Tokyo
Doubles Down
By John Mauldin
“When
it becomes serious, you have to lie.”
“I'm
ready to be insulted as being insufficiently democratic, but I want to be
serious... I am for secret, dark debates.”
“Of
course there will be transfers of sovereignty. But would I be intelligent to
draw the attention of public opinion to this fact?”
“If
it's a Yes, we will say ‘on we go,’ and if it’s a No we will say ‘we
continue.’”
“We
all know what to do, we just don't know how to get re-elected after we’ve done
it.”
–
All quotes from Jean-Claude Juncker, prime minister of Luxembourg and president
of the European Commission
I’ve
been busily writing a letter on oil and energy, but in the middle of the
process I decided yesterday that I really needed to talk to you about the Bank
of Japan’s “surprise” interest-rate move to -0.1%. And I don’t so much want to
comment on the factual of the policy move as on what it means for the rest of
the world, and especially the US.
But
before we go there, I also want to note that today
is Iowa, and so we’re about to turn a big corner in what is fast
becoming one of the wackiest years in American political history. I’m going to
sit down tonight after the caucus results come in and write to you again, for a
special edition
of Thoughts from the Frontline
that will hit your inbox tomorrow. Along with Iowa, I want to delve into the
issue of what a “brokered convention” would mean for the Republican Party, and
what one would look like.
I have
been steadfastly maintaining that the Bank of Japan was going to augment its
quantitative easing stance sometime this spring. Inflation has not come close
to their target, and the country’s growth is dismal, to say the least. So the
fact that the Bank of Japan “did something” was not a surprise. I will however admit
to being surprised – along with the rest of the world – that they chose to do
it with negative interest rates. Especially given the fact that Kuroda-san had
specifically said in testimony to parliament only a few days earlier that he
was not considering negative interest rates.
While
this development is significant for Japan, of course, I think it has broader
implications for the world; and the more I think about it, the more nervous I
get. First let’s look at some facts.
Conspiracy
theorists will love this Bank of Japan timeline:
Jan 21
– Kuroda emphatically tells Japanese parliament he is not considering NIRP.
Jan 22
– Kuroda flies to Davos.
Jan 29
– Kuroda enthusiastically embraces NIRP and promises more of it if needed.
So,
whom did he talk to in Davos, and what did they say to change his mind?
In an
email exchange I had with Rob Arnott about the Bank of Japan, he reminded me of
that wonderful Jean-Claude Juncker quote wherein he states, “When it gets
serious, you have to lie.” Which, given my theme, ties in well with another of
his quotes: “I'm ready to be insulted as being insufficiently democratic, but I
want to be serious... I am for secret, dark debates.”
Haruhiko
Kuroda, according to reports, came back from that testimony to parliament and
instructed his staff to prepare a set of documents outlining all the potential
choices, along with their pros and cons, to be ready for the next BOJ meeting
when he got back from Davos.
To
pretend that he walked into that meeting without having had lengthy talks about
whether to pursue negative interest rates strains credulity – and it just
wouldn’t be very Japanese. The conduct of business and governance in Japan
relies heavily on a process called nemawashi,
or “stirring the roots”: the outcome of any important meeting is decided ahead
of time through private discussions among those who will participate. In any
case, the vote to take rates into negative territory came down to a razor-thin
5 to 4, so you can be damn sure Kuroda knew exactly who was with him and who
was not. You do not take a vote like that and lose – not and remain chairman.
The
entire world has been watching the European experiment. Four countries in
Europe are now at negative rates (see graph below). Two others are so close
that it hardly makes a difference. The Federal Reserve and the Bank of England
are both at 0.5%.
Switzerland,
Denmark, and Sweden all lowered their rates to make their currencies less
attractive, since the franc, the krone, and the krona had appreciated too
strongly against the faltering euro. Meanwhile, the ECB is trying to stimulate
the Eurozone economy and create inflation. The question is, exactly how many
unintended consequences will there be with negative rates?
