by Doug Noland
February 28, 2014
Developments in China and the Ukraine weren't enough to restrain the exuberant bulls. For someone deeply engaged in monetary theory and policy, Thursday was special. While CNBC was carrying Janet Yellen’s testimony before the Senate Banking Committee, there was also a live feed available for a panel discussion on monetary policy at the Bundesbank Symposium on Financial Stability. The two discussions were separated by much more than the Atlantic.
The Bundesbank discussion panel included Federal Reserve of Dallas President Richard Fisher. And with Yellen in a dovish mood as she interacted with the Senators, I listened attentively for any subtle change in tone from the hawkish Dallas Fed head. Mr. Fisher did not disappoint. In an interesting testament to the tectonic shift unfolding in the U.S. monetary policy debate, Fisher went so far as to refer to the Dallas Fed as the “Bundesbank of the United States.” Moreover, he added the comment “we agree on almost everything” as he turned the forum over to the next panelist, Otmar Issing.
It is music to my ears to hear a top Federal Reserve official use the (catchy) word “Bundesbankification” and proudly state his agreement with prior Bundesbank Chief Economist Otmar Issing. It’s been a long wait! Over the years, I’ve chronicled the clash between the (“Austrian”) framework underpinning doctrine at the Bundesbank and an altogether different view of how economies and finance function from the Federal Reserve. I’ve always viewed Otmar Issing as a brilliant thinker and one of the great contemporary experts on monetary policy doctrine. One of my attempts to highlight the opposing economic doctrines dates back to an early-2004 CBB – “Issing v. Greenspan.”
I did my best to transcribe Dr. Issing’s astute comments below. He politely addressed his contrasting views over the years with those of the Fed, mentioning the “Greenspan put,” moral hazard, asymmetrical policymaking and the “risk management” approach adopted by the Greenspan and Bernanke Federal Reserves. I’ll go a step further than Fisher in agreeing with EVERYTHING Issing said.
Clearly, Issing and the Bundesbank decisively won the debate. The 2008 crisis illuminated the failings of the key facets of Federal Reserve monetary management. Yet, amazingly, instead of moving in the direction of a more Bundesbank approach, the Bernanke Fed lurched only further into the direction of experimental monetary inflation and aggressive market intervention. Adopting a sports analogy, Bernanke threw a “Hail Mary.” The ball might not have yet officially hit the turf, but there’s no way the play will end successfully. A new game plan is unavoidable, and I believe the heads of some of the regional Federal Reserve banks provide sound ideas. In the Q&A session, Issing shared an additional pertinent insight: “For me what is key: central banks should always make clear what they can deliver and what they cannot. And I think everybody’s experience in life is never take responsibilities for which you have no competencies.”
Sarcastically, Issing quipped: “I learn that we’re allowed to talk of Bubbles now, which was out of the question for a long time…” As I remember all too well, back in the late-nineties anyone warning of Bubble excess was dismissed as a nut ball. But after the technology Bubble burst the consensus view shifted to how obviously it was all a Bubble.
During the mortgage finance Bubble period, it really amazed me how dismissive everyone was that housing and mortgage finance could be in Bubbles. And in the crisis period that followed, it was again commonly understood that excesses were conspicuous. Why then is everyone so blind during the Bubble period?
In the spirit of “Deja vu all over again,” Bubble analysis is again disparaged and almost completely dismissed. But I’ll make a few predictions: At some point in the future, it will have been obvious to everyone that Federal Reserve monetary policy created historic securities market and asset price Bubbles. Everyone will have known that Federal Reserve and global central bank liquidity were instrumental in inflating unprecedented Bubbles throughout the emerging markets. In hindsight, the Chinese Bubble will have been obvious to everyone. For now, I’ll continue chronicling history’s greatest financial Bubble.
February 28 – MarkeNews International: “The yuan plunged through the key 6.150 level against the U.S. dollar on Friday morning as investors continued to unwind their bets on the currency in the wake of last week's depreciation signal from the authorities… The morning session saw some of the most violent moves in the currency since the People’s Bank of China triggered the sell-off with a dramatically lower central parity fixing on February 19. Traders said big state banks have been buying U.S. dollars again, sending the yuan sharply lower, but in light volumes.”
