Why Central Banks And Governments Will Both Fail In Fighting Deflation

by: Global Opportunities Analyst

 
Private deleveraging started in the US after the financial crisis but it didn't lead to deflation because China, and its massive credit binge, saved the world.

China is no longer the savior, but rather seems to be (for good reasons) the greatest deflationary threat in the horizon.

Governments will have to take over the job of fighting deflation from central bankers. And they will do so mostly through tax cuts for consumers.

Tax cuts for consumers will make the burden of debt easier, transferring it to governments, but that will not constrain deflation.

Risk asset prices fall in a deflationary environment, making the stock market a bad choice for investing. The situation will be worst for banks and indebted corporations.
 
This is not necessarily a continuation, but rather an important part of the same issue I discussed in a previous article. There I argued that the Fed (followed by other central banks all around the world) has, since 1980, encouraged more private indebtedness in the economy, by making credit ever more accessible, cutting rates with the occasion of every economic slowdown. This strategy produced benign inflation for decades, associated with economic growth, all underpinned by a massive credit expansion, outpacing GDP growth significantly.

The subject of this article is to show why central bank and government attempts will fail in fighting deflation in the Developed world.

Why do we reach deflation anyway, as the decades-long struggle in Japan, and a more recent battle in Europe, suggest? It's a rather simple mathematical equation, where the formation of a credit cycle is associated with inflation, and then automatically its rolling back is supposed to be associated with deflation. But everybody seems to like the inflation that is caused by credit expansion, but they don't want to deal with paying back the debt at some point, and that is automatically going to be the reversal, hence deflation. It is important to understand how credit expansion, which has been going on for decades in the world as a whole, has been producing inflation, to also understand how its reversal is supposed to produce the opposite, deflation.

When there is an environment of credit expansion, consumers borrow money from banks, or from other sources, and spend it on buying things, usually expensive items that most people cannot afford to buy with hard cash, like houses and cars, or even vacations. Businesses use borrowed money to invest in expanding their production capacity and quality, both of which are intended to increase productivity. Both these actions, taken by consumers and businesses alike, trickle down into the economy, where existing capacity in offering goods and services cannot satisfy increased demand, therefore aggregate prices rise in goods and services so that supply meets higher demand. This phenomenon of balancing between demand and supply, through a rise in aggregate prices, is called inflation. When, for some reasons, credit expansion reverses on aggregate, meaning that consumers and businesses don't take on new debt, and older debt mature (hence credit contraction), that automatically leads to less aggregate consumer, and business, spending. And this leads to the reverse consequence, of falling prices - deflation.

As the chart below demonstrates, almost 250% private debt to GDP is currently outstanding in the US, the remaining 100% or so being government debt.



Despite a private sector deleveraging in the US since the financial crisis, there hasn't been a fall in aggregate demand, and up until recently there has also been a reasonable amount of inflation. This can, theoretically, be the simplest debunking of the theory that deleveraging is supposed to be deflationary. But I believe the analysis is erroneous to only look at the US domestic picture. I believe that the real reason we have not seen the deflationary repercussions of the recent aggregate private deleveraging (though mild) in the US has been China (and to a smaller extent, up until 2014, also other Emerging economies). Keeping interest rates at zero, and lowering long term interest rates through QE (Quantitative Easing), have also helped, but the chart above clearly shows that private debt levels have slightly fallen. So they haven't done what they used to do up until 2008 - push private indebtedness to new highs against the GDP.

China, in order to achieve its official growth targets, embarked on the world's most aggressive credit expansion ever after the financial crisis, coupled with a strengthening currency up until 2014 (like the rest of the Emerging economies), sent a significant amount of inflationary pressures all around the world. And Chinese credit expansion has not been halted (let alone reversed) yet. What has happened though is that any credit expansion, at some point, reaches its limits, leading to gross misallocations. These misallocations, in the past, have been overcome by monetary easing (rate cuts, and more recently QE), which has (time and time again, for 30 odd years) pushed for further private indebtedness, creating additional, greater, demand.

Interest rates being at (or even below, in Europe and Japan) their limits in the Developed world, Chinese credit expansion is not finding enough additional demand, because Developed economies cannot create new credit expansion, hence more demand, any longer. Some would ask, why China's domestic credit expansion would create inflation in the rest of the world?

Because it has been (and is still ongoing) so massive. China used to be a rather small economy a decade ago, but it is the world's second largest economy now, and its currency has appreciated against the US dollar since 2005, a phenomenon which has been inflationary for the rest of the world - China could afford to buy more goods, assets, and services from other countries. And China's credit expansion, has been extraordinary (chart below).




The real issue here is not exactly how the chart (above) looks, but rather the numbers behind it.

According to a McKinsey report in late 2014, China's private debt to GDP levels were almost at 230% to GDP, a figure which is likely to be significantly higher now. But let's stick with this figure, and apply it to China's current GDP of about $11 trillion. According to the same McKinsey report, China's private debt to GDP was less than 120% before the financial crisis.

This equation shows an added private debt of over $20 trillion in just 7 years. This amount - greater than America's GDP - is sure to have an inflationary impact while it is being added, not just inside China, but also outside of it, especially when it has been associated with a strengthening yuan. China is still adding to its debts, but its credit expansion is no longer large enough to counter the natural deflationary tendency of capital misallocations that have been created. Credit expansion, in order to be sustained, needs to be followed by ever greater credit expansion. Otherwise, it is naturally inclined to lead to deflation.

Credit expansion, especially in the business sector, where jobs are created, leads to productivity growth, and in case demand does not outpace productivity growth, the natural tendency will be for prices to fall. The world is on the verge of another contraction in productivity because of falling prices, as misallocations (for example in commodities and energy) are abound. This happens once every few years, in various forms, leading to economic contractions (or recessions). Recent examples are 2001-2002 and 2008-2009. The world needs greater demand, which has for decades been created through credit expansion. Central bankers are no longer able to provide the world economy with additional demand through encouraging more indebtedness. It can no longer be done because interest rates cannot go below zero. Even if, theoretically, they do go below zero (as they have done in Europe and more recently in Japan), that will not encourage further credit expansion. How can you, realistically, encourage businesses to take on more debt because you take interest rates below zero? It doesn't make sense to businesses, because they still need to pay positive interest on their loans. Banks would not be willing to lend for zero interest. It would make no economic sense. Negative interest rates can only hurt banks and consumers by taking away some of their capital. It can also lead to speculation as investors would flee cash to real estate or other possibilities (gold and bitcoin for example) where they believe their capital is safe from negative interest rates.

Now that central bankers are unable to extend credit expansion, through more monetary 'easing' (meaning continuously reducing interest rates, short term and longer term), how will we counter a disastrous deflationary recession? The answer can be found in Japan, though probably in a more dramatic way, since there will no longer be the luxury Japan had in a still strong and growing export market. In the absence of monetary prowess, governments will have to replace central banks, and the easiest way to do it will be through individual income tax cuts.

This is the easiest way to reach the pockets of the ordinary consumers. This policy will be applied only after a deflationary recession will have hit, which will mean falling stocks and real estate. But I don't see how it can be applied to Europe where there is no common fiscal authority and no common debt. Europe will face a real existential question!

Most debts are linked to real estate and stock prices, one way or another. A fall in their values will be very discouraging in itself for consumers. A tax cut directed at consumers will not result in them spending the extra money. US household debt is currently above $12 trillion, of which almost 70% are in mortgages. This is an average debt per household of about $96,000, since there are almost 125 million households in the US. Would anybody realistically think that tax cuts will translate into increased consumption rather than reduced debt? Of course any tax cuts, in a recession where there is so much household debt, would facilitate debt repayment rather than create more consumption. And it would be a reasonable and wise decision.

