Global Depression or Persistent Stagflation?

Dr. Doom and Gloom lays out the downside global economic scenario. Worth reading and factoring into our economic posturing…[Comments bracketed in red].

Published in NY Magazine

Why Our Economy May Be Headed for a Decade of Depression

Eric Levitz May 22, 2020

The worst is yet to come?

In September 2006, Nouriel Roubini told the International Monetary Fund what it didn’t want to hear. Standing before an audience of economists at the organization’s headquarters, the New York University professor warned that the U.S. housing market would soon collapse — and, quite possibly, bring the global financial system down with it. Real-estate values had been propped up by unsustainably shady lending practices, Roubini explained. Once those prices came back to earth, millions of underwater homeowners would default on their mortgages, trillions of dollars worth of mortgage-backed securities would unravel, and hedge funds, investment banks, and lenders like Fannie Mae and Freddie Mac could sink into insolvency.

At the time, the global economy had just recorded its fastest half-decade of growth in 30 years. And Nouriel Roubini was just some obscure academic. Thus, in the IMF’s cozy confines, his remarks roused less alarm over America’s housing bubble than concern for the professor’s psychological well-being.

Of course, the ensuing two years turned Roubini’s prophecy into history, and the little-known scholar of emerging markets into a Wall Street celebrity.

A decade later, “Dr. Doom” is a bear once again. While many investors bet on a “V-shaped recovery,” Roubini is staking his reputation on an L-shaped depression. The economist (and host of a biweekly economic news broadcastdoes expect things to get better before they get worse: He foresees a slow, lackluster (i.e., “U-shaped”) economic rebound in the pandemic’s immediate aftermath. But he insists that this recovery will quickly collapse beneath the weight of the global economy’s accumulated debts. Specifically, Roubini argues that the massive private debts accrued during both the 2008 crash and COVID-19 crisis will durably depress consumption and weaken the short-lived recovery. Meanwhile, the aging of populations across the West will further undermine growth while increasing the fiscal burdens of states already saddled with hazardous debt loads. Although deficit spending is necessary in the present crisis, and will appear benign at the onset of recovery, it is laying the kindling for an inflationary conflagration by mid-decade. As the deepening geopolitical rift between the United States and China triggers a wave of deglobalization, negative supply shocks akin those of the 1970s are going to raise the cost of real resources, even as hyperexploited workers suffer perpetual wage and benefit declines. Prices will rise, but growth will peter out, since ordinary people will be forced to pare back their consumption more and more. Stagflation will beget depression. And through it all, humanity will be beset by unnatural disasters, from extreme weather events wrought by man-made climate change to pandemics induced by our disruption of natural ecosystems.

Roubini allows that, after a decade of misery, we may get around to developing a “more inclusive, cooperative, and stable international order.” But, he hastens to add, “any happy ending assumes that we find a way to survive” the hard times to come.

Intelligencer recently spoke with Roubini about our impending doom.

You predict that the coronavirus recession will be followed by a lackluster recovery and global depression. The financial markets ostensibly see a much brighter future. What are they missing and why?

Well, first of all, my prediction is not for 2020. It’s a prediction that these ten major forces will, by the middle of the coming decade, lead us into a “Greater Depression.” Markets, of course, have a shorter horizon. In the short run, I expect a U-shaped recovery while the markets seem to be pricing in a V-shape recovery.

Of course the markets are going higher because there’s a massive monetary stimulus, there’s a massive fiscal stimulus. People expect that the news about the contagion will improve, and that there’s going to be a vaccine at some point down the line. And there is an element “FOMO” [fear of missing out]; there are millions of new online accounts — unemployed people sitting at home doing day-trading — and they’re essentially playing the market based on pure sentiment. My view is that there’s going to be a meaningful correction once people realize this is going to be a U-shaped recovery. If you listen carefully to what Fed officials are saying — or even what JPMorgan and Goldman Sachs are saying — initially they were all in the V camp, but now they’re all saying, well, maybe it’s going to be more of a U. The consensus is moving in a different direction.

Your prediction of a weak recovery seems predicated on there being a persistent shortfall in consumer demand due to income lost during the pandemic. A bullish investor might counter that the Cares Act has left the bulk of laid-off workers with as much — if not more — income than they had been earning at their former jobs. Meanwhile, white-collar workers who’ve remained employed are typically earning as much as they used to, but spending far less. Together, this might augur a surge in post-pandemic spending that powers a V-shaped recovery. What does the bullish story get wrong?

Yes, there are unemployment benefits. And some unemployed people may be making more money than when they were working. But those unemployment benefits are going to run out in July. The consensus says the unemployment rate is headed to 25 percent. Maybe we get lucky. Maybe there’s an early recovery, and it only goes to 16 percent. Either way, tons of people are going to lose unemployment benefits in July. And if they’re rehired, it’s not going to be like before — formal employment, full benefits. You want to come back to work at my restaurant? Tough luck. I can hire you only on an hourly basis with no benefits and a low wage. That’s what every business is going to be offering. Meanwhile, many, many people are going to be without jobs of any kind. It took us ten years — between 2009 and 2019 — to create 22 million jobs. And we’ve lost 30 million jobs in two months. [This begins to show why employment is the wrong focus for the Information Age.]

So when unemployment benefits expire, lots of people aren’t going to have any income. Those who do get jobs are going to work under more miserable conditions than before. And people, even middle-income people, given the shock that has just occurred — which could happen again in the summer, could happen again in the winter — you are going to want more precautionary savings. You are going to cut back on discretionary spending. Your credit score is going to be worse. Are you going to go buy a home? Are you gonna buy a car? Are you going to dine out? In Germany and China, they already reopened all the stores a month ago. You look at any survey, the restaurants are totally empty. Almost nobody’s buying anything. Everybody’s worried and cautious. And this is in Germany, where unemployment is up by only one percent. Forty percent of Americans have less than $400 in liquid cash saved for an emergency. [This is a major policy failure that citizens of other countries do not share. Our tax policies have discouraged savings but encouraged borrowing.] You think they are going to spend?

Graphic: Financial Times
Graphic: Financial Times

You’re going to start having food riots soon enough. [I don’t see that happening, at least not in the US. People on state welfare support are going to need more of it and the welfare roles will rise.] Look at the luxury stores in New York. They’ve either boarded them up or emptied their shelves,  because they’re worried people are going to steal the Chanel bags. [Yes, because luxury goods are a form of currency. Luxury stores are also a focus of resentment.] The few stores that are open, like my Whole Foods, have security guards both inside and outside. We are one step away from food riots. There are lines three miles long at food banks. [This not a riot, it’s an overload on govt provided welfare.] That’s what’s happening in America. You’re telling me everything’s going to become normal in three months? That’s lunacy.

