Six Ways NIRP Is Economically Negative

By John Mauldin



 
“Positive anything is better than negative nothing.” 

– Elbert Hubbard
 
 

“Once you replace negative thoughts with positive ones, you’ll start having positive results.” 

– Willie Nelson
 
 
If you have any doubt that we’ve wandered into a new and unexplored economic universe, consider this number: $12.6 trillion. That’s the face value of government and corporate bonds currently trading worldwide with nominal yields below zero.
 

Note that word trading. These bonds are in fact trading. Liquidity has not dried up. An active market exists for negative-yield bonds. Buyers haven’t gone on strike, and sellers aren’t desperately dumping the bonds. This is weird. None of it should be happening. Plainly, however, it is happening.
 

Have traders and investors lost their minds? No. They are making the most rational decisions they can in an increasingly irrational world. And therein lies the problem with negative interest rate policies, or NIRP, as we now call them (not so fondly).
 

We don’t have infinite choices. Our decisions spring from the alternatives available to us. When all the alternatives are bad, any choice we make will be bad, too. Today we will start a two-part series on how central banks and specifically NIRP are hurting the global economy. First, a little background.
 
The Price of Liquidity
 
What is an interest rate? You might describe it as the price of money, or in investment terms it is the price of liquidity. You don’t have cash now, but you expect to have it in the future. If a lender believes your expectation is plausible, you can borrow the cash now in exchange for promising to replace it tomorrow. But you don’t just replace what you borrowed. You add an additional amount to compensate the lender for giving up liquidity on that money. That additional amount is what we call interest.
 
 
Now, thinking through this lending scenario, is there any way in which negative interest makes sense?  Maybe. It makes sense if liquidity is undesirable. Or it makes sense, at least to some central bankers, if you want to make liquidity undesirable in order to encourage people (and lenders) to take more risk. However, the data is all beginning to show that consumers and even some businesses are actually saving more money in low-interest-rate or negative-interest-rate environments.
 

Why would liquidity be undesirable? It would be if there was nothing of value to buy with your money. If you’re lost in the desert, having a thousand dollars in your pocket does you no good. You would trade it all for a gallon of water. There isn’t any water, so your money is worthless. So is your credit card.
 

How can undesirable liquidity pertain in a whole economy? Cash is useful to the extent that you can buy goods and services, but you can only buy so much. Beyond a certain point, liquidity becomes bothersome because you have to store and protect it.

This effort consumes time – the one resource we can’t replace.
 

Is it coincidence that cash is losing value at the very time technology has brought the whole world to our fingertips? What would the knowledge you can now get for free on the internet have cost in the 1970s? Quite a lot, I assure you.
 

I say all this to make a point: Even if we didn’t have central banks manipulating interest rates, rates might be very low just by virtue of our modern technology and circumstances. I actually think they would, but that is not an experiment we will be able to run. I’m just speculating about what might happen – which, come to think of it, is what central banks now do. They speculate that their radically new actions will have particular results, but they have no empirical evidence to verify that this is true.
 
So when you add central banks to the equation, interest rates get even lower because they manipulate them down. But that’s quite a different scenario than the below-zero yields we see in Europe and Japan right now – and may well see in the US when the next recession strikes.
 
NIRP Problem #1: Failure to Stimulate
 
The Federal Reserve’s mission is to maintain a stable inflation rate while spurring employment. Its main tools are control over the money supply and interest rates.
 
Lately exercising that control has meant keeping interest rates extremely low, especially by historical standards.
 

That’s simple enough, but recognize the grand and unproven assumption here: Lower interest rates will create higher demand for goods and services. If that’s true, the Fed can stimulate economic activity by pushing rates lower and keeping them there.
 

But is it really true? Certainly not for the last eight years. We’ve had short-term rates near zero the entire time and long-term rates at historical lows. Yet, as measured by GDP or any other standard, economic growth has been mild at best. This dearth of desired results is a real problem for central bankers everywhere.
 

It gets worse. Not only have very low or negative interest rates failed to stimulate demand, they have arguably reduced demand as people save more and spend less.

 
Why do people do this? Imagine you’re a retiree trying to live off the interest on your savings. In order to get any income at all, you’ve had to take on more risk by holding long-maturity bonds, junk bonds, preferred stocks, etc. You compensate for this risk by giving yourself a bigger savings cushion. That means you have to reduce spending somewhere else.
 

Do central bankers not see this? They can surely read the same studies I do. In any case, the financial industry is waking up to the fact that something is very wrong.
 

Last week the Financial Times had an excellent column by Eric Lonergan, a macro fund manager at M&G Investments and proprietor of PhilosophyofMoney.net. He quickly and eloquently dismantled the foundation of modern central banking.
 

The idea that lower interest rates raise demand is based on the view that households attempt to smooth their consumption over time. This assumed relationship has little empirical support, and there are good reasons, particularly when rates are extremely low or negative, to doubt it. High existing debt levels, or poor creditworthiness, are more realistic constraints on spending than higher interest rates.
 

And what of savers? Lower rates have a depressing effect on household incomes, through reduced interest on savings and pensions. It is likely that in relatively wealthy economies – with rising healthcare costs, increasing longevity and uncertainty over pension funding – households respond to lower income on their savings by trying to save more. If this outweighs the reduced incentive to save, the actions of central banks are self-defeating. The relationship of spending to lower interest rates may well be the reverse of that assumed by policymakers. If consumers do not respond to lower rates by spending more, this places an additional onus on the corporate sector.
 