Therefore, obviously, in the absence of an aggregate rise in consumption, deflation will continue unabated, though its repercussions will be much milder, because the number of delinquencies would be smaller as tax cuts would offer some relief for most of the indebted. Tax cuts will lead to huge government deficits, and unprecedented public debt, but that is not necessarily a major issue when interest rates are almost at zero and central bankers can keep buying government debt with printed money (QE). Japan has reached a public debt of more than 230% of GDP and its debt yields are smaller than much stronger and more fiscally conservative governments like the US and Germany! In a future of private deleveraging, and therefore deflation, fiscal profligacy will pretty much be the name of the game, and it will all, eventually, lead to currency valuations, deciding which economy is doing better or worse. Economies which will require much larger government fiscal expansion will have much weaker currencies, and those with less need of fiscal profligacy will have stronger currencies. But in the end, risk assets (real estate, stocks, corporate bonds etc.) and consumer prices will keep falling (at least in Developed economies), as there is no way of fighting it. Deflation will at some point come to an end, as governments will have taken over most of the debt from the private sector, but that has never happened in a global scale before and it is impossible to hypothesize when that will happen. It hasn't happened in Japan after more than 20 years and despite all their efforts. But Japanese private debt was bigger (to GDP) in early 1990s than what is the case now in the US and Europe. Emerging economies may see the opposite (high inflation) because of too much currency devaluation. In case governments would not act to cut taxes (which is very unlikely), deflation would be severe but it would be over relatively quickly (because of mass bankruptcies of indebted businesses) instead of being stretched for probably more than a decade, or a few, as has been the case in Japan until now. But non-intervention by governments in the face of deflation would lead to mass bankruptcies and unemployment, and nothing short of the 1930s depression.

What is to do in such an environment as an investor? I have argued for buying US Treasuries before, and I believe they still present the best choice out there. Government debt yields in developed economies (except southern Europe, as long as they have the euro) will eventually converge to zero, and this means good news for US Treasuries at this moment. Investing in risk assets has worked fine for decades, thanks to ever increasing leverage. Maybe it's time to be divesting (as opposed to investing) as the tide is going to turn, and leveraging will turn into deleveraging. This would practically mean shorting the market. Most people still believe that all central bank and government efforts against deflation will eventually succeed and that will be good news for stocks. That worked after 2008, as I explained, because of the China factor.

China is beyond loaded at this moment, and it will most likely have the opposite effect from now on. I believe that businesses most tied to debt will suffer worst. This would first of all mean banks, and then businesses with significant debts. A deflationary environment is a nightmare for debtor businesses as their products and services become cheaper, pushing down their revenues and earnings, while their debts either remain constant (best case) or become more expensive, in case they need to tap into new debt. This has already been happening in the US for more than a year, and it has, kindly, been called an earnings recession by the media. And this earnings contraction has been somewhat countered by corporations through more debt, which has gone to share buybacks and M&A (mergers and acquisitions).


The fallout from low interest rates (1)

Nope to NIRP
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Kuroda corrodes the Banks


UNTIL this month bond traders were the most voluble complainers about the Bank of Japan’s vast programme of quantitative easing (creating money to buy bonds). The central bank’s interventions had slashed trading volumes in their market. But their gripes had a tiny audience and, understandably, received scant sympathy. Things have changed with the central bank’s new negative interest-rate policy (NIRP), which went into effect on February 16th. It has pummelled banks and spooked Mrs Watanabe, the archetypal Japanese saver. Fans of the new policy are hard to find.

For around two trading days after the BoJ announced on January 29th that some bank reserves would be charged -0.1%, financial markets responded as intended—the yen weakened and the Nikkei 225 share index rose. Then, with the European Central Bank hinting at an extension of its own negative-rate policy, investors sought safety in the yen, which rose sharply.

In turn that dragged down the stockmarket, since Japan’s exporting giants may earn less if their competitive position is eroded.

Even after a rally on February 15th, when the Nikkei rose by 7.2%, the stockmarket is down by 9.6% since the BoJ’s announcement of negative rates; the yen is 5.9% higher against the dollar. Stocks were not helped by news that GDP contracted by an annualised 1.4% in the fourth quarter, chiefly because of weak consumption.

The chief surprise for the BoJ was that banking stocks fell even faster than the overall market, with the drop coming close to 24%. The direct effect on banks’ profits is limited. For now, the central bank’s negative-rate policy applies to only ¥23 trillion ($200 billion) out of the ¥253 trillion that banks have parked with it. A further ¥24 trillion will earn 0%, and the rest will continue to earn 0.1%. But the BoJ may not have thought as much about the indirect effect on their business models, says Naohiko Baba of Goldman Sachs.

Sharply lower long-term interest rates—the ten-year government-bond yield briefly dipped into minus territory (see chart), alongside overnight interbank rates—mean a sharp squeeze on net interest margins for all banks when profits from lending have already gone down. There is little room to shield margins. Deposit rates are wafer-thin; banks are unlikely to charge retail customers for parking their funds.
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Standard & Poor’s, a rating agency, expects profits at the five largest Japanese banks to fall by 8% over the next year or so and by 15% at regional banks, which are more dependent on their traditional lending businesses. A profits crisis among Japan’s 100-odd small local lenders may be just what the regulator ordered, since it is trying to consolidate them, but it probably had a smoother process in mind.

If the BoJ ventures further into negative territory in order to reach its target for sustained inflation of 2%, the impact on big banks could become too pronounced for comfort. The governor, Haruhiko Kuroda, would probably like to bring rates to levels similar to those of some European central banks, at perhaps -0.5% or lower. Negative rates are a potent new means of easing when the BoJ may face limits on expanding its bond purchases from its current ¥80 trillion a year. It now owns around a third of Japanese government bonds. Expanding purchases to around ¥100 trillion is probably as far as it can go.

Japan’s big banks have the capital and profits to withstand a squeeze. If, as the BoJ wishes, they are prompted to expand bargain-basement loans to companies and consumers, they will help stimulate the economy. Several are already lowering mortgage rates, sparking hopes for further house-price rises. Yet banking chiefs, who have until now supported the BoJ’s monetary easing, are likely to use their considerable influence to lobby against a further descent into the red.

Many ordinary savers, meanwhile, view the central bank’s move as a portent of unstable times.

Elderly deposit customers remember the time, after the second world war, when the government restricted cash withdrawals from banks and taxed deposits to pay off debts, notes Izuru Kato of Totan Research in Tokyo. Shopping malls in the capital are urging the merits of safety deposit boxes just in case commercial banks do impose negative rates, and they are selling well. A handful of local banks, such as Onga Shinkin Bank in Fukuoka prefecture, have defied the central bank with a rise in deposit rates to reassure their nervous customers.

Given the volatility associated with the introduction of negative rates, the BoJ has indicated that it will gauge the market’s mood before lowering them further. The turmoil is also prompting questions about the policies of Shinzo Abe, the prime minister. If monetary easing is reaching its limits, fiscal policy may be needed to try to revive the economy. Mr Abe’s advisers are once again strongly urging the postponement of a second increase in the consumption tax, or VAT, which is due in April 2017.

The rise has already been delayed once. Hawks at the Ministry of Finance are fighting hard against the possibility. But such a step would please almost everyone else, unlike negative rates.


Trump’s hostile takeover is on course with South Carolina


Property magnate’s bid to control the Republican party takes a step closer to fruition
 
‘Nothing is easy about running for president. It’s tough, it’s nasty, its mean, it’s vicious. It’s beautiful,’ said Donald Trump©Getty
‘Nothing is easy about running for president. It’s tough, it’s nasty, its mean, it’s vicious. It’s beautiful,’ said Donald Trump
 
 
Much like Donald Trump, facts are stubborn things. No Republican has ever won both New Hampshire and South Carolina and failed to win the nomination. Yet two earth-shattering victories later, swaths of the Republican establishment continue to think Mr Trump will prove an exception to that rule.
 