Your projection of a “Greater Depression” is premised on deglobalization sparking negative supply shocks. And that prediction of deglobalization is itself rooted in the notion that the U.S. and China are locked in a so-called Thucydides trap, in which the geopolitical tensions between a dominant and rising power will overwhelm mutual financial self-interest. But given the deep interconnections between the American and Chinese economies — and warm relations between much of the U.S. and Chinese financial elite — isn’t it possible that class solidarity will take precedence over Great Power rivalry? In other words, don’t the most powerful people in both countries understand they have a lot to lose financially and economically from decoupling? And if so, why shouldn’t we see the uptick in jingoistic rhetoric on both sides as mere posturing for a domestic audience?

First of all, my argument for why inflation will eventually come back is not just based on U.S.-China relations. I actually have 14 separate arguments for why this will happen. That said, everybody agrees that there is the beginning of a Cold War between the U.S. and China. I was in Beijing in November of 2015, with a delegation that met with Xi Jinping in the Great Hall of the People. And he spent the first 15 minutes of his remarks speaking, unprompted, about why the U.S. and China will not get caught in a Thucydides trap, and why there will actually be a peaceful rise of China.

Since then, Trump got elected. Now, we have a full-scale trade war, technology war, financial war, monetary war, technology, information, data, investment, pretty much anything across the board. Look at tech — there is complete decoupling. They just decided Huawei isn’t going to have any access to U.S. semiconductors and technology. We’re imposing total restrictions on the transfer of technology from the U.S. to China and China to the U.S. And if the United States argues that 5G or Huawei is a backdoor to the Chinese government, the tech war will become a trade war. Because tomorrow, every piece of consumer electronics, even your lowly coffee machine or microwave or toaster, is going to have a 5G chip. That’s what the internet of things is about. If the Chinese can listen to you through your smartphone, they can listen to you through your toaster. Once we declare that 5G is going to allow China to listen to our communication, we will also have to ban all household electronics made in China. So, the decoupling is happening. We’re going to have a “splinternet.” It’s only a matter of how much and how fast.

And there is going to be a cold war between the U.S. and China. Even the foreign policy Establishment — Democrats and Republicans — that had been in favor of better relations with China has become skeptical in the last few years. They say, “You know, we thought that China was going to become more open if we let them into the WTO. We thought they’d become less authoritarian.” Instead, under Xi Jinping, China has become more state capitalist, more authoritarian, and instead of biding its time and hiding its strength, like Deng Xiaoping wanted it to do, it’s flexing its geopolitical muscle. And the U.S., rightly or wrongly, feels threatened. I’m not making a normative statement. I’m just saying, as a matter of fact, we are in a Thucydides trap. The only debate is about whether there will be a cold war or a hot one. Historically, these things have led to a hot war in 12 out of 16 episodes in 2,000 years of history. So we’ll be lucky if we just get a cold war.

Some Trumpian nationalists and labor-aligned progressives might see an upside in your prediction that America is going to bring manufacturing back “onshore.” But you insist that ordinary Americans will suffer from the downsides of reshoring (higher consumer prices) without enjoying the ostensible benefits (more job opportunities and higher wages). In your telling, onshoring won’t actually bring back jobs, only accelerate automation. And then, again with automation, you insist that Americans will suffer from the downside (unemployment, lower wages from competition with robots) but enjoy none of the upside from the productivity gains that robotization will ostensibly produce. So, what do you say to someone who looks at your forecast and decides that you are indeed “Dr. Doom” — not a realist, as you claim to be, but a pessimist, who ignores the bright side of every subject?

When you reshore, you are moving production from regions of the world like China, and other parts of Asia, that have low labor costs, to parts of the world like the U.S. and Europe that have higher labor costs. That is a fact. How is the corporate sector going respond to that? It’s going to respond by replacing labor with robots, automation, and AI.

I was recently in South Korea. I met the head of Hyundai, the third-largest automaker in the world. He told me that tomorrow, they could convert their factories to run with all robots and no workers. Why don’t they do it? Because they have unions that are powerful. In Korea, you cannot fire these workers, they have lifetime employment. [There is a serious cost to raising labor rates in a world with price competition. Raising input costs means pricing power rules and most producers lack that pricing power. If Hyundai cars become more expensive, then Hyundai loses sales and Hyundai requires state subsidies paid for by Korean taxpayers. If Hyundai reduces costs, Hyundai workers face dimmer income prospects and more state welfare. The only way out of this conundrum is to share the economic costs across all stakeholders. That’s best done through equity rights than through state directives. This is especially true in the US under the corporate legal structure.]

But suppose you take production from a labor-intensive factory in China — in any industry — and move it into a brand-new factory in the United States. You don’t have any legacy workers, any entrenched union. You are going to design that factory to use as few workers as you can. Any new factory in the U.S. is going to be capital-intensive and labor-saving. It’s been happening for the last ten years and it’s going to happen more when we reshore. So reshoring means increasing production in the United States but not increasing employment. Yes, there will be productivity increases. And the profits of those firms that relocate production may be slightly higher than they were in China (though that isn’t certain since automation requires a lot of expensive capital investment).

But you’re not going to get many jobs. The factory of the future is going to be one person manning 1,000 robots and a second person cleaning the floor. And eventually the guy cleaning the floor is going to be replaced by a Roomba because a Roomba doesn’t ask for benefits or bathroom breaks or get sick and can work 24-7. [I’ve written many times in the past, what matters is who owns and controls the robots.]

The fundamental problem today is that people think there is a correlation between what’s good for Wall Street and what’s good for Main Street. [Yes, but conceptually we can close this conflict of interest by turning more of Main St. into entrepreneurial risk takers through the sharing of diversified equity risks.] That wasn’t even true during the global financial crisis when we were saying, “We’ve got to bail out Wall Street because if we don’t, Main Street is going to collapse.” How did Wall Street react to the crisis? They fired workers. And when they rehired them, they were all gig workers, contractors, freelancers, and so on. That’s what happened last time. This time is going to be more of the same. Thirty-five to 40 million people have already been fired. When they start slowly rehiring some of them (not all of them), those workers are going to get part-time jobs, without benefits, without high wages. That’s the only way for the corporates to survive. Because they’re so highly leveraged today, they’re going to need to cut costs, and the first cost you cut is labor. But of course, your labor cost is my consumption. So in an equilibrium where everyone’s slashing labor costs, households are going to have less income. [Again, this is why using wage labor as the dominant distributional mechanism for the success of capitalism is no longer viable. It only was during the industrial age.] And they’re going to save more to protect themselves from another coronavirus crisis. And so consumption is going to be weak. That’s why you get the U-shaped recovery.

There’s a conflict between workers and capital. [Only in the short-run.] For a decade, workers have been screwed. Now, they’re going to be screwed more. There’s a conflict between small business and large business.

Millions of these small businesses are going to go bankrupt. Half of the restaurants in New York are never going to reopen. How can they survive? They have such tiny margins. Who’s going to survive? The big chains. Retailers. Fast food. The small businesses are going to disappear in the post-coronavirus economy. So there is a fundamental conflict between Wall Street (big banks and big firms) and Main Street (workers and small businesses). And Wall Street is going to win. [We all win by participating in the financing and risk sharing of capitalism. We all need to be invested in Wall St., and finance – both ownership and control – must be transparent. Someday we will have blockchain smart contracts distribute corporate profits to shareholders in a transparent manner under the shareholders’ control, reducing the agency costs and conflicts of interest.]