Yet corporate investment appears similarly unresponsive. Investment decisions have financial consequences over many years, and are more influenced by beliefs about future growth and attitudes to risk than by overnight interest rates set by central banks.
 

Indeed, cash hoarding is exactly what we see corporations doing, or at least those corporations that can make a profit in this environment. Apple, Microsoft, and all the other US tech giants have billions stashed outside the country for tax reasons. But they would still keep much of that money in cash even if the tax disadvantage went away. They have no need to spend it, very little to invest in, and see no reason to risk losing it or to bring it back into the United States to pay high corporate taxes. So there it sits, not stimulating anything.
 

As for consumers, I think Lonergan explained it well: “High existing debt levels, or poor creditworthiness, are more realistic constraints on spending than higher interest rates.” Most Americans have excessive debt, low credit ratings, or both. Low or even negative interest rates will not make them spend more money as long as that is the case.
 
NIRP Problem #2: Betraying Lord Keynes
 
In 2008 the whole financial system was on the verge of collapse. Then-Fed Chair Ben Bernanke saw little choice but to use every tool in the Fed’s toolbox. So he cut rates, among other things. As Walter Bagehot noted (there’s more on him below), the purpose of a central bank is to provide liquidity at a price in the middle of a crisis. The Fed decided to set the price very low, but they did do the appropriate thing by adding liquidity. However, they overstayed their welcome because of lingering timidity.
 

I think they made the right move in 2008, even if I disagreed with the actual way they implemented it, but keeping rates near zero years later is harder to defend. Doing so has punished savers without stimulating growth. Why the Fed’s hundreds of PhDs didn’t know this would happen is beyond me. Even their demigod, John Maynard Keynes himself, said interest rates have to reflect reality.
 
 
Even if I disagree with some of Keynes’s conclusions, and especially with the way his disciples have used his work, I have to recognize and acknowledge his brilliance. In his magisterial General Theory of Employment, Interest and Money, chapter 21, Keynes describes his “theory of prices.” This includes interest rates, which as we saw above is simply the price of liquidity. You can read the full chapter here. I will quote from its last section (this gets a little academic, but work through it, especially the areas that I put in bold). Remember, this was in the ’30s, in the middle of the Great Depression.
 
Today and presumably for the future the schedule of the marginal efficiency of capital is, for a variety of reasons, much lower than it was in the nineteenth century. The acuteness and the peculiarity of our contemporary problem arises, therefore, out of the possibility that the average rate of interest which will allow a reasonable average level of employment is one so unacceptable to wealth-owners that it cannot be readily established merely by manipulating the quantity of money. So long as a tolerable level of employment could be attained on the average of one or two or three decades merely by assuring an adequate supply of money in terms of wage-units, even the nineteenth century could find a way. If this was our only problem now – if a sufficient degree of devaluation is all we need – we, today, would certainly find a way.
 

But the most stable, and the least easily shifted, element in our contemporary economy has been hitherto, and may prove to be in future, the minimum rate of interest acceptable to the generality of wealth-owners. [Footnote 2: Cf. the nineteenth-century saying, quoted by Bagehot, that “John Bull can stand many things, but he cannot stand 2 per cent.”] If a tolerable level of employment requires a rate of interest much below the average rates which ruled in the nineteenth century, it is most doubtful whether it can be achieved merely by manipulating the quantity of money. From the percentage gain, which the schedule of marginal efficiency of capital allows the borrower to expect to earn, there has to be deducted (1) the cost of bringing borrowers and lenders together, (2) income and surtaxes and (3) the allowance which the lender requires to cover his risk and uncertainty, before we arrive at the net yield available to tempt the wealth-owner to sacrifice his liquidity. If, in conditions of tolerable average employment, this net yield turns out to be infinitesimal, time-honoured methods may prove unavailing.
 
To paraphrase, Keynes is saying here that a lower interest rate won’t help employment (i.e. stimulate demand for labor) if the interest rate is set too low. Interest rates must account for the various costs he outlines. The lender must make enough to offset taxes and “cover his risk and uncertainty.” Zero won’t do it, and negative certainly won’t.
 

The footnote in the second paragraph is important, too. Keynes refers to “the nineteenth-century saying, quoted by Bagehot, that ‘John Bull can stand many things, but he cannot stand 2 per cent.’”
 

Is Keynes saying 2% is some kind of interest rate floor? Not necessarily, but he says there is a floor, and it’s obviously somewhere above zero. Cutting rates gets less effective as you get closer to zero. At some point it becomes counterproductive.
 

The Bagehot that Keynes mentions is Walter Bagehot, 19th-century British economist and journalist. His father-in-law, James Wilson, founded The Economist magazine that still exists today. Bagehot was its editor from 1860–1877. (Incidentally, if you want to sound very British and sophisticated, mention Bagehot and pronounce it as they do, “badge-it.” I don’t know where they get that from the spelling of his name. That’s an even more unlikely pronunciation than the one they apply to Worcestershire.)
 

Bagehot wrote an influential 1873 book called Lombard Street: A Description of the Money Market. In it he describes the “lender of last resort” function the Bank of England provided, a model embraced by the Fed and other central banks. He said that when necessary, the BoE should lend freely, at a high rate of interest, with good collateral.
 