As it happens, they thought his campaign would implode six months ago. The last to know are always those in charge. This is how C-suites react to hostile bids. First there is denial. Then anger. Then bargaining. Eventually they succumb to depression.

In the case of Mr Trump, Republicans might as well jump straight to the latter. It is hard to overstate how emphatically the party’s rank and file have repudiated their leaders in the past two weeks.
It is likely to get worse. On Tuesday, Mr Trump will almost certainly sweep Nevada, according to the polls. A week later most of the Bible Belt will vote in the Super Tuesday primaries on March 1 that will select a huge slate of delegates. With almost three-quarters of voters declaring themselves evangelical, South Carolina was about as biblical as a primary could be.
Not only did Mr Trump win 43 per cent of evangelical voters, according to exit polls. He won many more than his scripture-quoting rival, Ted Cruz. The portents for Texas, the most important state on Super Tuesday, look ominous.

To underline, the overtly Christian Mr Cruz lost hands down among socially conservative voters to a thrice-married, Pope-insulting, profanity-spewing, casino-owning mogul from New York.

Ben Carson, the other evangelical, did not clear double digits. “I am not going anywhere,” said Mr Carson. He spoke the truth. That is uncomfortable fact number one. Mr Trump reaches hitherto unsuspected corners of the evangelical mind.

Awkward fact number two hits even closer to the establishment nerve. Outside of the deep south, South Carolina is the state with the highest ratio of military bases to voters.

It strongly favoured George W Bush in 2000, his father, George HW Bush in 1988 and Ronald Reagan in 1980. It is the kind of place that backs whatever war happens to be going. It was the perfect venue for Jeb Bush’s comeback. He spent a lot of money there and enlisted his brother, George W, and his mother, former first lady, Barbara Bush, to help on the campaign trail.

Moreover, Mr Trump gave the House of Bush its perfect rallying cry at the Republican debate last week when he declared the Iraq war to have been a “big fat mistake”. He added: “They lied when they said there were weapons of mass destruction. There were none and they knew there were none.”

Finally, said the establishment, he had gone too far.

Mr Trump took four times as many votes as Mr Bush in South Carolina. Indeed, he took more than Mr Bush and Marco Rubio, the establishment favourite, combined. In his farewell speech on Saturday night, Mr Bush called on his unnamed rivals to act with “honour and decency”. He might as well have asked Mr Trump to join a monastic order.

But it is painful fact number three that most confounds the Republican establishment: Mr Trump is not a conservative. People can legitimately call him many things. He is Islamophobic. He is anti-immigrant. He is an affront to all forms of political correctness. But he is not a conservative. Alone in the Republican field, Mr Trump has vowed to protect US social security, Medicare and other federal entitlements from cuts. This is as close as it comes to heresy in ideological circles. He will also make hedge funds pay the same taxes as everyone else.

Furthermore, “The Donald” last week praised a key plank in the Affordable Care Act — otherwise known as Obamacare — that mandates every American to buy health insurance. He since disavowed those remarks. Yet the mere hint of such would be enough to trigger a successful primary challenge against a Republican legislator. Mr Trump got away with it. He does not preach the virtues of small government. Could it be that The Donald knows something about Republican voters that its leaders do not?

The answer is obviously yes. Does that mean he has the nomination? Not necessarily.

Panglossians are now pinning all hopes on Mr Rubio whom they believe could aggregate all anti-Trump voters under his banner. Mr Rubio’s chances cannot be ruled out.

Trump sceptics point out that he has a “high floor” of roughly a quarter of the Republican vote but a “low ceiling” of about a third. If Mr Rubio could sweep up everyone else, the Republican party as we know it would live to fight another day. But there are a lot of leaps of faith in that bet. The biggest is that Mr Cruz will drop out of the race and that all his evangelical supporters will go to Mr Rubio.
 
Both are rash assumptions. Equally possible is that Mr Trump will win Mr Cruz’s home state of Texas on March 1 and Mr Rubio’s home state of Florida on March 15. Polls suggest that he will. In which case it would be game over.

Either way, Mr Trump is very much the man to beat. In order to do so, Messrs Cruz and Rubio will need to take this already unpleasant contest to a whole new pitch. As Mr Trump said on Saturday night: “It’s tough, it’s nasty, it’s mean, it’s vicious. It’s beautiful.”


Grow, Baby, Grow!

Republicans have a great message about economic growth for middle America. Why make it so boring?

By William McGurn



Photo: Getty Images/istock
 

Why can’t Republicans talk about economic growth the way Bernie Sanders talks about his potted socialism or Donald Trump about making America great again: with an enthusiasm that connects with ordinary Americans?

Take Mitt Romney. In his 2012 run for president, Mr. Romney’s days as a partner at Bain Capital led to his being caricatured as a real-life Gordon “Greed Is Good” Gekko. Mr. Romney responded by playing his opponent’s game, emphasizing, for example, how his plan would ensure that the top 1% income earners would pay no less and possibly even more than they were paying.

By going on defense, Mr. Romney allowed Democrats to define his Bain years as a time when he destroyed lives rather than rescued companies. His greatest strength became his greatest weakness. And amid the wreckage of the election results, we learned that he lost to Barack Obama 81% to 18% on the question “cares about people like me.”

It’s not looking much better today, at least judging from the way the Republican candidates spoke about economic growth during Saturday night’s debate in South Carolina. Almost all checked the right boxes—lower taxes, smaller government, and so on. But they sound as dry and distant as Ben Stein’s high school Econ teacher in “Ferris Bueller’s Day Off,” boring his students out of their skulls as he drones on about the Smoot-Hawley tariff and the Laffer curve.

The tragedy is that the GOP’s rhetorical flatness comes at a moment when economic growth ought to be the heart of the Republican attack. After all, since 2000 the economy has been limping along at a tepid average annual growth rate of 2%. By contrast, in the half-century before that, the economy averaged 3.5% annual growth.

Hint: It’s not about numbers. The issue is the damage that low growth inflicts on possibility and aspirations and a ladder up. And the huge improvement in life for the Ordinary Joe if we could bump up that growth just one percentage point.

John Cochrane, an economist at Stanford’s Hoover Institution, highlights what’s at stake in an essay that can be found on his blog, the Grumpy Economist. The most striking fact from that essay? From 1952 to 2000, real income per person in the U.S. rose from $16,000 to $50,000.

Think about that. That’s more than doubling the standard of living for the average American.

Here’s the kicker: If over that same period of time the U.S. economy had been growing at our present 2% rate, real income per person in 2000 would have been only $23,000, not $50,000.

In other words, a growing economy means a growing standard of living. In human terms, that 3.5% growth from 1950 to 2000 translated into more dreams fulfilled for more Americans, whether that meant a college degree, a home in a decent neighborhood, or just the certainty that your children would do even better than you did. Not to mention the national wherewithal to do everything from tackling disease to providing for a military strong enough to meet America’s many challenges around the globe.

Now consider the future. In a back-of-the-envelope calculation that assumes a modest 1% boost in population, Mr. Cochrane worked out the difference between a U.S. economy whose GDP grows at 2% (the “new normal”) over the next eight years or one that grows at 3% (better than what we have, but by no means pie in the sky). For a guy earning $50,000 a year, with 2% average GDP growth, his income would rise to $54,400 in eight years. With 3% GDP growth, it’s $58,675.