Clearly, you’re bearish on the potential of existing governments intervening in that conflict on Main Street’s behalf. But if we made you dictator of the United States tomorrow, what policies would you enact to strengthen labor, and avert (or at least mitigate) the Greater Depression? 

The market, as currently ordered, is going to make capital stronger and labor weaker. So, to change this, you need to invest in your workers. [Yes, but that does not mean wage or labor supply controls – intervention on the cost side of production will only backfire.] Give them education, a social safety net — so if they lose their jobs to an economic or technological shock, they get job training, unemployment benefits, social welfare, health care for free. [These policies all lead to productive investment in human capital, but it is not enough. Workers need financial capital that generates diversified streams of income.]  Otherwise, the trends of the market are going to imply more income and wealth inequality. [The Fed has been no help here.] There’s a lot we can do to rebalance it. But I don’t think it’s going to happen anytime soon. If Bernie Sanders had become president, maybe we could’ve had policies of that sort. [No, Bernie is completely focused on intervening into labor markets. Workers look like they’re gaining in the short-run and lose big time in the long-run.] Of course, Bernie Sanders is to the right of the CDU party in Germany. I mean, Angela Merkel is to the left of Bernie Sanders. Boris Johnson is to the left of Bernie Sanders, in terms of social democratic politics. Only by U.S. standards does Bernie Sanders look like a Bolshevik.

In Germany, the unemployment rate has gone up by one percent. In the U.S., the unemployment rate has gone from 4 percent to 20 percent (correctly measured) in two months. We lost 30 million jobs. Germany lost 200,000. Why is that the case? You have different economic institutions. Workers sit on the boards of German companies. So you share the costs of the shock between the workers, the firms, and the government. [Yes, this is how it should be, but in US society and business, equity is the cleanest way to achieve this representation. Stakeholders should have board representation through their equity ownership claims.]

In 2009, you argued that if deficit spending to combat high unemployment continued indefinitely, “it will fuel persistent, large budget deficits and lead to inflation.” You were right on the first count obviously. And yet, a decade of fiscal expansion not only failed to produce high inflation, but was insufficient to reach the Fed’s 2 percent inflation goal. Is it fair to say that you underestimated America’s fiscal capacity back then? And if you overestimated the harms of America’s large public debts in the past, what makes you confident you aren’t doing so in the present?

First of all, in 2009, I was in favor of a bigger stimulus than the one that we got. I was not in favor of fiscal consolidation. There’s a huge difference between the global financial crisis and the coronavirus crisis because the former was a crisis of aggregate demand, given the housing bust. And so monetary policy alone was insufficient and you needed fiscal stimulus. And the fiscal stimulus that Obama passed was smaller than justified. So stimulus was the right response, at least for a while. And then you do consolidation.

What I have argued this time around is that in the short run, this is both a supply shock and a demand shock. And, of course, in the short run, if you want to avoid a depression, you need to do monetary and fiscal stimulus. What I’m saying is that once you run a budget deficit of not 3, not 5, not 8, but 15 or 20 percent of GDP — and you’re going to fully monetize it (because that’s what the Fed has been doing) — you still won’t have inflation in the short run, not this year or next year, because you have slack in goods markets, slack in labor markets, slack in commodities markets, etc. But there will be inflation in the post-coronavirus world. [We will have asset price inflation in the immediate and longer-term – this greatly aggravates inequality.] This is because we’re going to see two big negative supply shocks. For the last decade, prices have been constrained by two positive supply shocks — globalization and technology. Well, globalization is going to become deglobalization thanks to decoupling, protectionism, fragmentation, and so on. So that’s going to be a negative supply shock. And technology is not going to be the same as before. The 5G of Erickson and Nokia costs 30 percent more than the one of Huawei, and is 20 percent less productive. So to install non-Chinese 5G networks, we’re going to pay 50 percent more. So technology is going to gradually become a negative supply shock. So you have two major forces that had been exerting downward pressure on prices moving in the opposite direction, and you have a massive monetization of fiscal deficits. Remember the 1970s? You had two negative supply shocks — ’73 and ’79, the Yom Kippur War and the Iranian Revolution. What did you get? Stagflation.

Now, I’m not talking about hyperinflation — not Zimbabwe or Argentina. I’m not even talking about 10 percent inflation. It’s enough for inflation to go from one to 4 percent. Then, ten-year Treasury bonds — which today have interest rates close to zero percent — will need to have an inflation premium. So, think about a ten-year Treasury, five years from now, going from one percent to 5 percent, while inflation goes from near zero to 4 percent. And ask yourself, what’s going to happen to the real economy? Well, in the fourth quarter of 2018, when the Federal Reserve tried to raise rates above 2 percent, the market couldn’t take it. So we don’t need hyperinflation to have a disaster. [So we seesaw between heeling one way or the other –  inflationary or deflationary pressures with volatile financial policy. Sounds like a great policy scenario.]

In other words, you’re saying that because of structural weaknesses in the economy, even modest inflation would be crisis-inducing because key economic actors are dependent on near-zero interest rates?

For the last decade, debt-to-GDP ratios in the U.S. and globally have been rising. And debts were rising for corporations and households as well. But we survived this, because, while debt ratios were high, debt-servicing ratios were low, since we had zero percent policy rates and long rates close to zero — or, in Europe and Japan, negative. But the second the Fed started to hike rates, there was panic.

In December 2018, Jay Powell said, “You know what. I’m at 2.5 percent. I’m going to go to 3.25. And I’m going to continue running down my balance sheet.” And the market totally crashed. And then, literally on January 2, 2019, Powell comes back and says, “Sorry, I was kidding. I’m not going to do quantitative tightening. I’m not going to raise rates.” So the economy couldn’t take a Fed funds rate of 2.5 percent. In the strongest economy in the world. There is so much debt, if long-term rates go from zero to 3 percent, the economy is going to crash.

You’ve written a lot about negative supply shocks from deglobalization. Another potential source of such shocks is climate change. Many scientists believe that rising temperatures threaten the supply of our most precious commodities — food and water. How does climate figure into your analysis?

I am not an expert on global climate change. But one of the ten forces that I believe will bring a Greater Depression is man-made disasters. And global climate change, which is producing more extreme weather phenomena — on one side, hurricanes, typhoons, and floods; on the other side, fires, desertification, and agricultural collapse — is not a natural disaster. The science says these extreme events are becoming more frequent, are coming farther inland, and are doing more damage. And they are doing this now, not 30 years from now. 

So there is climate change. And its economic costs are becoming quite extreme. In Indonesia, they’ve decided to move the capital out of Jakarta to somewhere inland because they know that their capital is going to be fully flooded. In New York, there are plans to build a wall all around Manhattan at the cost of $120 billion. And then they said, “Oh no, that wall is going to be so ugly, it’s going to feel like we’re in a prison.” So they want to do something near the Verrazzano Bridge that’s going to cost another $120 billion. And it’s not even going to work.