Sound familiar? It was to Keynes, clearly, since he cited it in the General Theory. Yet today’s central bankers follow only the “lend freely” part of this advice. Bagehot said last-resort loans should impose a “heavy fine on unreasonable timidity” and deter borrowing by institutions that did not really need to borrow. Propping up the shareholders of banks by lending low-interest money essentially paid for by the public when management has made bad decisions is not what Bagehot meant when he said that the Bank of England should lend freely.
 

How did the Fed act in 2008? In exact opposition to Bagehot’s rule. They sprayed money in all directions, charged practically nothing for it, and accepted almost anything as collateral.
 
Not surprisingly, the banks took to this largesse like bees to honey. Taking it away from them has proved very difficult. We now find ourselves in an era of speculation about what will happen when interest rates are raised.
 

(By the way, thanks to reader Richard Field for pointing me to the above Keynes quote. It’s amazing how much help you can get from complete strangers on Twitter. I will admit that I ignored Twitter for a long time, but now I find myself roaming it when I’m sitting around with nothing else to do and my iPad in hand. You should consider following me on Twitter, right here.
 
NIRP Problem #3: Policy Paralysis
 

What would Keynes and Bagehot say about today’s interest rates, or lack thereof?
 
Their beloved Bank of England last week cut its benchmark rate to a record-low 0.25%. That is not what anyone would call a “heavy fine on unreasonable timidity.”
 

The problem is how to correct this policy error without causing yet more turmoil in the markets. On that, I’m stumped, and so are the central bankers. If they could wave a magic wand and get short-term rates back to, say, the 3% region where they were at the end of 2007, I’m sure they would be delighted. And we might see some positive effects. Savers would receive more income, for sure. However, this magic trick would also crater the stock market. The one thing we know is that the Federal Reserve is now in the thrall of the stock market.
 

The S&P 500 dividend yield is currently around 2%. To earn it, you have to accept the principal risk and volatility inherent in stocks. No one would do this if they could earn the same or even more in Treasury bills or bank savings accounts. An unexpected rate normalization by the Fed would jar the stock market downward to restore balance to the equation of risk and reward.
 

So we are stuck. The Fed can’t use the only available exit without slamming the markets. The only alternative is to stay in the trap and walk around in circles, hoping something will change. Someday it will, but I expect that it won’t be a pleasant change – but rather one that, in the minds of the central bankers, requires an even more unusual monetary policy. We will examine that potential in depth and detail next week. Until then, the room will get increasingly uncomfortable.
 
NIRP Problem #4: Killing Insurance Companies and
 
Pension Funds Softly
 
Insurance funds make a profit by taking your money and turning it into long-term loans. They use the money they make, along with your premiums, to cover your insurance risk in the event of need. Pension funds generate profits from long-term loans to grow the money they need, along with your contributions, in order to pay for your retirement. They have built into their models a reasonable long-term return – at least from a historical perspective – on bonds and the stock market.
 

This model can turn fall apart very quickly under a very-low-interest-rate or NIRP regime.
 
The returns insurers and pension plans make on their investments no longer adequately fund the promises they have made. It gets even worse with NIRP. Think of the poor insurance companies, monstrously bigger than banks in Europe, that are forced by regulations to invest in long-term government bonds, many of which are now earning negative returns. How in the Wide, Wide World of Sports can you make a positive return when you are forced to invest in negative interest-rate bonds?
 

Then we come to the banks. What happens when they make negative returns on their cash?
 
We haven’t seen extreme scenarios yet, as far as I can tell, but the banks are definitely getting squeezed. Last week Royal Bank of Scotland warned some corporate customers that it may start charging interest to hold their deposits. Some German banks have already done so.
 

Knowing this practice is a problem, banks try to offset NIRP by cutting other costs: by automating more tasks, laying off employees, closing branches, etc. This year we’ve heard a lot about banks investing in blockchain ledger technology – the same engine that drives Bitcoin digital currency. The banks aren’t doing this because they love Bitcoin. Their interest is in reducing costs, and blockchain applications promise to help them do it. That technology will lead to more job losses down the road.
 

Between NIRP and assorted technology and regulatory changes, the banking industry is on its way to becoming a kind of regulated utility. This shift might mean fewer bailouts in the future, but it will certainly mean less risk-taking and speculative lending and investing by banks. To the extent this dynamic makes it harder for worthy businesses to get capital, it will contribute to the generally low-growth economic conditions we’ve seen since the crisis.
 

I have written several letters about the plight of pension funds worldwide. I am gathering information on the situation with insurance companies, which my initial research shows is even more dire. If you have something I should know, please send it to me.
 
NIRP Problem #5: Distorting Signals
 
ECB President Mario Draghi famously pledged to do “whatever it takes” to restore eurozone growth. His attempts to fulfill that promise have led to NIRP and other bizarre policies like the central bank’s massive asset purchases.
 

Whether the ECB’s various interventions are helping the eurozone economy is not yet clear, but they are certainly having consequences, among them the appearance, if not the reality, of central bank interference and favoritism.
 

The ECB’s corporate bond-buying program, for instance, was originally going to purchase already existing bonds on the open market. However, it has evolved into a kind of closed market in which a favored group of companies issue bonds customized to the ECB’s specifications.
 

Last week the Wall Street Journal reported that the ECB had gone a step further, buying bonds directly from two Spanish companies through private placements. In other words, the ECB bypassed public markets completely and simply loaned money to selected companies.
 