February 27 – Bloomberg (Lilian Karunungan and Yumi Teso): “The yuan has gone from being the most attractive carry trade bet in emerging markets to the worst in the space of two months as central bank efforts to weaken the currency cause volatility to surge… ‘A lot of investors globally were invested in the yuan because of the interest-rate differential and the low volatility,’ Rajeev De Mello, who manages $10 billion… at Schroder Investment Management Ltd., said… ‘All of a sudden, the low volatility part of the argument is no longer there.’ An unwinding of the carry trade may spur a slide in the yuan, which is set for the biggest monthly decline since the government unified official and market exchange rates at the end of 1993. Deutsche Bank AG, the world’s largest foreign-exchange trader, estimated this week that bullish bets on China’s currency amount to about $500 billion.”
February 28 – MarketNews International: “The violent sell-off in the yuan on Friday is a reflection of market expectations and is ‘tolerable,’ a senior source close to the People's Bank of China source told MNI. The source, who helps formulate the government's exchange rate policy, was asked directly about a morning of trading which saw the yuan fall nearly the full 1% limit of its daily trading range… ‘The fall (in the yuan) reflects market expectations. It is tolerable,’ he said.”
Central to my historic Credit Bubble thesis is the view that speculative leveraging has played a momentous role in creating self-reinforcing liquidity excess. This liquidity drives asset inflation and speculative Bubble dynamics. In prolonged Bubble periods, liquidity excess will also work to inflate system incomes, spending, corporate incomes and cash flows, government receipts/spending, etc. We saw this dynamic mostly on a sectoral basis during the late-nineties “technology” Bubble and then on a more systemic basis during the mortgage finance Bubble. The ongoing current Bubble is inflating and distorting on a deeply systemic basis. In previous Bubble episodes, the amount of time that passed between the exuberant phase of perceived endless cheap liquidity and the onset of fear, de-risking/deleveraging and attendant illiquidity wasn’t terribly extended.
I believe the dynamic between Fed, BOJ and global central bank market liquidity injections and aggressive speculative leveraging has been especially dangerous throughout this cycle. These excesses went “parabolic” over the past 18 months, with global securities markets awash in destabilizing liquidity excess. From my perspective, key sources of global liquidity have included the Fed and Bank of Japan's balance sheets, Chinese Credit excess, and speculative leveraging, certainly including the hedge funds, the “yen carry trade” and a perhaps massive “yuan carry trade” in China.
As a Bubble analyst, I’m on guard these days. The Fed is at this point seemingly determined to wind down its balance sheet growth this year. And as the strongest major currency year-to-date, there is also potential pressure on yen short positions and related speculative leverage.
Meanwhile, Chinese officials are in the midst of some type of change in currency policy. Initial thinking in the marketplace was that the People’s Bank of China was seeking simply to add a little volatility to send a message to aggressive currency speculators. What has evolved into a more significant currency decline has analysts believing the market is being prepared for a wider trading band in China’s currency peg regime. At the same time, a few are beginning to worry that the Chinese might at some point be willing to adopt a more aggressive “beggar they neighbor” currency devaluation posture. Perhaps in the future China will be compelled to respond to competitive currency devaluations from Japan, South Korea or other Asian competitors.
Chinese policies and motivations will evolve over time. For now, there has been a significant change in the risk vs. reward calculus for “hot money” speculative flows streaming into China. In terms of the Chinese and global Bubbles, this development could prove a meaningful inflection point.
And while on the subject of Bubbles, almost simultaneously Thursday Richard Fisher spoke of growing signs of financial excess while Janet Yellen again stated that stock prices are not excessive. As an analyst of Bubbles, I contend that valuation is generally not a very helpful indicator. And I would be especially cautious against using broad market aggregates as evidence for or against Bubbles. The bulls argued vociferously in 1999 that if not for a group of technology stocks, U.S. equities were not overpriced. And the tech bulls even contended that technology stocks were valued fairly considering their incredible growth prospects. To most analysts and participants, stock prices did not look expensive in 1929. Whether it was the bulls from 1999 or 1929, what they didn’t see coming was the post-Bubble collapse in earnings.
U.S. stocks are obviously back in a Bubble. For starters, one only has to monitor trading in tech, biotech or “short” stocks. Or one could look to the parabolic nature of moves throughout the small and mid-cap stock universe. And, from my vantage point, the nature of stock trading provides confirmation of the Bubble thesis now on an almost daily basis. Stocks are clearly in speculative melt-up mode, feeding off short squeezes, derivatives and performance-chasing flows. Moreover, I would add that as the global speculator community has grown to gigantic proportions, market speculation has become a highly sophisticated game.