The Paris Accord said 1.5 degrees. Then they say two. Now, every scientist says, “Look, this is a voluntary agreement, we’ll be lucky if we get three — and more likely, it will be four — degree Celsius increases by the end of the century.” How are we going to live in a world where temperatures are four degrees higher? And we’re not doing anything about it. The Paris Accord is just a joke. And it’s not just the U.S. and Trump. China’s not doing anything. The Europeans aren’t doing anything. It’s only talk.

And then there’s the pandemics. These are also man-made disasters. You’re destroying the ecosystems of animals. You are putting them into cages — the bats and pangolins and all the other wildlife — and they interact and create viruses and then spread to humans. First, we had HIV. Then we had SARS. Then MERS, then swine flu, then Zika, then Ebola, now this one. And there’s a connection between global climate change and pandemics. Suppose the permafrost in Siberia melts. There are probably viruses that have been in there since the Stone Age. We don’t know what kind of nasty stuff is going to get out. We don’t even know what’s coming. [Climate change and environmental degradation need to be managed, probably in a decentralized manner using market signals to change behavior. But a society needs resilience, slack, and insurance to manage the vagaries and risks of uncertain change. We’ve reduced our ability to adapt through misguided policies for about 50 years now, greatly increasing systemic risk. That’s what man-made disasters are made of.]

It’s the Fed, Stupid!

A Messaging Tip For The Donald: It’s The Fed, Stupid!

The Fed’s core policies of 2% inflation and 0% interest rates are kicking the economic stuffings out of Flyover AmericaThey are based on the specious academic theory that financial gambling fuels economic growth and that all economic classes prosper from inflation and march in lockstep together as prices and wages ascend on the Fed’s appointed path.

Read more

Why it’s impossible to predict this election

The bottom line is that in a bizarre election like this one — with so many variables and so much emotion — polls may well under- or over-predict votes for the two major candidates.

What this essentially means is that strategic voting is a crapshoot. Most emotional partisans (like Dershowitz in his last sentence) will claim that a protest vote is a vote for the other candidate. Or that protest votes will determine who wins this election. This is pure nonsense and contradicts everything he wrote previous to that last sentence.

To paraphrase Hollywood: there are three things that will determine the result of this election.  But nobody knows what they are.

I will stand by my original analysis from my post last week. Vote sincerely, not strategically.

From the Boston Globe

By Alan M. Dershowitz   SEPTEMBER 13, 2016

DESPITE THE POLLS, the outcome of this election was unpredictable even before Hillary Clinton’s recent health scare. It was only a month ago that The Washington Post predicted: “Hillary Clinton will defeat Donald Trump in November. . . . Three months from now, with the 2016 presidential election in the rearview mirror, we will look back and agree that the presidential election was over on Aug. 9th.”

On Aug. 24, Slate declared, “There is no horse race: it’s Clinton by a mile, with Trump praying for black swans” — only to “predict” one week later “Trump-Clinton Probably Won’t be A Landslide.” A few days ago, in a desperate attempt to analyze the new polls showing Trump closing in on Clinton, Slate explained sheepishly, “Things realistically couldn’t have gotten much worse for Trump than they were a few weeks ago, and so it’s not a shock that they instead have gotten a little better of late.” Some current polls even show Trump with a slight lead.

The reality is that polling is incapable of accurately predicting the outcome of elections like this one, where so many voters are angry, resentful, emotional, negative, and frightened. In my new book, “Electile Dysfunction: A Guide for the Unaroused Voter,” I discuss in detail why so many voters now say they won’t vote at all or will vote for a third-party candidate. As The New York Times reported, “Only 9 percent of America chose Trump and Clinton as the Nominees.” Or, to put voters’ frustration with the candidates more starkly, “81 percent of Americans say they would feel afraid following the election of one of the two politicians.” [Note: If that’s the way you feel, vote accordingly.]

The bottom line is that in a bizarre election like this one — with so many variables and so much emotion — polls may well under- or over-predict votes for the two major candidates. Think about the vote on Brexit. Virtually all the polls — including exit polls that asked voters how they voted — got it wrong. The financial markets got it wrong. The bookies got it wrong. The 2016 presidential election is more like the Brexit vote in many ways than it is like prior presidential elections. Both Brexit and this presidential election involve raw emotion, populism, anger, nationalism, class division, and other factors that distort accuracy in polling. So those who think they know who will be the next president of the United States are deceiving themselves.

One reason for this unique unpredictability is the unique unpredictability of Donald Trump himself. No one really knows what he will say or do between now and the election. His position on important issues may change. Live televised debates will not allow him to rely on a teleprompter, as he largely did in his acceptance speech or in his speech during his visit to Mexico City. He may once again become a loose cannon. This may gain him votes, or it may lose him votes. Just remember: Few, if any, pundits accurately predicted how far Trump would get when he first entered the race. When it comes to Trump, the science of polling seems inadequate to the task.

Clinton’s political actions are more predictable, although her past actions may produce unpredictable results, as they did when FBI director James Comey characterized her conduct with regard to her e-mails as “extremely careless.” It is also possible that more damaging information about her private e-mail server or the Clinton Foundation may come from WikiLeaks or other such sources.

Another unpredictable factor that may have an impact on the election is the possibility of terrorist attacks in the lead-up to the voting. Islamist extremists would almost certainly like to see Trump beat Clinton, because they believe a Trump presidency would result in the kind of instability on which they thrive. If ISIS attacks American targets in October, that could turn some undecided voters in favor of the candidate who says he will do anything to stop terrorism.

A final reason why this election is so unpredictable is that the voter turnout is unpredictable. The “Bernie or bust” crowd is threatening to stay home or vote for the Green Party. Young voters may do here what they did in Great Britain: Many failed to vote in the Brexit referendum and then regretted their inaction when it became clear that if they had voted in the same proportion as older voters, Brexit would likely have been defeated. Some Clinton supporters worry that black voters who voted in large numbers for Barack Obama may cast fewer votes for Clinton in this election. Voters who usually vote Republican but can’t bring themselves to pull the lever for Trump may decide to stay home. The effect of low voter turnout is as unpredictable as turnout overall.

So for all these reasons and others, no one can tell how this election will ultimately unfold. It would be a real tragedy, and an insult to democracy, if the election were to be decided by those who fail to vote, rather than by those who come out to vote for or against one of the two major candidates.

Book Review: Makers and Takers

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

Crown Business; 1st edition (May 17, 2016)

Ms. Foroohar does a fine job of journalistic reporting here. She identifies many of the failures of the current economic policy regime that has led to the dominance of the financial industry. She follows the logical progression of central bank credit policy to inflate the banking system, that in turn captures democratic politics and policymaking in a vicious cycle of anti-democratic cronyism.