They weren’t even going to tell anyone. Someone at the WSJ, God bless their attention to detail, did some data mining and found the two private placements. One was to the Spanish oil company Repsol and the other to Iberdrola, an electric power utility. Morgan Stanley acted as underwriter in both cases. I wish my friends at Morgan Stanley would arrange to give me long-term money that cheaply. Just saying.
 

Now maybe the ECB had good reason to make these two transactions privately. I don’t know, and they won’t say. But we shouldn’t have to wonder. The reality is that the ECB is buying so much of the corporate bond market in Europe that it is becoming difficult for the bank to find things to purchase on the public markets, and so they are beginning to look into the private markets. One of the great ironies is that European divisions of US companies are creating loans so they can get the ECB to buy them. It makes perfect sense from the company’s standpoint, of course – let’s hear it for replacing expensive loans with cheap ones. That’s an easy way to make an executive look smart.
 

The problem is that this sort of thing generates false market data that leads other players to make bad decisions. Consider this chart from the WSJ. It depicts credit spreads of European corporate bonds. Lower numbers mean a tighter spread, which is good from the issuing company’s point of view because it means their cost of capital is lower.
.
.

 
We can see here that bonds eligible for ECB purchase (the green line) have consistently outperformed other bonds since the program launched. The advantage seems to be growing with time, too. Are these bonds really better, or are they just getting the benefit of ECB’s buying – buying that could end at any time?
 
Technically, we don’t know. There is no way to tell. My guess? We will know when the ECB runs out of bonds to buy and starts having to loosen its determination as to what it can buy, such that more corporate bonds become eligible. If this new category of bonds sees its credit spread drop, too, we will know for sure that the critical variable at work is not bond quality, per se, but the ECB’s purchases.
 

European bond investors don’t have clean data that will let them make confident decisions. Some will no doubt withdraw from the bond market, leaving the ECB even more of a monopoly purchaser than it already is. That’s the opposite of what ECB claims to want, but its strategy is making the problem worse, not better.
 
NIRP Problem #6: Repressing Retirees
 
I saved this one for last because it is, for me, the most enraging consequence of ZIRP, NIRP, QE, and all the rest. Savers, the people who read my newsletters and buy my books, are paying the price of our central bankers’ mistakes and arrogance. People who did nothing to cause this situation are getting punished for it.
 

Back in February I wrote about how ZIRP and NIRP are “Killing Retirement As We Know It.” I don’t often quote myself, but this is important. Follow the link if you want to read the full section. I was talking about how retirees could once live off their savings without too much trouble.
 
It was even simpler if you had an employer or union pension plan to do the work for you. Pension plans pooled people’s money, calculated how much cash they would need to pay benefits in future years, and built portfolios (mainly bonds) to match the liability projections. Government and corporate bonds yielded enough to make the process feasible.
 

Younger readers may think I just described a fantasy world. I assure you, it was very much a reality not so long ago. Ask your grandparents if you don’t believe me.
 
However, you may find them in a state of shock today because they thought the fantasy would last forever. Indeed, their financial planner probably told them they could count on drawing down 5% of their portfolio per year to live on, because the income from the investments in their portfolio would more than make up for the drawdown.
 

None of this is possible today. Neither you nor a massive pension plan acting on your behalf can generate enough risk-free income to assure you a comfortable retirement.
 

Why not? Because our monetary overlords decreed that it should be so. Retirees and their pensions are being sacrificed for what now passes as “the greater good.”
 
Because these very compassionate overlords understand that the most important prerequisite for successful future retirements is economic growth. And they think that an easy monetary environment is the necessary fertilizer for that growth. So, when they dropped rates to zero some years ago, they believed they would soon be able to raise them again – and get people’s retirements back on track – without risking future economic growth. The engine of growth would fire back up, and everything would return to normal.
 

So much for the brilliant plan. You and I, the expendable foot soldiers in the war to reignite growth, now gaze about, shell-shocked, as the economic battlefield morphs from the Plains of ZIRP to the Valley of NIRP.
 
Note: Next week we are going to examine the “causality” of low interest rates and easy monetary policy and their connection with the mediocre recovery we have experienced. I am going to argue that the US economy has recovered (to the modest extent that it has) in spite of monetary policy, not because of it, just as economies have in every recovery since the Medes were trading with the Persians. Current Fed policy is actually distorting the process, not helping it.
 

The Federal Reserve’s choice to keep interest rates near zero for years on end has exacted a direct and sometimes devastating human cost. Real people who worked hard all their lives and made sensible decisions about retirement are, to be blunt, getting the shaft.
 

I thought about this at the Camp Kotok economic retreat in Maine a few weeks ago.
 
The little town of Grand Lake Stream is beautiful, remote, and poor. Our group’s annual visit gives a big boost to the local economy. The residents roll out the red carpet and make us feel very much at home.
 

Attending the event every year for over a decade, I’ve come to know many of the locals.  
 
They are fine people who love their home and want only to live there in peace. They are far more like the people I grew up with out in the West Texas country than many of the denizens here in downtown Dallas. I know they struggle financially but had never really asked them for details. This time I did.
 

My son Trey, my colleague Patrick Watson, and I were out in a small boat in the middle of a big lake. With us was our guide, Jeff Cochran. Jeff spent 30 years working hard at a Maine paper mill. Patrick and I were talking about economics, of course, and we drew Jeff into the conversation.
 