(For
the record, to my knowledge none of the banks charge negative rates on required
reserves, just on excess reserves. Excess reserves are defined as money on
deposit at a bank in excess of whatever the regulators think is necessary to
fund the bank’s operations. The concept of excess reserves is a totally
artificial one. Aggressive banks will keep reserves as low as possible in order
to make maximum returns, and conservative banks will of course hold more
reserves. Where do you want to put your money? Then again, if you’re looking to
borrow money, which bank do you go to?)
The
people that NIRP (negative interest rate policy) hurts the most are those who
are living on their savings or trying to grow their retirement accounts, but
apparently our all-wise central banks have decided that a little pain for them
is worth the potential for growth in the long run. Savers in both Germany and
Japan have to buy bonds out past seven years just to see a positive return.
Some 29% of European bonds now carry a negative interest rate. Recently we have
seen Japanese corporate bonds paying negative interest.
Sidebar:
if I am a Japanese corporation and somebody is willing to pay me to lend me
money, why am I not backing up the truck and seeing how much the market will
give me? Then turn around and invest the money in fixed-income assets? Just
asking…
Whatever
turmoil the Bank of Japan had already created was apparently not enough to
concern a majority of its board, so they have moved to negative interest rates.
Let’s
shift from Japan to the US. Last week, former Fed chair Ben Bernanke said in an
interview
that the Fed should consider using negative rates to counter the next serious
downturn. “I think negative rates are something the Fed will and probably should
consider if the situation arises,” he said.
The
same story at MarketWatch mentioned that former Fed Vice-Chairman Alan Blinder
has already suggested using negative interest rates for overnight deposits.
And
Janet Yellen, who said in her confirmation testimony to Congress in 2013 that
the potential for negative interest rates to cause disruption was significant,
now says they are an option the Fed would consider.
We
often refer to the herd mentality when we talk about investors. Economic
academicians and central bankers are equally prone to bovine behavior. Theirs
is a slow-moving herd, to be sure, but it raises much dust as it lumbers.
One of
the biggest “aha” moments of my life came as I listened to David
Blanchflower, former Bank of England governor (during last decade’s financial
crisis), in a debate a few summers ago at Camp Kotok, the Maine fishing retreat
I attend every August. The debate centered around whether the Fed and the Bank
of England should have engaged in quantitative easing.
Blanchflower
shared a rather chilling description of what was going on at the time and made
the point that, as bad off as the banks were in the US, they might have been
worse off in England. They were literally days from a total collapse. Liquidity
had to be provided – and that is the one true and worthwhile purpose of central
banks (but then they double down). Blanchflower’s argument was that you could
not sit in the BOE’s meetings, see how impossible the situation was, and do
nothing. You had to act.
In
such a predicament you rely upon your best instincts and education and
training, and then you act. And you hope that the actions you take do more good
than harm.
Now,
let’s fast-forward right into the future and the next recession in the US,
which will probably be part and parcel of a global recession. Major central
banks everywhere will be lowering rates, engaging in quantitative easing, and
in some cases going even deeper into negative interest rates.
You
sit on the Federal Open Market Committee. Almost everyone in the room with you
is a committed Keynesian. That is the bulk of your training and experience,
too, and everyone agrees with you. You are going to take actions that are in
alignment with your theoretical understanding of how the world works.
And
your theory says that you need to reduce the cost of money so that people will
borrow and spend. You know that doing so will hurt savers, but it is more
important that you get the economy moving again.
What
do you do? You are hearing from everyone that the dollar is too strong and is
hurting US business. You worry about the unintended consequences of taking the
world’s reserve currency into negative-interest-rate territory, but the staff
economists are handing you papers that argue persuasively that the best
possible alternative is negative rates. So you throw in the towel.
Which
is pretty much the situation Kuroda-san was in when he came back from Davos –
his staff economists (who have had much the same training as the Fed economists
have) were waiting for him. Yes, and he may have received assurances from the
central bankers of other countries who have already gone negative, but you
don’t make such a decision based on a few conversations. Kuroda had been
thinking about negative rates for a long time.