However, her ability to follow the money and power is not matched by an ability to analyze the true cause and effect and thus misguides her proposed solutions. Typical of a journalistic narrative, she identifies certain “culprits” in this story: the bankers and policymakers who favor them. But the true cause of this failed paradigm of easy credit and debt is found in the central bank and monetary policy.

Since 1971 the Western democracies have operated under a global fiat currency regime, where the value of the currencies are based solely on the full faith and credit of the various governments. In the case of the US$, that represents the taxing power of our Federal government in D.C.

The unfortunate reality, based on polling the American people (and Europeans) on trust in government, is that trust in our governmental institutions has plunged from almost 80% in 1964 to less than 20% today. Our 2016 POTUS campaign reflects this deep mistrust in the status quo and the political direction of the country. For good reason. So, what is the value of a dollar if nobody trusts the government to defend it? How does one invest under that uncertainty? You don’t.

One would hope Ms. Foroohar would ask, how did we get here? The essential cause is cheap excess credit, as has been experienced in financial crises all through history. The collapse of Bretton Woods in 1971, when the US repudiated the dollar gold conversion, called the gold peg, has allowed central banks to fund excessive government spending on cheap credit – exploding our debt obligations to the tune of $19 trillion. There seems to be no end in sight as the Federal Reserve promises to write checks without end.

Why has this caused the complete financialization of the economy? Because real economic growth depends on technology and demographics and cannot keep up with 4-6% per year. So the excess credit goes into asset speculation, mostly currency, commodity, and securities trading. This explosion of trading has amped incentives to develop new financial technologies and instruments to trade. Thus, we have the explosion of derivatives trading, which essentially is trading on trading, ad infinitum. Thus, Wall Street finance has come to be dominated by trading and socialized risk-taking rather than investing and private risk management.

After 2001 the central bank decided housing as an asset class was ripe for a boom, and that’s what we got: a debt-fueled bubble that we’ve merely re-inflated since 2008. There is a fundamental value to a house, and in most regions we have far departed from it.

So much money floating through so few hands naturally ends up in the political arena to influence policy going forward. Thus, not only is democratic politics corrupted, but so are any legal regulatory restraints on banking and finance. The simplistic cure of “More regulation!” is belied by the ease with which the bureaucratic regulatory system is captured by powerful interests.

The true problem is the policy paradigm pushed by the consortium of central banks in Europe, Japan, China, and the US. (The Swiss have resisted, but not out of altruism for the poor savers of the world.) Until monetary/credit policy in the free world becomes tethered and disciplined by something more than the promises of politicians and central bankers, we will continue full-speed off the eventual cliff. But our financial masters see this eventuality as a great buying opportunity.

The Guardian view on central bankers: growing power and limited success

I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment.

– John Maynard Keynes

This editorial by The Guardian points out the futilities of current central banking policy around the world. Unfortunately, they only get it half right: the prescience of Keynes’s first sentence is only matched by the absurdity of his second sentence. Calculate the marginal efficiency of capital? Directing investment? Solyndra anyone? The captured State is the primary problem of politicized credit…

Reprinted from The Guardian, Thursday 25 August 2016

To find the true centre of power in today’s politics, ignore the sweaty press releases from select committees, look past the upcoming party conferences – and, for all our sakes, pay no mind to the seat allocations on the 11am Virgin train to Newcastle. Look instead to the mountains of Wyoming, and the fly-fishers’ paradise of Jackson Hole.

Over the next couple of days, the people who set interest rates for the world’s major economies will meet here to discuss the global outlook – but it’s no mere talking shop. What’s said here matters: when the head of the US Federal Reserve, Janet Yellen, speaks on Friday, the folk who manage our pension funds will take a break from the beach reads to check their smartphones for instant takes.

This year the scrutiny will be more widespread and particularly intense. Since the 2008 crash, what central bankers say and do has moved from the City pages to the front page. That is logical, given that the Bank of England created £375bn of new money through quantitative easing in the four years after 2009 and has just begun buying £70bn of IOUs from the government and big business. But the power and prominence of central banks today is also deeply worrying. For one, their multibillion-pound interventions have had only limited success – and it is doubtful that throwing more billions around will work much better. For another, politicians are compelling them to play a central role in our politics, even though they are far less accountable to voters. This is politics in the garb of technocracy.

Next month is the eighth anniversary of the collapse of Lehman Brothers. Since then the US central bank has bought $3.7tn (£2.8tn) of bonds. [Note: We’re going on $4 trillion of free money pumped into the financial sector, folks] All the major central banks have cut rates; according to the Bank of England’s chief economist, Andy Haldane, global interest rates are at their lowest in 5,000 years. Despite this, the world economy is, in his description, “stuck”. This government boasts of the UK’s recovery, but workers have seen a 10% drop in real wages since the end of 2007 – matched among developed economies only by Greece. Fuelling the popularity of Donald Trump and Bernie Sanders is the fact that the US is suffering one of the slowest and weakest recoveries in recent history. In April, the IMF described the state of the global economy as “Too Slow for Too Long”.

Having thrown everything they had at the world economy, all central bankers have to show is the most mediocre of score sheets. When it comes to monetary policy, the old cliche almost fits: you can lead a horse to water, but you cannot make it avail itself of super-low interest rates to kickstart a sustainable recovery. Two forces appear to be at work. First, monetary policy has been used by politicians as a replacement for fiscal policy on spending and taxes, when it should really be complementary. Second, major economies – such as Britain after Thatcher’s revolution – have become so unequal and lopsided that vast wealth is concentrated in the hands of a few who use it for speculation rather than productive investment. QE has pushed up the price of Mayfair flats and art by Damien Hirst. It has done next to nothing for graphene in Manchester. [Does it take a rocket scientist to figure this out?]

All this was foreseen by Keynes in his General Theory: “I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest. I expect to see the State, which is in a position to calculate the marginal efficiency of capital-goods on long views and on the basis of the general social advantage, taking an ever greater responsibility for directly organising investment.”

Eighty years on, it is time those words were heeded by policymakers. In Britain, that means using state-owned banks such as RBS and Lloyds to direct loans to those industries and parts of the country that elected and accountable politicians see as being in need. Couple that with a tax system that rewards companies on how much value they add to the British economy, and the UK might finally be back in business.

The State, run by the political class and their technocrats? Yikes!!! Will we ever learn?

Helicopter Money

Central bank “Helicopter Money” is to the economy what helicopter parents are to their unfortunate children. This from Bloomberg View:

`Helicopter Money’ Is Coming to the U.S.

Aug 5, 2016 5:41 AM EDT

Several years of rock-bottom interest rates around the world haven’t been all bad. They’ve helped reduce government borrowing costs, for sure. Central banks also send back to their governments most of the interest received on assets purchased through quantitative-easing programs. Governments essentially are paying interest to themselves.

What is Helicopter Money? 

Since the beginning of their quantitative-easing activities, the Federal Reserve has returned $596 billion to the U.S. Treasury and the Bank of England has given back $47 billion. This cozy relationship between central banks and their governments resembles “helicopter money,” the unconventional form of stimulus that some central banks may be considering as a way to spur economic growth.