Jeff retired from the paper mill with a small pension that he had to roll into a 401(k) that at one time would have enabled a modest living. Now, thanks to the Fed, it doesn’t. He earns extra income as a fishing and hunting guide but is still drawing down his pension far faster than experts would advise. I asked him about that, and he admitted that he was truly living on the edge.
 

He’s not the only one. Many of his neighbors are in similar situations. People all over the country are just folks who played by the rules and then found out the rules could change. It’s easy for someone like me to look at aggregate numbers and pontificate. Then I see the people behind those numbers, and it all becomes very real. I have been carrying around a true sense of outrage ever since that morning at Grand Lake Stream.
 

The folks of Grand Lake Stream don’t sit around waiting for charity. They work hard and always with a smile. I’ve actually never been there except to attend Camp Kotok, but I need to go more often. For a lifelong Texan, upstate Maine is about as far out of bounds as you can get.
 

If you want a Maine fishing or hunting getaway, Jeff can fix you up. You can reach him by email at jwcochran81@gmail.com. I also recommend either Leen’s Lodge or Canalside Cabins for lodging. All these people know each other and will take good care of you.
 

Consider the trip to Grand Lake Stream your own little economic stimulus plan. I guarantee it will be far more effective than anything the central banks are doing.
 
And you might find it as restful and stimulating as I have.
 

Next week we are going to continue with our thoughts on central banks, but focus on the Jackson Hole speeches and activities. A lot of what came out of that august gathering has helped me to realize that we are truly in a world where the unthinkable is now thinkable. Maybe I am just sensitive to it, but ever since I wrote that letter, I have seen the word unthinkable entering more and more into the discussion. Then again, I often use a concept in a letter and am then reminded that somebody else wrote about it six months earlier, and it just entered my mind and gestated there, which is what good concepts are supposed to do.
 
Denver, Denver, and Dallas
 
I will be in Denver on September 14 for the S&P Dow Jones Indices Denver Forum. If you are an advisor/broker and are looking for ideas on portfolio construction, I will be there along with some friends to offer a few suggestions. Then I will stay in Denver for the next few days to give the closing keynote at Financial Advisor magazine’s 7th annual Inside Alternatives conference, where I will again share my thoughts on how to construct portfolios that are designed to get us to the other side of the problems I see coming in the macro world. Bluntly, I think that portfolios constructed along the traditional 60/40 model are going to cause their owners significant pain in the future. And if you think the recovery has been slow this time, then you will not appreciate the snail’s pace of the ne xt recovery.
 

Sometime in the fourth quarter I will go public with what I think is an innovative way to approach portfolio construction and asset class diversification.
 

I’ve been thinking about this new “Mauldin Solutions” portfolio model for a very long time, and now we are putting the final touches on the project. While the investment model itself is relatively straightforward, all of the details involved with making sure that the regulatory i’s and business t’s are crossed (the stuff that has to happen behind the scenes) are far more complex. Plus, as you might guess, there are white papers to write and web pages to construct.
 

I am now fully operational, at least computer-wise, and hopefully can spend the next few days paying attention to the 415-odd emails in my inbox and whittle them down to under 30 over time. I will admit that the fuller my inbox is, the higher my stress level is; and over 400 is about as high as it has got in many, many years.
 
And with that said, I think I will go ahead and hit the send button and wish you a great week.
 

Your frustrated with central banks analyst,


John Mauldin


The Ukraine Trap: U.S., Russia, Germany and China Play Geopolitical Musical Chairs


The 18th Century called: It wants its Eastern European diplomacy back. While the world focused on a potential crisis that could have arisen from a disaster at the Sochi Olympics (which never happened), the Crimean/Ukranian crisis came as a Black Sea surprise that hardly anyone saw coming. But developments there could create globally important economic ramifications for years to come.

The Russians have dominated Ukraine and the Crimean peninsula (part of Ukraine) for hundreds of years. And although Ukraine has been its own country for much of that time, its governments have been almost always directly controlled by, or subordinated to, Russia. The control has been so complete that in the 19th Century Russia was happy to locate its primary naval base on the Crimean peninsula, a move that gave the Russians an all-year window to the Mediterranean and beyond. But in March, when a popular uprising deposed Russia's puppet government in Ukraine, Vladimir Putin lost no time shoring up his strategic interests. His moves have drawn parallels to the "Sudetenland Crisis" manufactured by the Nazis in Czechoslovakia in 1938. In that episode, Hitler exploited the supposed "oppression" of ethnic Germans living in Czechoslovakia to fracture Western alliances and win territorial expansion for his own country. And we all know how that worked out...

What's at Stake

As the Ukrainian crisis deepens (as more violent pro-Russians increasingly attack strategic targets throughout eastern Ukraine), Russia and the Unites States/EU/ NATO will likely settle into a protracted political standoff. Unlike the late 1930's, however, there is very little chance that it will lead to a continental land war fought with live ammunition. Instead, economic weaponry could be heavily deployed.

At issue is the ability of tens of millions of Eastern Europeans, particularly in the nations that formerly fell behind the Cold War's "Iron Curtain", to drift into the Western sphere of influence. However, this very old conflict does contain some distinctly 21st Century features.

The standoff could become a test of strength between the heavily indebted, but financially dominant, developed economies and the resources rich creditor nations of the emerging markets. Instead of mounted Cossacks or Katyusha rockets, the Russians now wield pipelines and refineries.