Succumbing once again to the “lunatic fringe,” I’ve found recent attention paid to market charts comparing current stock price trends to 1929 interesting. It’s related to my long-standing fascination with the final “Roaring Twenties” Bubble speculative melt-up - commencing in 1927 (“coup de whiskey”) and culminating in the spectacular 1929 “blow off” top. For a while, it paid handsomely to ignore the deteriorating fundamental backdrop. Indeed, complacency had become deeply embedded in the marketplace, fomenting a problematic divergence between bullish perceptions and bearish underlying fundamentals.
In the face of mounting negative fundamental developments, stocks these days just march higher and higher. Not a worry in the world. Friday, with an alarming litany of troubling developments – certainly including Russian troops moving into Crimea – U.S. stocks posted another record high as the VIX volatility index end the week at 14 – not far off seven-year lows.
Comments from Otmar Issing, former Bundesbank and ECB Chief Economist and current president of the Center for Financial Studies, at the Bundesbank Symposium of Financial Stability, February 27, 2014.
“The Great Depression had a global, deep and lasting impact not only on policy concepts but also on economic theory. Suffice it to mention the rise of Keynesianism. So for me a big question is will the Great Recession also have comparable effects on economic theory – how will it react to that. To some extent, this has happened always in our science. New approaches are also taking up past ideas. So it’s not surprising that (Friedrich) Hayek and (Joseph) Schumpeter and how they judged the development in the Twenties of last century have kind of come back – at least for some economists. …The panel was asked: “Do we need a new paradigm for monetary policy?” I think we are now – all of us would agree –that financial imbalances can also develop in a context of price stability. And price stability might even foster the sense of certainty and initiate too high risk-taking, etc.
I’m reminded of a conference organized by the BIS – I think it was 2001/2002 – one of the questions was: is there a tradeoff between price stability and financial stability? I would not, of course, go so far. But price stability is not enough. And I think this has dramatic consequences for the conduct of monetary policy. For me, the implication is very clear: policy which relies on a forecast (model) based on a real economy only without a financial sector – without taking into account money and Credit in a sensible way - is not anymore state of the art. If you have just such a narrow aspect - in contrast to our experience, again, that price stability is not enough – it’s not enough. So, monetary policy has to take into account the development of money and Credit – by that I mean a very broad approach considering all aspects of financial stability.
What follows also for me is that monetary policy should have a proactive view on financial stability issues – “leaning against the wind” or whatever you would call it. And in this context I think a very important, interesting aspect comes into the picture which is this approach must be symmetric – must be symmetric. What we have seen in the past – I don’t know how many asymmetric cycles. And I wonder if we have a continuation of one asymmetric policy cycle after the other – where will we end finally? We are already in the midst of such a situation. And the asymmetric approach - the famous “Greenspan put” - was creating moral hazard. If you can rely that once asset prices collapse central banks come in to rescue the system, at least, this creates moral hazard in a very broad sense. This approach was for some time – I think it has more or less disappeared from theory and research – it was based on the “risk management approach.” The “risk management approach” was based on the idea that there might be events with low probability but with high impact. And I’m reminded in this moment of a remark from Greenspan – I think it was in Jackson Hole – when he said “of course we have to react asymmetrically, because the buildup of Bubbles” – and I learn that we’re allowed to talk of Bubbles now, which was out of the question for a long time in research – “the buildup of Bubbles goes very slowly – softly - but the collapse goes very fast. So it’s obvious that that the [central] bank should react in a decisive way one prices collapse.”
But I think there is no defense for the concept of asymmetrical policy once a Bubble – or whatever you will call it – is building up. One argument was that monetary policy is too blunt a tool. I think this argument has lost its credibility. We know from many studies that even small early increases in interest rates would have an impact on interest rate structure, risk-taking, etc. In the context of an asymmetric approach and “risk management,” I am reminded writing these few pages, I’m reminded of many, many meetings here or especially in the U.S. with my friends from the Fed. Their reaction was absolutely clear: when I referred to a potential Bubble in real estate, what I heard always was “never in the last 50 years have real estate prices fallen on a nationwide aspect. For me, this was not a comfort. Because in economics – and this was before the ‘black swan’ became popular – and once this happens their reaction to my critique or argument was very relaxed: “In the meantime, we have had much higher GDP, higher employment , more houses, etc. So compared to the cost of raising interest rates would be much too high – much too high.” I have never seen so far the comparison of the high cost of the mess we are in if we take this “risk management” approach.