You
have to understand that in the world of truly elite economists, everyone knows
everyone. Many of them went to the same schools, and they regularly talk at
conferences, in private meetings, and by phone and email. I can guarantee you
that they are talking about if and when it might be necessary for the US to go
down the path of negative interest rates. The policy makers are not committed
to following that path, but they are certainly talking about it. When they tell
us it’s an option, we need to take them seriously.
I have
been in the room (under Chatham House rules, so I cannot reveal when or where
or who) with some of the world’s most elite economists (Nobel laureates, etc.),
who were privately advocating that the US should pursue not just 2% but 4%
inflation. This is not the language I hear when they are interviewed in public.
They very well get the seriousness of our current economic predicament, but
their academic theory tells them that the way to resolve that predicament is
with more quantitative easing and even lower rates.
You
need to understand that economists have faith in their theories in the same way
that many people have faith in their religion.
We
need to seriously contemplate and war-game in our investment committee
meetings, in meetings with our investment advisors, etc., what negative
interest rates would mean for our portfolios. You do not want to wait until the
last minute, when negative rates are already an adopted policy, to try to
react. NIRP is not going to happen in the US this week or this month, and I
seriously doubt we’ll even see negative rates this year; but if it’s on the
table at the Federal Reserve, then you need to have it on the table as a
distinct possibility.
Four
months ago Lacy Hunt wrote about the negative consequences of a negative interest-rate
policy. I sent that to you as an Outside
the Box, but let’s excerpt a few paragraphs:
The
Fed could achieve negative rates quickly. Currently the Fed is paying the
depository institutions 25 basis points for the $2.5 trillion in excess
reserves they are holding. The Fed could quit paying this interest and instead
charge the banks a safekeeping fee of 25 basis points or some other amount.
This would force yields on other short-term rates downward as the banks,
businesses and households try to avoid paying for the privilege of holding
short-term assets.
No
guarantees exist that such an action would be efficacious. Heavily indebted
economies are not very responsive to such small changes in short-term interest
rates. Many negatives would outweigh any initially positive psychological
response. Currency in circulation would rise sharply in this situation, which
would depress money growth. The Fed may try to offset such currency drains, but
this would only be achievable by further expanding the Fed’s already massive
balance sheet. If financial markets considered such a policy inflationary over
the short-term, the more critically sensitive long-term yields could rise and
therefore dampen economic growth.
An
extended period of negative interest rates would lead to many adverse
unintended consequences just as with QE and ZIRP. The initial and knockoff
effects of negative interest rates would impair bank earnings. Income to
households and small businesses that hold the vast majority of their assets
with these institutions would also be reduced. As time passed a substantial
disintermediation of funds from the depository institutions and the money
market mutual funds into currency would arise. The insurance companies would
also be severely challenged, although not as quickly. Liabilities of pension
funds would soar, causing them to be vastly underfunded. The implications on
corporate capital expenditures and employment can simply not be calculated. The
negative interest might also boost speculation and reallocation of funds into
risk assets, resulting in a further misallocation of capital during a time of
greatly increased corporate balance sheet and income statement deterioration.
Lakshman
Achuthan posted an essay this week (which I sent to Over My Shoulder readers) in which he outlines
why growth in the US will slow to 1% over the next decade. He talks about the
economic establishment’s betting everything on policies of quantitative easing
and low rates. And by everything he means the global economy. Everything. Quoting:
The
math is too simple to ignore. Potential labor force growth will average ½% per
year for at least the next decade, and US labor productivity growth may well
stay around ½% a year, its rough average for the last five years. These add up
to 1% long-term potential GDP growth, which actual GDP growth can surpass only
temporarily during a cyclical upswing – and certainly not during a cyclical
slowdown. This is a challenging problem, with demographics practically set in
stone, and a boost to productivity growth realistically possible only in the
long run.
Consequently,
after years of ZIRP and QE attempting to pull demand forward from the future,
central banks are increasingly powerless when it comes to the economy itself.
They can “print” money, but not economic growth. The world is watching, so
those who are thought to walk on water cannot afford to be seen to have feet of
clay.