While it is clear that the West easily out-muscles Russia in financial firepower, Vladimir Putin has the advantage of singularity of purpose and the patience to play the long game. In contrast, the Western alliance is a hodgepodge of competing interests held together by loose legal and political ties. When looked at closely, various fractures emerge within the alliance that will make common purpose difficult. Putin's trump card is Europe's varying degree of reliance on Russian energy.

By seeking to "drive a wedge" between EU members or between the United States and the rest of NATO, Putin may feel confident in his ability to achieve his aims, despite his relatively weak hand. While many in the West dismiss such a possibility as paranoia, the potential for this outcome could make a profound impact on the global economy and, in particular, the energy sector.

While the EU likes to pretend that it is a united economic bloc, in practice the 27 member nations are driven by competing histories, ethnicities, ideologies, and economic necessities.

Nowhere is this variety seen more clearly than in energy policy. Nations such as the UK get little to nothing from Russia. On the other end of the spectrum, countries like Poland, Finland, Romania and Hungary get nearly 100% of their oil and natural gas from Russia. Germany sits somewhere in the middle, receiving 37% of its natural gas imports from Russia. For now, at least, Angela Merkel has stood strong against Russia, calling a nullification of the annexation of Crimea to Russia, a withdrawal of Russian troops from the peninsula, and a relaxation of Russian military posturing along its border with eastern Ukraine. But none of these outcomes seem likely without the threat of serious economic warfare.

Europe is Ill-Prepared for an Energy Crisis

But it is difficult to imagine that the EU countries of Eastern Europe, which are poorer, less self-sufficient, and less able to tap other sources of energy, would be eager to sign up for tough stance against Russia. In the past, Putin has not hesitated to restrict energy deliveries to those neighboring countries that have defied his will. In 2009, Putin literally turned the heat off while Ukraine suffered through a particularly chilly winter. Countries from the Baltic to the Balkins (many of which are unhealthily dependent on Russian energy) will logically fear similar treatment if push comes to shove. Adding to the anxiety is the fact that the vast majority of Russian gas destined for Central and Western Europe is delivered through pipelines that pass through Ukraine. This means that no deliveries can be considered secure if Ukrainian needs become desperate.

If orders from the Kremlin were to stop, or severely curtail oil and gas shipments, could there be any doubt that a Continent-wide crisis would ensue? As the leading exporter of goods in Europe, German policy seems to be largely focused on the maintenance of open markets throughout the continent. Many argue that the entire Eurozone apparatus has been constructed simply to ensure markets for German manufacturers. Nothing would cut orders faster than an energy crisis. And while many Western politicians have noted the dangers of over-dependence on Russia, the EU has developed energy policies that have only made things worse.

For the last decade or so, environmental concerns have come to dominate the energy discussion.

And while Europe has made huge strides on that front (25% of German electricity now comes from renewable sources), the era of full reliance on renewable energy sources remains in the distant future. But the environmental issue has ironically pushed Europe further into Russia's bear hug. Because of the environmental lobby, European energy producers have not been adopting the hydro-fracking technologies that have transformed oil and gas production in the United States. Similarly, the use of coal, which is relatively abundant in Europe and had provided the bulk of the Continent's thermal needs in the not too distant past, has been cut drastically.

Additionally, the Fukushima disaster has greatly discouraged European leaders from expanding their well-established nuclear power capacity. As a result, to meet the power and heating needs of the more than half a billion people in the Eurozone, there seems to be little alternative to the relatively cheap, clean and pipeline-delivered supplies of Russian natural gas.

But current events now show the risks that this dependence creates.

Recently, German Economic Minister Sigmar Gabriel seemed to state the obvious by saying that there is "no sensible alternative" to Russian gas. Given the financial realities, there should be little doubt that he was speaking the truth. Currently, Germans pay three times as much for electricity as do Americans. As a result, few politicians see much room for maneuver on any policy that further restricts supply and pushes energy prices higher. Higher prices would be even a harder pill to swallow for those Eastern European countries that are still struggling to hit their strides economically.

America Has Other Concerns

But with no dependence on Russian energy, the U.S. has an entirely different set of priorities.

In fact, an energy crisis in Europe would not push up gas prices in the U.S. (natural gas markets are regional not global). In addition, U.S. manufacturers would gain a competitive advantage against European rivals that would be struggling with higher energy costs. The price that could be paid by America in forcing a confrontation with Putin will not come in the form of higher energy bills, but in lost global prestige.

Due to a string of foreign policy blunders, President Obama is keenly aware that America is losing its reputation as the guarantor of global security. In particular, the President's failure to take action against Syria's Assad regime when it became clear that it had used chemical weapons showed weakness in the face of Russian opposition. As a result, the President does not want to be similarly rolled over by the nation that we apparently defeated in the Cold War. In order to restore this tough guy reputation, Obama may overplay his hand and be tempted to write a check that must be paid for by the Europeans. If this were to happen, Putin could be provided with a means to exploit these divisions and strike back hard on his Cold War adversary.

The Trap

In exchange for promises to contain his expansion into the Ukraine and the former Warsaw Pact countries (thereby soothing fears in Berlin, Prague, and Warsaw), Russia could look to formalize an energy trade agreement in currencies other than the U.S. dollar, the euro in particular. Such a move would help push the global economy into the "post-dollar" world that has long been mentioned by Russia and China. It would also burnish the reputation and stability of the euro, which has come back strongly from the drubbing the currency took as a result of the European sovereign debt crisis. Such a deal that marginalizes the United States would be a crowning achievement of the Putin regime. In April, Platt's Energy, a leading journal of the energy industry, reported Andrei Kostin, the president of VTB, Russia's biggest state-run bank, as saying, "It is time to change the entire international financial system that considers the dollar the key reserve currency." Kostin was reported to be in talks with major Russian energy providers such as Gazprom and Rosneft whose eagerness to make a change has been catalyzed by the Ukrainian conflict. Alexander Dyukov, the head of Gazprom's trading arm, said that 95% of his customers were ready to switch their dollar-based contracts into euros.