Of course, this does not mean that monetary policy could do all the work. We need a combination of macro-prudential tools and this raises the question: ‘Who should have the responsibility – the competence for that?’ From an efficiency point of view, it seems clear that one institution should be responsible for macro prudential and monetary policy. And monetary policy should remain with central banks, central banks should also be responsible for macro-prudential policies. And this fits into the context of central banks having got so much power – partly on their own initiative and partly they were pushed into that position. I’m very afraid of that because the application of macro-prudential tools will have dramatic… distributional effects. And for such distributional effects, I think you need democratic legitimization. I’m very afraid that central banks entering in this field of politics will undermine their independence and this may not be positive for the welfare of society because in the end it will also undermine the efficiency of maintaining price stability.
Let me conclude by a remark: I made the note, Michael (inaudible) said ‘regulation should punish the bad guys and reward, so to say, the cautious ones.’ This is kind of a reformulation of the (inaudible) principle. What we’re seeing now is the opposite effect. Because in an environment of extremely low interest rates and low quality for collateral everywhere, this is just the opposite – it’s keeping so many banks alive and we know some of the banks will keep so many companies alive and then finally the economy might be trapped in a situation in which even the continuation of zero interest rate policy will not have very positive effects. So what I’m missing is, I think in most countries policies are still in the mode of crisis management. I think this time has passed. And crisis management must be linked to, a few at least, a structure of what sustainable policy in the future should be… If crisis management is just continued, and this is left out of sight, and I don’t see in many cases how crisis management finally will emerge into a sustainable situation of the financial system. If this continues I think we are in an extremely dangerous situation.”
After the great recession ended in early 2009, the normal post-recession growth spike in the U.S. never happened, meaning the world's people missed out on a lot of productive economic activity. And don't hold your breath. According to the Congressional Budget Office's outlook report this Feb. 4, "The growth of potential GDP over the next 10 years is much slower than the average since 1950." Not slower. Much slower.
Hang around the Washington political and pundit class these days, and you get the impression this doesn't matter much. We'll muddle through low growth till the sun comes out again. Raise the minimum wage, create more tax credits or spend $300 billion pouring federal concrete, and the clouds will part.
The U.S. and Western Europe have lived through these recent years with the illusion that economic mediocrity can't be so bad because they've had no Orange Revolutions on their lovely streets. In fact, these vain and decelerating advanced economies are living off the accumulated inheritance of a century and a half of good growth.
Angus Maddison, the late and eminent economist for the OECD, produced a famous chart in 1995, depicted nearby. For the longest time—basically from after the Garden of Eden until the 19th century—economic benefit for the average person in the West or Japan was flat as toast. The Mona Lisa aside, there was a reason someone back then said life was nasty, brutish and short. Then suddenly, new wealth spread broadly.
Maddison describes 1820 till 1950 as the "capitalist epoch." He means that admiringly. The tools of capitalism unlocked the knowledge created until then. What came to be called "economic growth" gave more people jobs that lifted them and their families from the muck of joblessness and poverty. Maddison also noted that much of the world did not participate in the capitalist epoch. No wonder they revolt now.
This history is worth restating because the importance of strong economic growth, and the unavoidable necessity of a U.S. that leads that growth, may be disappearing down the memory hole of public policy, on the left and even among some on the right. Both share the grim view that the U.S. economy is flatlining, and the grim fight is over how to divide what's left.
There is no alternative to strong economic growth. None. They know this in Beijing, Seoul, Kuala Lumpur, Jakarta, Warsaw, Bratislava, Taipei, even Hanoi. The missing piece is a global growth agenda led by a U.S. president and Treasury secretary who aren't fundamentally at odds with capitalism. The revival of tax reform announced this week (and on these pages) by House Ways and Means Chairman Dave Camp is a start.
In a puckish moment, Angus Maddison did say that income inequality was rather minimal in the 11th century. Now those were the days.