If
U.S. growth keeps slowing this year, recession risk will rise, and the Fed will
likely revisit ZIRP, in one way or another. The failure of Abenomics is not
inevitable, but appears increasingly probable. And while China is not yet
facing a hard landing, growth continues to slow, raising legitimate concerns
about its leaders’ capability to avoid one.
By
clinging to unrealistic growth expectations, the economic establishment has
effectively bet everything on the success of these grand experiments, and the
risk of losing that bet is rising inexorably. Ultimately, only policies that
genuinely address the challenges of demographics and productivity have a chance
to succeed. It is high time for that discussion to begin.
Lakshman
is right, but we are not really going to get that discussion, except in the
context of Keynesian policy. Which is at the very heart of the problem. There
would have to be an admission of failure by the economic establishment in order
for there to be a serious discussion. It would be like asking the Pope and all
his priests to convert to another theological viewpoint. Here and there it
could happen, but a mass shift?
In the
world of the leading economists and central bankers, “everyone” believes what
“everyone” knows to be true. All their research agrees with them, and any that
doesn’t is labeled as flawed. Any empirical evidence that shows quantitative
easing hasn’t been working is ignored or explained away, even when it is
presented by outstanding academic economists. No, quantitative easing didn’t
work because we didn’t do enough of it. Negative interest rates aren’t working
because we haven’t gone low enough.
Clearly,
QE has not worked. We have not had one year of 3%+ growth since the Great
Recession and are barely averaging 2%. Yes, if your measure is the stock market
and other financial assets that have inflated, then QE has worked quite well.
But the boost QE was supposed to deliver just hasn’t reached Main Street. One
of the basic tenets of QE and other related policies is that if you want to
increase consumption, you lower the cost of borrowing. But if out-of-control
borrowing was the original problem, then QE as a solution is kind of like
drinking more whiskey in order to sober up. And if you reduce the earnings of
those who are savers so that they are no longer able to spend, the whole
purpose of the original project – to foster economic growth – is defeated. But
we can’t acknowledge that, because if we did, we’d have to admit that our
theories don’t work. And we all know, because God knows, that our theories are
correct.
The
theme of negative interest rates is one we are going to come back to again and
again. We have little idea what NIRP’s unintended consequences to our
portfolios and to our businesses will ultimately be, but we had better start
thinking them through.
I know
we have been pushing early registration for my conference rather heavily in the
past few weeks, and I want to thank the large number of people who have already
signed up. It is going to be a dynamite conference. I really am putting
together a fabulous lineup to discuss critical economic trends and policies like
the ones we covered in this letter. And we will have a fair representation of
those who believe that QE has been precisely what was needed and has been
successful. We will get both sides of the argument. I am really not so much
interested in trying to determine the correctness of one belief or another at
the conference as I am in discerning the practical implications for our
investment portfolios and discussing how those of us who are in the money
management business need to position our clients. NIRP-proofing our portfolios
is a most vexing conundrum.
Wednesday
we fly to the Cayman Islands, where I’ll speak at the Cayman
Alternative Investment Summit, one of the biggest hedge fund and
alternative investment gatherings outside of the US. They have an impressive
lineup of speakers, and I note that this year the celebrity guest speakers are
Jay Leno and the star of my all-time favorite movie, Trading Places – Jamie Lee
Curtis. That should be fun. I just looked through the speaker list and noticed
that Pippa Malmgren, who will also be at my SIC conference, is speaking, and it
will be fun to catch up with her again. I will be on a panel (moderated by KPMG
chief economist Constance Hunter) with old and brilliant friends Nouriel
Roubini and Raoul Pal. At least I know that with those two guys there is no
need to wear a tie. Don’t tell the conference organizers this, but I will
probably be paid more per word for this panel than I have ever been paid in my
life. That is because with these three I will be lucky to get a word in
edgewise.
Theoretically,
unless the Chinese central bank decides to go to negative rates, I will write
about oil next week.
Your
going to watch the Iowa returns closely analyst,
John Mauldin
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