I’m looking for more such helicopter money — fiscal stimulus applied directly to the U.S. economy and financed by the Fed –no matter who wins the Presidential election in November.

It’s called helicopter money because of the illusion of dumping currency from the sky to people who will rapidly spend it, thereby creating demand, jobs and economic growth. Central banks can raise and lower interest rates and buy and sell securities, but that’s it. They can thereby make credit cheap and readily available, yet they can’t force banks to lend and consumers and businesses to borrow, spend and invest. That undermines the effectiveness of QE; as the proverb says, you can lead a horse to water, but you can’t make it drink.

Furthermore, developed-country central banks purchase government securities on open markets, not from governments directly. You might ask: “What’s the difference between the Treasury issuing debt in the market and the Fed buying it, versus the Fed buying securities directly from the Treasury?” The difference is that the open market determines the prices of Treasuries, not the government or the central bank. The market intervenes between the two, which keeps the government from shoving huge quantities of debt directly onto the central bank without a market-intervening test. This enforces central bank discipline and maintains credibility.

In contrast, direct sales to central banks have been the normal course of government finance in places like Zimbabwe and Argentina. It often leads to hyperinflation and financial disaster. (I keep a 100-trillion Zimbabwe dollar bank note, issued in 2008, which was worth only a few U.S. cents as inflation rates there accelerated to the hundreds-of-million-percent level. Now it sells for several U.S. dollars as a collector’s item, after the long-entrenched and corrupt Zimbabwean government switched to U.S. dollars and stopped issuing its own currency.)

Argentina was excluded from borrowing abroad after defaulting in 2001. Little domestic funding was available and the Argentine government was unwilling to reduce spending to cut the deficit. So it turned to the central bank, which printed 4 billion pesos in 2007 (then worth about $1.3 billion). That increased to 159 billion pesos in 2015, equal to 3 percent of gross domestic product. Not surprisingly, inflation skyrocketed to about 25 percent last year, up from 6 percent in 2009.

To be sure, the independence of most central banks from their governments is rarely clear cut. It’s become the norm in peacetime, but not during times of war, when government spending shoots up and the resulting debt requires considerable central-bank assistance. That was certainly true during World War II, when the U.S. money supply increased by 25 percent a year. The Federal Reserve was the handmaiden of the U.S. government in financing spending that far exceeded revenue.

Today, developed countries are engaged not in shooting wars but wars against chronically slow economic growth. So the belief in close coordination between governments and central banks in spurring economic activity is back in vogue — thus helicopter money.

All of the QE activity over the past several years by the Fed, the Bank of England, the European Central Bank, the Bank of Japan and others has failed to significantly revive economic growth. U.S. economic growth in this recovery has been the weakest of any post-war recovery. Growth in Japan has been minimal, and economies in the U.K. and the euro area remain under pressure.

The U.K.’s exit from the European Union may well lead to a recession in Britain and the EU as slow growth turns negative. A downturn could spread globally if financial disruptions are severe. This would no doubt ensure a drop in crude oil prices to the $10 to $20 a barrel level that I forecast in February 2015. This, too, would generate considerable financial distress, given the highly leveraged condition of the energy sector.

Both U.S. political parties seem to agree that funding for infrastructure projects is needed, given the poor state of American highways, ports, bridges and the like. And a boost in defense spending may also be in the works, especially if Republicans retain control of Congress and win the White House.

Given the “mad as hell” attitude of many voters in Europe and the U.S., on the left and the right, don’t be surprised to see a new round of fiscal stimulus financed by helicopter money, whether Donald Trump or Hillary Clinton is the next president.

Major central bank helicopter money is a fact of life in war time — and that includes the current global war on slower growth. Conventional monetary policy is impotent and voters in Europe and North America are screaming for government stimulus. I just hope it doesn’t set a precedent and continue after rapid growth resumes — otherwise, the fragile independence of major central banks could go the way of those in banana republics.

The FED That Rules the World

Financial markets exhibit centripetal forces, sucking in all the capital from the periphery to the center. That’s why our financial centers have become the repository of capital wealth. As NYC is to Peori or Decatur; the US$ economy is to the rest of the world. As the FED screws up the world’s monetary system, dollar holders will be the least hurt. A very unneighborly result that usually leads to military conflicts.

From the WSJ:

The Dollar—and the Fed—Still Rule

Americans may think the U.S. is in hock to China, but Beijing’s economic fate lies in Washington’s hands.

By Ruchir Sharma
July 28, 2016 7:20 p.m. ET

When Donald Trump recently declared that “Americanism, not globalism, will be our credo,” he was expressing the kind of sentiment that animates not only his new Republican coalition, but nationalists everywhere. From the leaders of Russia and China to the rising European parties hostile to an open Europe, these nationalists are linked by a belief that in all matters of policy, their nation should come first.

This world-wide turning inward, however, comes in a period when countries are more beholden than ever to one institution, the U.S. Federal Reserve. Every hint of a shift in Washington’s monetary policy is met with a sharp response by global markets, which in turn affect the U.S. economy more dramatically than ever.

The Fed has been forced to recognize that it can no longer focus on America alone. When the Federal Open Market Committee voted in January 2015 to hold interest rates steady, its official statement explicitly noted, for the first time, that it was factoring “international developments” into its decisions. Since then the Fed, including this week, has frequently cited international threats, from Brexit to China, as reason to continue with hyper-accommodative monetary policy.

Though Mr. Trump argues that America must tend to its own affairs because it is weak, the Fed’s evolving role shows the limits of this argument. The U.S. may have slipped as an economic superpower, falling to 23% of global GDP from 40% in 1960. But as a financial superpower Washington has never been more influential. Forecasts of the dollar’s downfall have completely missed the mark.

Since the 15th century the world has had six unofficial reserve currencies, starting with the Portuguese real. On average they have maintained their leading position for 94 years. The dollar succeeded the British pound 96 years ago, and it has no serious rival in sight.

In the past 15 years, total foreign currency reserves world-wide rose from under $3 trillion to $11 trillion. Nearly two thirds of those reserves are held in dollars, a share that has barely changed in decades. Nearly 90% of global trade transactions involve dollars, even in deals without an American party. A Korean company selling TVs in Brazil, for instance, will generally ask for payment in dollars.

Because the Fed controls the supply of dollars, it reigns supreme. Its influence has only grown since the financial crisis of 2008. As the Fed began experimenting with quantitative easing to inject dollars into the system, tens of billions flowed out of the country every month. The amount of dollar loans extended to borrowers outside the U.S. has doubled since 2009 to $9 trillion—a record 75% of global nonresidential lending. Many of those are in the form of bonds, and bond investors are highly sensitive to U.S. interest rates.

That helps explain why any sign of Fed tightening, which reduces the supply of dollars, sends global markets into a tizzy. Earlier this year, for example, Chinese investors were shipping billions abroad every month, searching for higher yields. The Fed had been expected to raise short-term interest rates later this year, but it backed off that commitment in February, when China appeared headed toward a financial crisis.