The point is, small marginal gains in economic growth translate into huge gains for the American people. Better yet, this growth is compounded—like getting a raise year after year.

“Next to this increase in the standard of living, nothing the candidates are talking about—monetary policy, Fed, fiscal stimulus, minimum wage hikes, pay equity, and so on—even comes close to what growth can bring ordinary Americans,” says Mr. Cochrane.

This is the Republican answer to all those Democratic promises of new goodies, whether it’s Bernie Sanders saying college will be free or Hillary Clinton promising paid family leave. Most Republicans understand that jacking up taxes to expand social spending is a sucker’s bet. But most Republicans are not yet fluent in a language of growth and opportunity that goes far beyond vows of “creating jobs.”

The dominant narrative today holds that economic growth is something that benefits only hedge-fund managers and Wall Street. In fact, a booming economy is the Ordinary Joe’s only real hope for a better future for himself and his family, and this future withers when growth is anemic. This presidential campaign still awaits the Republican with the wit and vision to make that case effectively to the American people.


The Inequality Puzzle

Dambisa Moyo

 Broken jigsaw puzzle

NEW YORK – Over the past decade, income inequality has come to be ranked alongside terrorism, climate change, pandemics, and economic stagnation as one of the most urgent issues on the international policy agenda. And yet, despite all the attention, few potentially effective solutions have been proposed. Identifying the best policies for reducing inequality remains a puzzle.
 
To understand why the problem confounds policymakers, it is helpful to compare the world’s two largest economies. The United States is a liberal democracy with a market-based economy, in which the factors of production are privately owned. China, by contrast, is governed by a political class that holds democracy in contempt. Its economy – despite decades of pro-market reforms – continues to be defined by heavy state intervention.
 
But despite their radically different political and economic systems, the two countries have roughly the same level of income inequality. Each country’s Gini coefficient – the most commonly used measure of income equality – is roughly 0.47.
 
In one important way, however, their situations are very different. In the US, inequality is rapidly worsening. In 1978, the top 1% of the US population was ten times richer than the rest of the country. Today, the average income of the top 1% is roughly 30 times that of the average person in the remaining 99%. During the same period, inequality in China has been declining.
 
This poses a challenge for policymakers. Free market capitalism has proved itself to be the best system for driving income growth and creating a large economic surplus. And yet, when it comes to the distribution of income, it performs far less well.
 
Most democratic societies have attempted to address the problem through left-leaning redistributive policies or right-leaning supply-side approaches. But neither seems to be particularly effective. In the US, income inequality has steadily widened under both Democratic and Republican administrations. China’s success in this arena points to the possible advantages of its heavy-handed system – a conclusion that makes many Western policymakers uncomfortable.
 
One aspect of the discussion, however, need not be so controversial. Adding to the challenges of the policy debate are assertions that inequality is unimportant. If a rising tide is lifting all boats, the thinking goes, it doesn’t matter that some may be rising more slowly than others.
 
Those who argue for de-emphasizing income inequality maintain that public policy should seek to ensure that all citizens enjoy basic living standards – nutritious food, adequate shelter, quality health care, and modern infrastructure – rather than aiming to narrow the gap between rich and poor. Indeed, some contend that income inequality drives economic growth and that redistributive transfers weaken the incentive to work, in turn depressing productivity, reducing investment, and ultimately harming the wider community.
 
But societies do not flourish on economic growth alone. They suffer when the poor are unable to see a path toward betterment. Social mobility in the US (and elsewhere) has been declining, undermining faith in the “American Dream” (which includes the belief that hard work will make one better off than one’s parents). Over the past 30 years, the probability that an American born into the bottom quartile of the income distribution will end his life in the top quartile has more than halved.
 
To be sure, much progress has been made. Over the past 50 years, as countries such as China and India posted double-digit economic growth, the global Gini coefficient dropped from 0.65 to 0.55. But further headway is unlikely – at least for the foreseeable future.
 
Economic growth in most emerging economies has slowed below 7%, the threshold needed to double per capita income in a single generation. In many countries, the rate has fallen below the point at which it is likely to make a significant dent in poverty.
 
This bleak economic outlook has serious consequences. Widening inequality provides fodder for political unrest, as citizens watch their prospects decline. Reports that just 158 wealthy donors provided half of all campaign contributions in the first phase of the 2016 US presidential election cycle highlight the worry that income inequality can lead to political inequality.
 
Globally, the slowdown in economic convergence has similar implications, as richer countries maintain their outsize influence around the world – leading to disaffection and radicalization among the poor. As difficult a puzzle as income inequality may seem today, failing to solve it could lead to far more severe challenges.
 


Precious Metal's War: Central Bankers Have Not Lost and Never Will

By: Sol Palha
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"An empty head is not really empty; it is stuffed with rubbish. Hence the difficulty of forcing anything into an empty head."

~ Eric Hoffer


They might lose a battle or two, but war is a composition of battles, and when it comes to war, these guys never lose as their principle is simple. Take no prisoners, shoot to kill and ask questions only if the enemy survives the onslaught of bullets. This would be a good time to read the book "the art of war" by Sun Tzu.

All along we have stated that the world is the midst of a full-blown currency war: Japan just upped the ante by cutting rates into negative territory, and Sweden has driven the knife deeper in by pushing negative rates even lower. In fact, Sweden has stated that they are prepared to do this, till inflation is at the 2% mark. Interest rates are -0.5% currently, so one wonders how low rates will have to drop for them to hit this pie in the sky inflation target of 2%

This going to put pressure on China and a host of other nations to take the same route; the velocity of the "devalue or die" currency war game has increased five-fold. It won't be long before the Fed is forced to take a similar path. Start paying attention to the news, for our central bankers are suddenly going to start listing a slew of factors to backtrack on their claims that the economy was sound. Many Gold bugs have been stating that the central bankers are running out of room to manoeuvre; our response to this is a dream on. Look at the stunning rally the markets mounted when BOJ (Bank of Japan) fired its latest shot. The only day the central bankers will run out of ammunition is the day the masses wake up and that day is sadly still a long way in the making. Central bankers don't need to continuously lower rates; they can simply flood the markets with money while maintaining an ultra-low rate environment. What's another 1-2 trillion dollars when our debt is now over $19 trillion?

What has changed between 2000 and 2016; our debt in 2000 was significantly lower, and it was even lower in 1990; from the 1980's the debt has tacked on roughly $17.6 trillion dollars and the masses are still quiet.

The short answer is that nothing has changed other than the level of the misery individuals are forced to endure. 76% of families are living from pay check to pay check, does that signify an improving economy for you. It seems that this phenomenon is not restricted to the poor only, according to CBS 33% of families earning 75,000 per year are living from pay check to pay check.

Today the average hourly salary is approximate $25.00 an hour. Do you know that $22.41 today has the same buying power as $4.03 which was the average salary in 1973? So $25.00 has roughly the buying power of less than $5.00. Welcome to the nefarious and deadly game of inflation. Things are only going to get worse; the dollar amount might look like it's trending upwards, but individuals are working more for a lot less; to solve a problem you have to understand the problem, the masses are blind to the concept of inflation. They are caught up in a vicious game of just trying to pay the bills and survive. They hardly look up to see what is going on. This sort of like Plato's allegory of the cave; if you are unfamiliar with this famous concept, you can view it here

Against this backdrop, we can safely state that the Fed is omnipotent and that those gold bugs and hard money experts are smoking some strong medicine that they need to get off immediately when they falsely assume that Gold will surge to the moon simply because the Fed has the pedal to the metal. We believe in the concept of hard money, and we believe that the world would be a better place if central bankers adhered to such rules. However, we are not fools as we understand that being right does not equate to success in the markets. The key to the markets are the masses, and the masses believe that the Fed and the government can solve their problems.