The fulcrum for any potential shift in the status quo may be found in Germany. In the 70 years since its defeat in the Second World War, Germany has been largely content to function as a loyal soldier in the Anglo-American led Western alliance. But in recent years, Germany (a creditor nation) has often found herself isolated from her debtor nation allies on questions of central bank and fiscal stimulus. As a result, it is not too difficult to foresee a situation where Germany becomes less willing to go along with NATO on energy and financial policy. A May 2 front page story in the Wall Street Journal detailed a series of unusually frank public comments from leading German industrialists urging Chancellor Merkel to refrain from imposing additional sanctions on Russia. This comes just two days after the WSJ reported that in late April Vladimir Putin attended a birthday celebration in St. Petersburg for former German Chancellor Gerhard Schroeder. It appears that the two remain on friendly terms.

A recent poll of Germans revealed that more (49%) wanted their country to mediate between the U.S. and Russia over the Ukraine, rather than simply back up American policy (45%). The same poll showed that a majority of Germans objected to the regular presence of NATO troops in countries that border Russia. Pushing back against the Americans on this issue could provide Germany the European leadership role that she has been pursuing since Bismarck.

The Eastern Option

But even if the EU were to resist the enticement of energy trading in their own currency, and instead were prepared to hang tough in order to teach a lesson to the bully in the Kremlin, there is reason to believe that Russia would simply look for new customers, particularly in China. By failing to criticize Russian actions in the Ukraine (China has said very little on the crisis and was recently absent at the UN vote in which the secession referendum in Crimea was declared illegal), China may be setting itself up as the beneficiary of a disruption of Russian-European gas deliveries. Bilateral trade between Russia and China has taken off in recent years, and the two countries have been cooperating diplomatically on a number of fronts. In February alone, China imported 2.72 million metric tons of Russian crude oil, a monthly pace that has more than tripled in a decade. Customs data indicates that China imports approximately 12% of its crude from Russia.

There can be little doubt that as China's energy needs explode, the country will be forced to reduce its overdependence on coal (70% of its energy supply), which is creating unsustainable environmental stress on China's citizens. Pollutants pouring from coal-burning power plants are turning many of China's biggest cities into unlivable smog pits. This will have to change. According to an April 14 Bloomberg article, the Ukraine crisis increases the chances Putin will sign a long negotiated 30-year deal to supply pipeline gas to China.

Major pipeline construction has already begun that will allow Russia to pipe gas to China that it currently sends to Europe. As the capstone of increased energy trade, Russia and China could agree to a deal to trade energy in the Chinese RMB. Such a move would shift much of the globe's economic gravity further into China's orbit, and would help the RMB take a step forward to global reserve status. As would be the case in a euro-based energy trade deal, this scenario would be detrimental to the U.S..

In any event, the crisis now unfolding contains many more seeds for bad outcomes than the financial commentators understand. If the Obama Administration falls into a trap and misplays the situation, it could see stronger ties between the Russian Federation and EU or Russia and China. Either way, it moves us closer to the "post-dollar" world that many have predicted.


China’s Corporate-Debt Challenge

David Lipton
. China debt



WASHINGTON, DC – The Chinese economy has slowed in recent years, but it is still a strong performer, contributing about one-third of total economic growth worldwide. It is also becoming more sustainable, in line with the shift in its growth model away from investment and exports and toward domestic demand and services.
 
In the run-up to next month’s G20 summit in Hangzhou, China has been calling loudly for new commitments to structural reforms to stimulate growth in advanced and emerging-market economies. But China faces serious risks at home. Above all, domestic credit continues to expand at an unsustainable pace, with corporate debt accumulating to dangerous levels.
 
According to the International Monetary Fund’s recently published annual report on the Chinese economy, credit is growing about twice as fast as output. It is rising rapidly in both the non-financial private sector and in an expanding, interconnected financial sector that remains opaque. Moreover, while credit growth is high by international standards – a key indicator of a potential crisis – its ability to spur further growth is diminishing.
 
Warning signs are flashing, and the Chinese government has acknowledged the overall problem. But, to avoid a crisis, it should immediately implement comprehensive reforms to address the root causes of the corporate debt problem. These include soft budget constraints for state-owned enterprises (SOEs) and local governments, implicit and explicit government guarantees of debt, and excessive risk taking in the financial sector – all of which have been perpetuated by unsustainable official growth targets.
 
To tackle the problem, the Chinese government must, in the words of Premier Li Keqiang, “ruthlessly bring down the knife [on] zombie enterprises.” This culling should be combined with a concrete strategy to restructure salvageable firms; recognize and allocate creditor losses; account for displaced workers and other social costs; and further open private-sector markets. More fundamentally, the government must accept the inevitability of lower near-term growth.
 
It is especially important to restructure SOEs. Many are essentially on life support, contributing only one-fifth of total industrial output but accounting for about half of all corporate debt. A serious restructuring effort – including stricter budget constraints and an end to lending to non-viable firms and government guarantees on debt, along with other supply-side reforms already underway – will create space for more dynamic companies to emerge and contribute to growth.
 