Had the Fed tightened, China’s central bank would have been pressured to follow, crippling the flow of credit that is keeping the Chinese economy afloat. So instead the Fed held steady, effectively bailing out Beijing. Though many Americans still see the U.S. as deeply in hock to China, the fact is that China is even more reliant on easy money to fuel growth—putting the country’s economic fate in Washington’s hands.

The Fed is thus caught in a trap. Every time the U.S. economy starts to perk up, the Fed signals its intent to start returning interest rates to normal. But that signal sends shock waves through a heavily indebted global economy and back to American shores. So the Fed delays rate increases, as it did in June and again this week.

The rest of the world recognizes the Fed’s power as well. As soon as quantitative easing began, finance ministers from Brazil to Taiwan warned about the risks of unleashing torrents of dollars. They said it would drive up the value of currencies in the emerging world, destabilize local financial markets, undermine exports and economic growth.

The Fed was initially skeptical. Its then-chief Ben Bernanke argued that the central bank’s policies were a boost for every country. Other officials stated bluntly that the rest of the world wasn’t their problem. “We only have a mandate to concern ourselves with the interest of the United States,” Dennis Lockhart, president of the Atlanta Fed, said in 2013. “Other countries simply have to take that as a reality and adjust to us if that’s something important for their economies.”

The Fed has since discovered the world, which matters more than ever to the American economy. In the past 15 years the share of U.S. corporate revenues that come from foreign markets has risen from a quarter to a third. The more interconnected global markets become, the more rapidly financial instability in the rest of the world ricochets to hurt the U.S.

In the immediate aftermath of the financial crisis, the Fed’s loose policies may have temporarily stimulated growth world-wide. But those policies have come back to haunt it. Fed officials ignored the resulting excesses, including the credit and asset bubbles building around the world. Now every time the Fed tries to tighten, the dollar starts to strengthen and global markets seize up, forcing the Fed to retreat. It’s unclear how to end this cycle, but this much is apparent: The financial hegemony of the U.S. has never been greater, making the Fed the central bank of the world.

Blog Note: the world is screwed and we’re part of it.

Statistical Fixations

Martin Feldstein is nowhere near as excitable as David Stockman on Fed manipulations (link to D.S.’s commentary), but they both end up at the same place: the enormous risks we are sowing with abnormal monetary policies. The economy is not nearly as healthy as the Fed would like, but pockets of the economy are bubbling up while other pockets are still deflating. There is a correlation relationship, probably causal.

The problem with “inflation targeting” is that bubble economics warps relative prices and so the correction must drive some prices down and others up. In other words, massive relative price corrections are called for. But inflation targeting targets the general price level as measured by biased sample statistics – so if the Fed is trying to prop up prices that previously bubbled up and need to decline, such as housing and stocks, they are pushing against a correction. The obvious problem has been these debt-driven asset prices, like stocks, government bonds, and real estate. In the meantime, we get no new investment that would increase labor demand.

The global economy needs to absorb the negative in order to spread the positive consequences of these easy central bank policies. The time is now because who knows what happens after the turmoil of the US POTUS election?

Ending the Fed’s Inflation Fixation

The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.

By MARTIN FELDSTEIN
The Wall Street Journal, May 17, 2016 7:02 p.m. ET

The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.

The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.

For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%. Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.

The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.

When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.

Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.

The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.

With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.

Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.

The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.

Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply. [Sounds good, huh? Not quite. Read Stockman’s analysis.]

The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.

inflation-vs-employment

Has the Fed Been Feeding the Zombies?

There’s little that is technically wrong with this exposition of Fed policies that puts it pretty much between a rock and a hard place. But why not question whether the Fed is really the problem rather than the solution? How did we arrive at a zombie economy? Was it excess credit and debt that ended up being unproductive? Perhaps costlier credit would have prevented unproductive investments (like new cars financed with home re-fis? Or stock/housing prices that had a tenuous relationship to income and earnings?). I suspect that by propping up prices the Fed has merely been feeding the zombies instead of letting them die off…

Reprinted from Barrons:

How the Fed Fights the Zombie Economy With Easy Money

Reinvesting the principal and interest from bonds purchased in the quantitative-easing program gives the Fed more leverage over the economy.

April 16, 2016

[IllustratIon: Martin Kozlowski]

The rabbi and philosopher Shimon Green, founder of the Bircas Hatorah center in Jerusalem for the study of ancient wisdom, has observed that the fear of zombies is cross-cultural: “The fear stems from our own fear of living hopeless lives…a fear that our lives are nonproductive, and that we are the walking dead.”

Many fear that the U.S. economy is “the walking dead”—that the economy is a charade produced by an elixir of low interest rates administered by the Federal Reserve. In an effort partly intended to dispel that fear, the Fed raised the federal-funds rate in December.

With inflation languishing below its 2% target, the Fed began a process of interest-rate normalization, thereby demonstrating confidence in the economy. Raising the fed-funds rate was supposed to encourage expectations of higher growth, which resulted, in part, from the Fed’s recognition of considerable improvements in labor markets.

When the Fed raised rates, it said it was reasonably confident that inflation would rise to meet its objective, describing the impact of energy prices as transitory and predicting that they would pick up in 2016.

While 2016 got off to a rocky start with oil and stock prices declining, both have rebounded and are now trading at levels comparable to December. The Fed continues to project confidence, and the Federal Open Market Committee recently announced that it is on course to continue to raise rates.

The official dot plot of members’ expectations shows that they expect two rate hikes in 2016 and a fed-funds rate of 3% by mid-2018. This contradicts market expectations for a more muted path forward.

While the Fed sends a message of confidence, pointing to decreases in unemployment, a pickup in average hourly earnings, and core consumer-price-index inflation exceeding 2%, it is aware that inflation continues to run below its longer-run objective.

The Fed is also mindful of the potential for adverse shocks that could derail the economy. The International Monetary Fund last week lowered its global growth forecast, saying that the sluggish pace of growth leaves the world economy more exposed to risks.

The Fed needs to remain accommodative while continuing to raise the fed-funds rate. While that rate is a short-term one charged between banks for overnight money, longer rates have the greatest impact on asset purchases (like buying a home).

Thus, the Fed pursued quantitative easing, purchasing longer-term securities to directly lower long-term yields. It intended to encourage growth more directly.

The QE program effectively ended in 2014, but longer-term rates have continued to decline. Since the Fed raised fed-funds rates in December, 30-year yields have gone down from 3% to 2.5%.

THUS THE END OF QE and a rising fed-funds rate do not necessarily spell the end of easy money. The Fed continues to buy long bonds by reinvesting principal and interest from its maturing securities. Its balance sheet is about $4.5 trillion, of which approximately $1.5 trillion matures in fewer than seven years.

An oft-overlooked paragraph in FOMC statements promises to continue the reinvesting until the normalization of federal funds is “well under way.”