Until they think otherwise, the Gold bugs and the hard money experts will experience small moments of victory followed by massive periods of punishment. This is why they cannot understand why gold and the precious metals sector have taken a beating since 2011. Gold will rise again, but then any crappy sector can have its day in the sun given enough of time. This is why it is dangerous to be a Gold bug, for they assume that precious metals can rise forever in price. They will make the same mistake during the next Bull Run in metals. No market can simply trend upwards forever; the only exception being stupidity; it has been in a perpetual bull market, and there are no signs of even a small correction.


Main Point to keep in mind

Central bankers have not run out of firepower, in fact, we think they are so cocky now that they have just barely started to fire their bullets. So far they have been using pistols and rifles; they are about to transition to machine guns. The masses are sedated, so this process of pillaging the populace will go on for a long period. Translation; very strong market corrections or as the naysayers would have you believe "market crashes" have to be viewed as buying opportunities.

Game Plan For precious metals

We are not stating that Gold and Silver will not have their day in the sun again. In fact, we still hold onto the view that Gold could trade high as $5,000 and silver north of $200. We have still not had the feeding frenzy stage; in other words, the masses did not participate in the last Bull Run that ended in 2011. However, do not assume that Gold or for that matter any market will trend upwards forever. At this point of the game, it makes sense to deploy some money into Bullion. Until there is a clear signal that a bottom is in place, it would be wise to limit your foray into Gold stocks.


"Strange as it may seem, no amount of learning can cure stupidity, and formal education positively fortifies it."

 ~ Stephen Vizinczey


Ray Dalio: What Monetary Policy 3 Will Look Like

by: ValueWalk


Summary
 
- Monetary Policy 1 was via interest rates.

- Monetary Policy 2 was via quantitative easing.

- It will be important for policy makers and us as investors to envision what Monetary Policy 3 will look like.

- Monetary Policy 3 will have to be directed at spenders more than at investors/savers.
 
By Mark Melin
 
 
As Ray Dalio's end of the debt super-cycle is playing itself in real time, with upside and downside volatility playing itself out as predicted, he notes the impact of quantitative easing and monetary policy in general is having less impact the further into debt cycle the economy travels. There is still currency moves to take place - and currency is perhaps the one area where stimulus will have the most significant economic impact.
 
If one is an investor or saver, these are difficult times as "pushing on a string" perhaps has multiple meanings - the specter of negative interest rates is on the horizon. It is through the eyes of investors/savers and borrowers/spenders that Dalio considers this rather odd moment in history. From many perspectives, success has been pulled from the future to the present. The question is: how long can this last?
 
The machine of how currencies, interest rates and modern economies work together can at times look like a dysfunctional family where the fight for parental attention can at times reach new and destructive lows, while at other times the kids seem like angels and the economy is on a fairytale track. It is in this sycophantic market environment that Dalio attempts to explain the economic forces that are converging to make history. ValueWalk has obtained an advance copy of a note which Ray Dalio will be releasing publicly later today. Below readers can find the entire memo (which was originally a lengthier Daily Observations note sent to clients on February 12th).
 
------------------------------------------------------------------------------
 
What Monetary Policy 3 Will Look Like
 
By Ray Dalio
 
Monetary Policy 1 was via interest rates. Monetary Policy 2 was via quantitative easing. It will be important for policy makers and us as investors to envision what Monetary Policy 3 (MP3) will look like.

While monetary policy in the US/dollar has not fully run its course and lowering interest rates and quantitative easing can still rally markets and boost the economy a bit, the Fed's ability to stimulate via these tools is weaker than it has ever been. The BoJ's and ECB's abilities are even weaker. As a result, central banks will increasingly be "pushing on a string." Let's take just a moment to review the mechanics of why and then go on to see what MP3 will look like.
 
Why "Pushing on a String"?
 
Lending in order to finance spending requires both investors/savers and borrowers/spenders, who have very different objectives, to each operate in both their own interests and in a symbiotic way. For example, when a debt expansion that finances spending on goods and services takes place, both a) the investors/savers increase their debt holdings because they believe that they are increasing their assets, and b) the borrowers produce those borrowings (that investors/savers call an 'asset') to increase their spending. When both are going on in a big way (i.e., when debts, financial assets, and spending are rising fast), we have a boom. However, because both savers and borrowers often don't do the calculations very well to determine whether the debt created will be used to produce more than enough income to service the debts, we also have busts. So, to understand how central banks' monetary policies work, one has to see things through the eyes of both investors/savers and borrowers/spenders.
 
I will look at the process from the investment side, as that is now more important because central bank policies, especially quantitative easing, have their effects more by affecting the behavior of investors/savers than by affecting the behavior of borrowers/spenders. When the central bank buys a bond, it does so from a saver/investor who takes the cash to make an alternative investment decision.
 
What they invest/save in makes all the difference in the world. When investing/saving is in the sort of assets that finance spending, that stimulates the economy. However, when investing in that sort of asset is unattractive, which is what happens when the "risk premiums" are low and/or investors are scared, it does not. To the extent that interest rates decline, that also has a positive effect on all asset prices because all investments are exchanges of lump sum payments for a stream of future cash flows, and the interest rate (i.e., the discount rate) is the rate that is used to calculate the present value of these cash flows. All else being equal, the more interest rates are pushed down, the more asset prices will be pushed up. That is how monetary policy now Works. 
 
So, Where Do Things Now Stand?
 
The discount rate is just about as compressed as it can be, so the potential present value effect of lowering it is nearly at its end. That's a big thing. In terms of the risk premiums of "risky assets," they're now neither especially high nor low, so there is a bit more to be squeezed out of them, more so in the US than elsewhere. Put these two pieces together and it's clear that the future returns of assets will be low, which will be a problem given what the returns need to be to meet our future obligations. Though not pressing, that issue is something that central banks will have to deal with, which helps to inform the picture of what MP3 will probably look like - i.e., they will need more "money printing." From the perspective of an investor, if you look at the level of the returns relative to levels of volatility, the expected reward-risk could make those who are long a lot of assets view that terrible-returning asset called cash as appealing.
 
To clarify, take current bond yields (less than 2%) and cash (0%) and compare that to something like a 4% expected return on equities. Because of volatility, the 4% expected annual return pick up of equities over cash, or 2% over bonds, can be lost in a day or two. (For example, stocks fell by nearly 5% in a week earlier this month.) And then there is the feedback loop where a sell-off in the stock market in turn has a negative pass-through effect on the rate of economic activity. All that makes for asymmetric risks on the downside in the US - and the pictures in other countries are even more asymmetrical on the downside, as their interest rates are even lower and their risk premiums are nearly gone.
 
The mechanics of how currencies, interest rates, and economies work together is also important to understand at this time as they will have a big effect. Remember that all debt is a promise to deliver a specific currency, so when the currency gets more or less valuable, it affects people's behaviors. That is true now more than ever because those who have money are exposed to alternative currencies to keep their wealth in (or to borrow in) and because the major currency systems are all in fiat currency.
 
So more money than ever will move from one currency to another, or from currencies to other assets (e.g. gold), based on what people are thinking about how the values of currencies will change. Also we should expect currency volatility to be greater than normal because 1) when interest rates can't be lowered and relative interest rates can't be changed, currency movements must be larger, and 2) when both relative interest rates and relative currency movements are locked together (e.g., in European countries and wherever there are pegged exchange rates), relative economic movements must be larger. Said differently, to avoid economic volatility, currency movements must be larger. That reality creates "currency wars," pegged exchange rate break-ups, and increased currency risk for investors.
 
