morphine that the central bank has dispensed in recent years. The near vertical rise in central bank balance sheets in the aftermath of the coronavirus crisis has suppressed market volatility, but, like morphine, it cures few underlying economic illnesses. In fact, with the echo of the Great Depression in mind, it may eventually make them worse.

With the Nasdaq index pushing through all-time highs at the start of last week (and now retreating a little), valuations becoming very stretched and an increasingly well documented retail investor trading frenzy occurring, we are entitled to ask where and when the consequences of aggressive central bank activity will lead?

While the official line at the Federal Reserve and other central banks regarding asset price bubbles is that asset bubbles are hard to identify and harder still to burst in a controlled manner, there are at least two risky side-effects of current policy, and then two potential endgames.

The first risk relates to the consequences of the ‘stupefaction’ of the political economy through monetary policy. For instance, politicians, such as the once fiscally conservative Republican party, seem to care less about rising debt and deficit levels in the face of central bank asset purchases.

In Europe, capital markets union, the consolidation and rebuilding of the banking sector, and more active and sophisticated regulation of fintech and payment systems are half made projects that lack urgency. In general, central bankers seem to focus too much on liquidity, than on the plumbing of market and banking systems.

Another side effect is inequality, in multiple forms. Wealth inequality in the US is the most pronounced since before the Great Depression. Another form is central bank inequality. The monetary aggression of the Fed and ECB makes life difficult for other smaller and less activist central banks, through the resulting fluctuations in their currencies for example. In particular in recent years, the likes of the Norges Bank and Riksbank have struggled with the side-effects of ECB policy.

Central bankers are known to be sensible, rational people and in the face of mounting evidence of the distortions of their work and the hint that they are losing their independence, we might expect them to signal an elegantly coordinated end to extraordinary policy. The opposite is likely to be the case.

The great risk to financial stability is that central bankers continue to internalize the benefits of quantitative easing, to the extent that they go into monetary warp factor and break markets. The Bank of Japan, which now owns nearly 80% of the Japanese ETF market, is a candidate here, given the store it sets by monetary activism and discussions it has conducted on monetizing government debt.

Monetizing government debt is not a free lunch, and if for argument’s sake it were executed by the Bank of Japan it could trigger broad currency volatility, a pensions crisis and a very confused credit market. Risk cannot be made to go away, it is simply distributed by markets and central banks that intervene in this process risk a ‘nuclear’ level financial accident.

The second related risk is indebtedness which before the financial crisis was – in terms of the aggregate world debt to GDP ratio – approaching levels not seen since after the Second World War, and now may be on course to reach levels comparable to the aftermath of the Napoleonic Wars. Low rates make this debt load manageable but a credit cycle downturn may result in a market unwind that even the Fed and other central banks cannot forestall. The endgame here may be a severe recession, or an broad debt restructuring conference.

Whether they are ‘Lords of Finance’ or ‘Sorcerer’s Apprentices’ today’s central bankers have contorted the financial world in an effort to stave off another Great Depression, and now having done too much, risk going full circle.

Have a great week ahead,

Mike

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

Charlie Chaplin and the Japanese bond market

The future all over again – satire and dictatorship

On May 15 1932 there was an attempted coup d’etat in Japan, led by a militant, nationalistic faction in the Imperial Army. The principal victim was the Japanese Prime Minister, Inukai Tsuyoshi. The perpetrators of the coup were given relatively light prison sentences, a pointer to the less democratic and belligerent Japan that would soon follow.

The bizarre element of the coup, which fortunately did not succeed was a plan to murder the actor Charlie Chaplin. The thinking was that such a deed would incite popular fury in the US, and thus lead to war, in which Japan would prevail. At the time of the coup Chaplin was watching a sumo wrestling match with the Prime Minister’s son, and thereby escaped the assassins.

This was more than lucky and in many ways Chaplin’s film The Great Dictator is a fine riposte to the destructive nationalism and totalitarianism that took hold across the world from the mid 1930’s. It is a film that still resonates today.

The view that this incident presents of Japan is also interesting. At the time, economically at least Japan was still an emerging market. Indeed the poor performance of the Japanese stock market around the second world war period is responsible for the historic muted performance of emerging markets relative to developed over the past seventy years.

While our view of Japan today is of a placid country, its history in the past two centuries is a reminder of the pitfalls of isolationism, nationalism and war – concerns that are now echoing louder across the international political economy debate. It should be said at the same time that that the post second world war relationship between the US and Japan is a good example of how two feuding countries can come together (Al Alletzhauser’s ‘House of Nomura’ is good on this topic).

That relationship is pivotal today for a number of reasons. First, a series of military equipment purchases by Japan, mostly notably of over 100 F-35 stealth fighters, manifestly aligns it as America’s fulcrum in Asia and unambiguously points to a change in its defence doctrine.

Second, as the world’s third largest economy, and a cyclical one at that, Japan is a large cog in the trade dispute between the US and China. There was a time when America feared the rise of Japan as it now does China, and any fans of economic history may know that during the 1980’s and 1990’s Donald Trump was an eminent Japan-trade basher. For those of you who want a market scare, the April 13 1987 cover of Time magazine carried an image of Uncle Sam pitted against a sumo wrestler under the banner ‘Trade Wars – the US gets tough with Japan’. The stock market crashed five months later. Does history teach us anything?

Japan may profit strategically from the curbing of China by America, though economically it will suffer from the diminution in world trade and through the side-effects of a stronger yen. In that respect, this weekend’s G20 finance minister’s meeting, lead by Taro Aso, is important as it offers an opportunity to begin to mend relations between the US and China. If this does not happen, then Japan’s bond market offers up a vision of what a trade damaged financial landscape may look like.

Last week, Japanese two year bond yields dipped towards minus 20 basis points, very close to the lows of the last decade. That German and many other euro-zone bond yields are at similarly low levels (indeed globally 11 USD trillion worth of bonds trades with negative yields) will encourage many commentators to suggest that Europe is the next Japan. In this respect if bond yields are a forecast of future growth, this is not an optimistic view.

Here, one of the central tenets of The Levelling is that there is too much debt in the global financial system, and that too little is being done about it. Quantitative easing makes this worse by diminishing the urgency which with indebtedness should be tackled and creating the circumstances where economic actors feel that they can take on even more debt. In many cases, Japan being one, debt clogs and distorts the economic system, and until it is paid back or restructured, economic growth in indebted countries (most of the world) will remain sluggish. Its all enough to make me think of Charlie Chaplin’s depression era film Modern Times.

Have a great week ahead,

Mike