It is no surprise that the Fed’s balance sheet grew for over a year after QE ended. Reinvestment can keep pressure on longer-term rates as the Fed deploys its reinvestment across the curve. Its role in monetary policy will grow as short-dated bonds mature.

The Fed’s reinvestment policy is vital, considering the impact of rising rates and a shrinking balance sheet on fiscal policy. In 2007, the government paid $430 billion in interest on $9 trillion of debt. In 2015, the total interest paid on $19 trillion was about $402 billion. Like many Americans, Treasury has more debt and pays less interest.

If that is not enough to encourage the Fed to keep interest rates low, consider that Treasury effectively pays zero interest on T-bonds that the Fed keeps on its balance sheet (most of the interest Treasury pays to the Fed is given back to Treasury as profit). Higher rates and a shrinking balance would certainly create new burdens that might not be offset by economic growth.

Fiscal realities and the fear of adverse economic shocks drive the Fed to keep long rates lower. Vice Chairman Stanley Fischer recently said a larger balance sheet is accommodative and reduces risks to the economy. This would explain why the yield curve has flattened since December, as the market digested the distinction between higher fed-funds rates and an easy long-rate policy.

Raising the fed-funds rate demonstrates confidence in the economy; lowering long-term rates may be what is necessary to make that perception a reality. Former Fed Chairman Ben Bernanke recently described longer-term “rate targeting” as a possible tool that the Fed could use to stimulate growth. With rate targeting, the Fed would peg long-term interest rates while creating a ceiling for long-term Treasury debt. Though he declared that such an “exotic” approach is not likely in the foreseeable future, he pointed out that “public beliefs about these tools may influence expectations.”

If the Fed continues to emphasize that it will be reinvesting in long bonds for some time, it can change public perception of rising short rates to navigate long rates lower without using exotic tools. On the path to normalization, the Fed then would maintain the flexibility to raise the fed-funds rate while keeping long rates low. [So we move into an inverted yield curve? That is supposed to signal tightening credit.] 

Such an accommodative stance would help our economy grow while relieving some of the fiscal pressure. This is how the Fed’s balance sheet can buy time until we arrive at a point where the inflation data confirm that we are not zombies after all. [So, inflation is going to save us? Why, instead, does a little deflation scare the Fed so much? Because we are over-leveraged with cheap credit?]

Impotent Fed

From an interview of Bill Gross in Barron’s:

You have taken central bankers to task for impotence and ignorance, among other sins. In particular, you have written that Fed Chair Janet Yellen and others are ignorant of the harm done by their policies “to a classical economic model that has driven prosperity.” Just what did you mean, and what sorts of dangers do we face?

The Federal Reserve was created in 1913. President Nixon took the U.S. off the gold standard in 1971. For the past 40-plus years, central banks have been able to print as much money as they wanted, and they have. When I started at Pimco in 1971, the amount of credit outstanding in the U.S., including mortgages, business debt, and government debt, was $1 trillion. Now it’s $58 trillion. Credit growth, at least in its earlier stages, can be very productive. For all the faults of Fannie Mae and Freddie Mac, the securitization of mortgages lowered interest rates and enabled people to buy homes. But when credit reaches the point of satiation, it doesn’t do what it did before.

Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a “wafer-thin mint.” He swallows it and explodes. It’s pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we’re to the point where every bite is less and less fulfilling. Even though credit isn’t being created as rapidly as in the past, it doesn’t do what it did before.

Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn’t the case.

So where does that leave our economy?

In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.

To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany’s case, what happens? We’ve seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts.

Now consider mom and pop and other people who read Barron’s. They are saving for retirement and to put their kids through college. They might have depended on a historic 8%-like return from stocks and bonds. Well, sorry. When interest rates get to zero—and that isn’t the endpoint; they could go negative—savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth.

Are you suggesting a recession looms?

No. I see very slow growth. In the U.S., instead of 3% economic growth, we have 2%. In euroland, instead of 2%, growth is 1%-plus. In Japan, they hope for anything above zero.

What governments want, and what central banks are trying to do, is produce, in addition to minimal growth, a semblance of inflation. Inflating is one way to get out from under all the debt that has been accumulated. It isn’t working, because with interest rates at zero, companies and individual savers sense the futility of taking on risk. In this case, the mint eater doesn’t explode, but the system sort of grinds to a halt.

It doesn’t look like anything is grinding to a halt around here. You can see gorgeous golf courses from one window and a yacht basin from the other.

This isn’t the real economy. It is Disneyland and Hollywood. It is finance-based prosperity, based on money that doesn’t produce anything anymore because yields are so low.

Even in a negative-rate environment, as in Germany or Switzerland, banks and big insurance companies have little choice but to park their money electronically with the central bank and pay 50 basis points. But an individual can say “give me back my money” and keep it in cash. That’s what would make the system implode. I’m not talking about millionaires or Newport Beach–aires, but people with $25,000 or $50,000. Without deposits, banks can’t make loans anymore, so the system starts to collapse.

Let’s say Yellen steps down and President Obama appoints you the new head of the Fed. What would you do differently?

What you’re really asking is: What is the way out? The way out is a little bit of pain over a relatively long period of time. That is a problem for politicians and central bankers who are concerned with their legacy. It means raising interest rates and returning the savings function to normal. The Fed speaks of normalizing the yield curve but knows it can’t go too fast. A 25-basis-point increase [in the federal-funds rate] in December had consequences in terms of strengthening the dollar and hurting emerging markets.

Will the Fed raise rates this year?

Yes, as long as the stock market permits it. They have to normalize interest rates over a period of two, three, four years, or the domestic and global economy won’t function. In today’s world, normalization would mean a 2% fed-funds rate, a 3.5% yield on the 10-year bond, and a 4.5% mortgage rate. Would this create some pain? Of course. Housing prices probably would stop rising, and might fall a bit. The Fed has to move gradually.

What will be the 10-year Treasury yield at the end of 2016?

Close to what it yields now. I expect the Fed to raise rates once or twice this year. That would put the fed-funds rate at 1%. Does the 10-year deserve to yield 1.90% with fed funds at 1%? Yes, so long as inflation is 2% or less. If the Fed raises rates, the euro and yen could weaken. That would mean rates in Europe and Japan don’t have to go negative, or to extreme lows. In a sense, the Fed is driving everything. But it can’t raise rates too much without threatening a country like Brazil, whose corporations have tons of dollar-dominated debt.

What will the global economy look like in five or 10 years?

Structurally, demographics are a problem for global growth. The developed world is aging, with Japan the best example. Italy is another good example, and Germany is a good, old society, too. As baby boomers get older, they spend less and less. But capitalism has been based on an ever-expanding number of people. It needs consumers.

Another thing happening is deglobalization, whether it’s Donald Trump building a wall to keep out Mexicans, or European nations putting up fences to keep out migrants. Larry Summers [former secretary of the Treasury] has talked about secular stagnation, or a condition of little or no economic growth. At Pimco, I used the term “the new normal” to refer to this condition. It all adds up, again, to very slow growth. The days of 3% and 4% annual growth are gone.

Gross

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