Because currency movements benefit one country at the expense of another (e.g., they're beggar-thy-neighbor), if the world's largest economies all face the difficulty of pushing on a string, exchange rate shifts won't create a needed global easing. Nobody intends these wars to happen. That's just how the economic machine works.

For these reasons investors should expect to experience lower than normal returns with greater than normal risk.
 
Asset prices have fallen largely as a result of this, together with the deflationary pressures brought about by most economies being in the later stages of their long term debt cycles.
 
So, how might the current decline in risky assets transpire? That depends on what levels risky assets need to decline to in order to raise their risk premiums enough to cause investors who have a long bias (which most all have) to take their cash holdings (or to borrow cash) to add to those assets. With the central banks' abilities to be effective in easing to reverse a downturn weaker than before, the past may not be a good guide because the self-reinforcing cycle of falling asset prices having negative economic effects may not be as easily reversed as in more normal times. In other words, the downside risks are greater. That doesn't mean that a downturn is likely - it's just that the risks are asymmetrical if one does.
 
Most likely, as risk premiums increase, central banks will increasingly ease via more negative interest rates and more QE, and these moves will have a beneficial effect. However, I also believe that QE will be less and less effective because there is less "gas in the tank." To convey how much gas they have left in the tank, we created an index based on the previously described drivers. It is shown below for the US since 1920 and for Euroland and Japan since 1975. As shown, for the US it is as low as ever and approximately the same as in 1937. Because of this, we think that the 1937-38 period, though not identical, is the most analogous period to look at when thinking about interest rates, currency rates, monetary policies, and global economic activity. It, and the mechanics behind it, are worth understanding.
 
The next two charts show the same measure going back to 1975 in Euroland and Japan.
 
 
Ray Dalio: What Will Monetary Policy 3 Look Like?
 
 
While negative interest rates will make cash a bit less attractive (but not much), it won't drive investors/savers to buy the sort of assets that will finance spending. And while QE will push asset prices somewhat higher, investors/savers will still want to save, lenders will still be cautious lenders, and cautious borrowers will remain cautious, so we will still have "pushing on a string." As a result, Monetary Policy 3 will have to be directed at spenders more than at investors/savers. In other words, it will provide money to spenders and incentives for them to spend it. How exactly that will work has to be determined. However, we can say that the range will extend from classic fiscal/monetary policy coordination (in which debt to finance government spending will be monetized) to sending people cash directly (i.e., helicopter money), and will likely fall somewhere between these two (i.e., sending people money tied to spending incentives).
 
To be clear, we are not describing what will happen tomorrow or what we are recommending, and we aren't sure about what will happen over the near term. We are just describing a) how we believe the economic machine works, b) roughly where we believe that leaves us, and c) what these circumstances will probably drive policy makers to do - most importantly that central bankers need to put their thinking caps on.


Saudi Foreign Minister

'I Don't Think World War III Is Going To Happen in Syria'

Interview Conducted By Samiha Shafy and Bernhard Zand

 Saudi Foreign Minister Adel al-Jubeir at the Westin Grand Hotel during the Munich Security Conference: "ISIS is as much an Islamic organization as the KKK in America is a Christian organization."
Armin Smailovic/ DER SPIEGEL
Saudi Foreign Minister Adel al-Jubeir at the Westin Grand Hotel during the Munich Security Conference: "ISIS is as much an Islamic organization as the KKK in America is a Christian organization."

In an interview, Saudi Arabian Foreign Minister Adel al-Jubeir expresses his continued support for regime change in Syria and his desire for rebels to be supplied with anti-aircraft missiles that could shift the balance of power in the war.


The wait for the interview with the minister takes six hours, but then he greets the journalists in a large conference room in a grand hotel in Munich. Adel al-Jubeir, 54, a slim, amiable man, wears a traditional robe and looks a bit fatigued. He and his counterparts spent the previous evening negotiating a cease-fire in Syria well into the night. And since early this morning, they have been busily discussing current global events. Al-Jubeir is the embodiment of a new breed of top Saudi Arabian leaders: He went to school in Germany and college in the United States and then served as the Saudi ambassador to Washington. In contrast to his longtime predecessor Prince Saud al-Faisal, who served as the country's top diplomat for decades stretching from the oil crisis in the 1970s until early 2015, al-Jubeir is not a member of the royal family. At the time of his appointment as foreign minister last April, Saudi Arabia had just gone to war with neighboring Yemen and the situation in Syria was escalating. Al-Jubeir is now responsible for representing his country's controversial foreign policy. And he allowed himself plenty of time to do so in this interview with SPIEGEL. When his staff sought to end the interview after 45 minutes because he had a speech to give at the Munich Security Conference, al-Jubeir suggested we continue the discussion in his limousine -- both on the way to his talk and back to the hotel afterward.

SPIEGEL: Mr. al-Jubeir, have you ever seen the Middle East in worse shape than it is in today?

Al-Jubeir: The Middle East has gone through periods of turmoil before. In the 1950s and 1960s, there were revolutions. When monarchies were collapsing in a number of countries, we had radicals and we had Nasserism. Today it's a little bit more complicated.

SPIEGEL: The most complicated and dangerous situation, obviously, is the one in Syria. What does Saudi Arabia want to achieve in this conflict?

Al-Jubeir: I don't think anyone can predict what the short term will look like. In the long term, it will be a Syria without Bashar Assad. The longer it takes, the worse it will get. We warned when the crisis began in 2011 that unless it was resolved quickly, the country would be destroyed. Unfortunately, our warnings are coming true.

SPIEGEL: What do you want to do now that the Assad regime has gained the upper hand?

Al-Jubeir: We have always said there are two ways to resolve Syria, and both will end up with the same result: a Syria without Bashar Assad. There is a political process which we are trying to achieve through what is called the Vienna Group. That involves the establishment of a governing council, which is to take power away from Bashar Assad, to write a constitution and to open the way for elections. It is important that Bashar leaves in the beginning, not at the end of the process. This will make the transition happen with less death and destruction.

SPIEGEL: And the other option?

Al-Jubeir: The other option is that the war will continue and Bashar Assad will be defeated. If, as we decided in Munich, there will be a cessation of hostilities and humanitarian assistance can flow into Syria -- then this will open the door for the beginning of the political transition process. We are at a very delicate juncture, and it may not work, but we have to try it. Should the political process not work, there is always the other approach.

SPIEGEL: Assad has said he considers a short-term cease-fire in Syria to be impossible. Has the Munich agreement failed already?

Al-Jubeir: Bashar Assad has said many things. We will see in the near term whether he is serious about a political process.

SPIEGEL: Russian Prime Minister Dmitry Medvedev spoke of the danger of "World War III" at the Munich Security Conference.

Al-Jubeir: I think this is an over-dramatization. Let's not forget: This all began when you had eight- and nine-year-old children writing graffiti on walls. Their parents were told: "You will never see them again. If you want to have children, go to your wife and make new ones."

Assad's people rebelled. He crushed them brutally. But his military could not protect him. So he asked the Iranians to come in and help. Iran sent its Revolutionary Guards into Syria, they brought in Shia militias, Hezbollah from Lebanon, militias from Iraq, Pakistan, Afghanistan, all Shia, and they couldn't help.

Then he brought in Russia, and Russia will not save him. At the same time, we have a war against Daesh (the Islamic State, or IS) in Syria. A coalition that was led by the United States, with Saudi Arabia being one of the first members of that coalition.

SPIEGEL: You've just named all the actors. Is that not already a world war of sorts?

Al-Jubeir: I will get to this in a second, if you allow me. The air campaign started, but it became very obvious that there may have to be a ground component. Saudi Arabia has said that if the US-led coalition against Daesh is prepared to engage in ground operations, we will be prepared to participate with special forces. The Russians say their objective is to defeat Daesh, too. If the deployment of ground troops helps in the fight against Daesh, why is that World War III? Is Russia worried that defeating Daesh will open the door for defeating Bashar Assad?

That would be a different story. But I don't think World War III is going to happen in Syria.

SPIEGEL: Would Saudi Arabian ground troops only battle Islamic State or would you also join the fight against Assad?

Al-Jubeir: We expressed our readiness to join the US-led, international coalition against Daesh with special forces. All of this, however, is still in the discussion phase and in the initial planning phase.

SPIEGEL: Is Saudi Arabia in favor of supplying anti-aircraft missiles to the rebels?

Al-Jubeir: Yes. We believe that introducing surface-to-air missiles in Syria is going to change the balance of power on the ground. It will allow the moderate opposition to be able to neutralize the helicopters and aircraft that are dropping chemicals and have been carpet-bombing them, just like surface-to-air missiles in Afghanistan were able to change the balance of power there. This has to be studied very carefully, however, because you don't want such weapons to fall into the wrong hands.

SPIEGEL: Into the hands of Islamic State.

Al-Jubeir: This is a decision that the international coalition will have to make. This is not Saudi Arabia's decision.

SPIEGEL: The Russian intervention has had a big impact on the situation in Syria. How would you describe Saudi Arabia's relationship with Russia at this point?

Al-Jubeir: Other than our disagreement over Syria, I would say our relationship with Russia is very good and we are seeking to broaden and deepen it. Twenty million Russians are Muslims.

Like Russia, we have an interest in fighting radicalism and extremism. We both have an interest in stable energy markets. Even the disagreement over Syria is more of a tactical one than a strategic one. We both want a unified Syria that is stable in which all Syrians enjoy equal rights.

SPIEGEL: That sounds well and good, but you are also providing support to the opposing camp in a war. Even more than your relationship with Russia, the world is worried about the deep schism between Saudi Arabia and Iran.

Al-Jubeir : Iran has been a neighbor for millenia, and will continue to be a neighbor for millenia. We have no issue with seeking to develop the best terms we can with Iran. But after the revolution of 1979, Iran embarked on a policy of sectarianism. Iran began a policy of expanding its revolution, of interfering with the affairs of its neighbors, a policy of assassinating diplomats and of attacking embassies. Iran is responsible for a number of terrorist attacks in the Kingdom, it is responsible for smuggling explosives and drugs into Saudi Arabia. And Iran is responsible for setting up sectarian militias in Iraq, Pakistan, Afghanistan and Yemen, whose objective is to destabilize those countries.

SPIEGEL: If all this is the case, then how can you possibly establish "the best terms you can" with Iran?

Al-Jubeir: Yes, we want to have good ties with the Iranians, but if they want good ties with us, then I tell them: Don't keep attacking us as you have done for the last 35 years. As long as Iran's aggressive policies continue, it's going to be bad for the region. Iran has to decide whether it wants a revolution or a nation-state.

SPIEGEL: Are the Iranians the only ones to blame? What can Saudi Arabia offer to improve this vital relationship?

Al-Jubeir: Show me one Iranian diplomat we killed! I can show you many Saudi diplomats who were killed by Iran. Show me one Iranian embassy that was attacked by Saudi Arabia. Show me one terrorist cell that we planted in Iran. Show me one activity by Saudi Arabia to create problems among Iranian minorities.

SPIEGEL: Your Iranian counterpart, Foreign Minister Mohammad Javad Zarif, accused Saudi Arabia of provoking Iran by actively sponsoring violent extremist groups.

Al-Jubeir: What's the provocation that he's talking about?

SPIEGEL: Is Saudi Arabia not financing extremist groups? Zarif speaks of attacks by al-Qaida, the Syrian al-Nusra and other groups -- of attacks on Shiite mosques from Iraq to Yemen.

Al-Jubeir: Yes, but that's not us. We don't tolerate terrorism. We go after the terrorists and those who support them and those who justify their actions. Our record has been very clear, contrary to their record. They harbor al-Qaida leaders. They facilitate al-Qaida operations. They complain about Daesh, but Iran is the only country around the negotiating table that has not been attacked by either al-Qaida or Daesh.

SPIEGEL: Can the West play a role in mediating between Saudi Arabia and Iran, following the example of the Commission on Security and Cooperation in Europe, the organization which helped end the Cold War?

Al-Jubeir: The Iranians know what they need to do in order to become a responsible member of the international community and in order to become a good neighbor, and it's really up to them to change their behavior.

SPIEGEL: So there is nothing that Saudi Arabia itself or the West could do to encourage this process?

Al-Jubeir: There is nothing to encourage. The Iranians should just stay away from us.

SPIEGEL: How do you explain the ideological closeness between the Wahhabi faith in Saudi Arabia and Islamic State's ideology? How do you explain that Daesh applies, with slight differences, the same draconian punishments that the Saudi judiciary does?

Al-Jubeir: This is an oversimplification which doesn't make sense. Daesh is attacking us. Their leader, Abu Bakr al-Baghdadi, wants to destroy the Saudi state. These people are criminals.

They're psychopaths. Daesh members wear shoes. Does this mean everybody who wears shoes is Daesh?

SPIEGEL: Are you contesting the similarities between the extremely conservative interpretation of Islam in Saudi Arabia and Islamic State's religious ideology?

Al-Jubeir: ISIS is as much an Islamic organization as the KKK in America is a Christian organization. They burned people of African descent on the cross, and they said they're doing it in the name of Jesus Christ. Unfortunately, in every religion there are people who pervert the faith. We should not take the actions of psychopaths and paint them as being representative of the whole religion.

SPIEGEL: Doesn't Saudi Arabia have to do a lot more to distance itself from ISIS and its ideology?

Al-Jubeir: It seems people don't read or listen. Our scholars and our media have been very outspoken. We were the first country in the world to hold a national public awareness campaign against extremism and terrorism. Why would we not want to fight an ideology whose objective is to kill us?

SPIEGEL: At the same time, your judges mete out sentences that shock the world. The blogger Raif Badawi has been sentenced to prison and 1,000 lashes. On Jan. 2, 47 men were beheaded, among them Sheikh Nimr al-Nimr. His nephew Ali has been sentenced to death as well and his body is to be crucified after the execution.

Al-Jubeir: We have a legal system, and we have a penal code. We have the death penalty in Saudi Arabia, and people should respect this. You don't have the death penalty, and we respect that.

SPIEGEL: Should we respect the flogging of people?

Al-Jubeir: Just like we respect your legal system, you should respect our legal system. You cannot impose your values on us, otherwise the world will become the law of the jungle. Every society decides what its laws are, and it's the people who make decisions with regards to these laws. You cannot lecture another people about what you think is right or wrong based on your value system unless you're willing to accept others imposing their value system on you.

SPIEGEL: Is it even compatible with human rights to display the body of an executed person?

Al-Jubeir: This is a judgment call. We have a legal system, and this is not something that happens all the time. We have capital punishment. America has capital punishment. Iran has capital punishment. Iran hangs people and leaves their bodies hanging on cranes. Iran put to death more than a thousand people last year. I don't see you reporting on it.

SPIEGEL: We have reported on it.

Al-Jubeir: Anyway, Nimr al-Nimr …

SPIEGEL: … who was executed on Jan. 2 and was the uncle of Ali al-Nimr …

Al-Jubeir: Nimr was a terrorist, he recruited, he plotted, he financed and as a consequence of his actions a number of Saudi Arabian police were killed. Are we supposed to put him on a pedestal? He was put on trial. His trial was reviewed at the appellate level. It went to the supreme court, and the sentence was death, like the other 46 people who were put to death.

SPIEGEL: Your foreign policy has become more aggressive as well. According to the United Nations, about 6,000 people have been killed in Yemen since the beginning of the Saudi Arabian offensive in March 2015. What do you want to achieve with this war?

Al-Jubeir: The war in Yemen is not a war that we wanted. We had no other option -- there was a radical militia allied with Iran and Hezbollah that took over the country. It was in possession of heavy weapons, ballistic missiles and even an air force. Should we stand by idly while this happens at our doorstep, in one of the countries in which al-Qaida has a huge presence? So we responded, as part of a coalition, at the request of the legitimate government of Yemen, and we stepped in to support them.

We have removed, to a large extent, the threat that these weapons posed to Saudi Arabia. Now 75 percent of Yemen has been liberated and is under the control of the government forces.

SPIEGEL: For how long is this supposed to continue? Half of the victims in this war have been civilians.

Al-Jubeir: We will continue the operation until the objective is achieved. We hope that the Houthis and Saleh will agree to a political settlement, and we are prepared, along with our Gulf allies, to put in place a very substantial reconstruction plan for Yemen. We have no interest in seeing an unstable Yemen or seeing a Yemen that is devastated.

SPIEGEL: With several interventions in Yemen, Syria and other countries in the region, it appears that Saudi Arabia is aspiring to become the Middle East's hegemonial power. Isn't your country punching above its weight?

Al-Jubeir: We are not seeking this role for Saudi Arabia. What we want is stability and security so we can focus on our own development. But we have these problems in our region, and nobody has been able to resolve them. The whole world was saying that the countries of the regions should step up and resolve their problems, so we stepped up. Now people are saying, "Oh my God, Saudi Arabia has changed." It's a contradiction. Do you want us to lead, or do you want us to play a supporting role? Because we can't do both. If you want us to lead, don't criticize us. And if you want us to play a supporting role, then tell us who is going to lead.

SPIEGEL: Does Saudi Arabia feel threatened by the Iranian nuclear deal, by a posible rapprochement between your hostile neighbor and your closest ally in the West, the United States?

Al-Jubeir: We support any deal that denies Iran nuclear weapons, that has a continuous and robust inspection mechanism and that has snap-back provisions in case Iran violates the agreement. Our concern is that Iran will use the income it receives as a result of the lifting of the nuclear sanctions in order to fund its nefarious activities in the region.

SPIEGEL: The United States' foreign policy in the Middle East has become more restrained under President Obama. Is that a mistake?

Al-Jubeir: I don't believe in the theory that the United States is reducing its presence in the Middle East. Quite the contrary, in the Gulf, we see an increase in American military presence, as well as an increase in American investments. The argument is more accurate when one says America is focusing more attention to the Far East. But I don't believe it comes at the expense of the Middle East.

SPIEGEL: Your Excellency, we thank you for this interview.


Free exchange

Slight of hand

Timid central bankers have failed to convince sceptical audiences



IS THE job of central bankers more like that of technicians, carefully turning knobs as they fine-tune the economy, or magicians, manipulating the audience into the suspension of disbelief? Most of the time it is the former. Monetary maestros nudge interest rates up and down with meticulous precision. Yet in extreme cases—such as when economies become trapped in a low-growth rut—central bankers must try to conjure up a change in the public’s economic outlook. Just as uncertain magicians often fail to pull off their tricks, so central banks are finding their audiences in an ever-more sceptical mood.

Economists have long acknowledged the role of mass psychology in business cycles. In 1936 John Maynard Keynes described the “animal spirits” that could drive swings in spending or investment. The power of an abrupt change in market beliefs came sharply into focus in the early 1980s, when many economies were struggling to clamp down on stubbornly high inflation.

Economists at the time worried that using interest rates to rein in inflation would be enormously costly. Because the public had come to expect high inflation, they reckoned, growth-crushing rate rises would be needed to force down prices and create new consumer expectations. A common estimate at the time had it that reducing America’s inflation rate by just one percentage point would cause economic damage of nearly 10% of GDP.

Thomas Sargent, a winner of the Nobel prize for economics, questioned this logic. In a paper published in 1982 he pointed out that historical episodes of hyperinflation did not end slowly, as central banks subjected economies to grinding recessions, but almost overnight. An abrupt but credible “regime change” in policy could realign popular expectations almost instantaneously, he reasoned. If people believed a government’s promise to halt inflation, and immediately began behaving as if the promise were credible, then in principle the adjustment could occur quickly.

In a paper published in 1990 Peter Temin, of the Massachusetts Institute of Technology, and Barrie Wigmore, of Goldman Sachs, argued that Mr Sargent’s regime-change hypothesis might just as easily apply in reverse to an economy stuck in a slump. They analysed the American economy in the 1930s. Franklin Roosevelt’s programme of expansion—which included a departure from the gold standard, devaluation of the dollar, and a boost to government spending—was instrumental in bringing America out of depression, they allowed. But the turnaround in America’s fortunes occurred remarkably quickly, before those policies had time to work. As Christina Romer, an economist at the University of California, Berkeley, noted in 2013, the change in expectations in America happened almost immediately on Roosevelt’s arrival. Equity prices jumped by 70% between March 1933 and June of that year. An analysis of market expectations of inflation concluded that traders anticipated deflation of 7% at the beginning of 1933, but inflation of 6% by the end of the year.

Messrs Temin and Wigmore credit Roosevelt with transforming the public’s beliefs about how the economy would perform in future. During his campaign and after his inauguration, Roosevelt repeatedly pledged to raise prices in the deflation-stricken economy. The choice to leave the gold standard—the centre of monetary orthodoxy at the time—was a powerful signal that the break with the past would be complete.

When, in 1999, Japan became the first big economy to sink into a world of zero interest rates since the 1930s, economists spotted the parallel. Japan risked becoming stuck in a liquidity trap, they pointed out. When an economy is weak, a dose of bad news can cause people to revise down their expectations for future inflation (since less spending and hiring will mean slower growth in prices and wages). A drop in inflation expectations pushes up the real interest rate, squeezing borrowing and adding to pessimism.

With the nominal interest rate stuck at zero, the Bank of Japan could not compensate for such increases through further cuts to interest rates; only the credible promise to boost inflation and keep it up could help the economy escape from the trap. In a paper published in 1998, Paul Krugman, another Nobel prizewinner, argued that Japanese central bankers had to issue a credible promise “to be irresponsible”. Ben Bernanke, who later became chairman of the Federal Reserve, mused that it was “time for some Rooseveltian resolve in Japan”. Both argued that Japan should aim for an unusually high target for inflation, of between 3% and 4%, and should promise to print money as needed to hit the target.

The Bank of Japan instead opted for knob-turning. It eventually created money to buy assets.

Yet not until 2012 did it set a firm inflation target, of just 1% (which it raised to 2% in 2013).

When other advanced economies joined Japan in the zero-rate world after the financial crisis of 2007-08, they too failed to make a Rooseveltian commitment to regime change by promising, for example, to return the price level to the previous trend.

Hocus pocus
 
In this fraught world, central bankers risk falling into what Mr Krugman has called a timidity trap. The longer that knob-turning fails to get an economy out of the zero-rate rut, the less credible markets are likely to find subsequent attempts at regime change. Recent efforts to push interest rates into negative territory seem to have unnerved markets rather than sparked confidence. Perhaps more importantly, central bankers tend not to adopt major shifts in mandates and targets unless urged to do so by popularly elected governments. It is difficult to muster Rooseveltian resolve without a Roosevelt. Expect growing scepticism about the power of knob-turning until voters choose politicians confident enough to wave a magic wand.