China is unique in many respects, but it is not the first country to experience corporate-debt difficulties. Its leaders should heed three broad lessons from other countries’ experience.
 
First, the authorities should act quickly and effectively, lest today’s corporate-debt problem become tomorrow’s systemic debt problem. Second, they should deal with both creditors and debtors – some countries’ solutions address only one or the other, sowing the seeds for future problems. Finally, the governance structures that permitted the problem to arise must be identified and reformed. At a minimum, China needs an effective system to deal with insolvency; strict regulation of risk pricing and assessment; and robust accounting, loan-loss provisioning, and financial disclosure rules.
 
Influential voices in China are quick to draw the lesson from international experience that tackling corporate debt can limit short-term growth and impose social costs, such as unemployment. These are valid concerns, but the alternatives – half measures or no reform at all – would only make a bad situation worse.
 
China should begin by restructuring unviable companies in its fastest-growing regions, where workers will find new jobs more quickly and reforms are not likely to hurt growth. Policymakers can then be more selective when it comes to restructuring in slower-growing regions and cities where a single company dominates the local economy.
 
Moreover, structural unemployment and worker resettlement costs can be mitigated with a strong social safety net that includes funds for targeted labor redeployment so that workers can get back on their feet. This approach would show the government’s commitment to those at risk of displacement.
 
To its credit, China has already made some efforts to solve its debt problem and begin deleveraging.
 
The current Five-Year Plan aims to reduce excess capacity in the coal and steel sectors, identify and restructure nonviable “zombie” SOEs, and fund programs to support affected workers.
 
Now is the time for China to push for far-reaching reforms. Banks’ balance sheets still have a relatively low volume of non-performing loans (and high provisioning). The costs of potential losses on corporate loans – estimated at 7% of GDP in the IMF’s latest Global Financial Stability Report – are manageable. Furthermore, the government maintains high buffers: debt is relatively low, and foreign-exchange reserves are relatively high.
 
The question is whether China will manage to deleverage enough before these buffers are exhausted.
 
Given its record of economic success and the government’s strong commitment to an ambitious reform agenda, China can rise to the challenge. But it must start now.
 
 


How weak productivity can neuter monetary policy


What was seen as a cyclical problem has morphed into a supply-side constraint, writes Stephen King
 
 
 
Throughout the developed world, productivity growth has been remarkably weak. Even though we are faced daily with new technological gizmos, growth in output per hour has been dismal.
 
Admittedly, some countries have done better than others. Between 2007 and 2014, the latest year for which comparable data are available, output per hour rose more than 7 per cent across the US economy while in the UK it was broadly unchanged and in Italy it fell 2 per cent.

Yet even the “successes” are failures judged by their own history. Other than during the dark days of the early 1980s, when two recessions led to a serious, albeit temporary, loss of output, the US has never before experienced such a fallow period of productivity growth.

There are many explanations for this, including Lawrence Summers’ revival of secular stagnation, Robert Gordon’s claim that the biggest technological impacts on living standards are in the past and, for what it is worth, my own view that we are returning to economic “normality” after an extended postwar period of economic catch-up.

The Summers view is, in many ways, the most optimistic. Offer fiscal stimulus, particularly focused on infrastructure projects, in the hope that higher demand will create higher supply.

Yet the risk is that stimulus will raise government debt with no lasting benefit for the economy.

Think of Japan over the past two decades, and US stimulus after the dotcom bubble burst that triggered only a housing boom and bust with no lasting benefit for productivity growth.

Weak productivity has a corrosive impact on living standards. Should the post-financial crisis trend continue, in the US by 2021 average incomes would be 16 per cent lower than had the 2 per cent per annum postwar productivity trend been maintained. Tax revenues, healthcare, pensions, wage growth and other contributors to a nation’s welfare would be lower. Promises made across the political spectrum would have to be abandoned.

To date, attempts to boost productivity have failed. What was seen as a cyclical economic problem has morphed into a biting supply-side constraint. Worse, the stimulus aimed at boosting economic growth and limiting unemployment may have inadvertently damaged productivity performance.

Exceptionally low interest rates and quantitative easing may have lifted asset prices indiscriminately, crimping capital markets’ abilities to separate productive wheat from unproductive chaff.

Further, persistently low productivity growth may be neutering monetary policy. In a world in which growth and inflation are structurally low, interest rates will be dragged down to incredibly low levels — precisely the conditions we see today. If, however, interest rates are low on a structural basis, there is nowhere for them to go in the event of a deep recession.

In these circumstances, the entire monetary policy framework is up for grabs. Shibboleths will have to be dispensed with. At zero rates, central banks may have to work increasingly closely with finance ministries, prioritising the need for co-ordinated action over the desire for independence. Inflation targeting may have to be ditched, perhaps replaced by nominal gross domestic product targeting: a slowdown in real growth would then be countered by a commitment to higher inflation, boosting nominal GDP and limiting the risk of ever more indigestible debt.

Yet nominal GDP targeting will work only if central banks can credibly demonstrate not just their desire for higher inflation but also their ability to deliver it. To date, they have not been particularly successful. And if productivity growth is permanently lower, expectations of a life of ever-rising prosperity will have to be abandoned. If the economics are already difficult, the politics will be considerably harder.

The writer is HSBC’s senior economic adviser and author of ‘When the Money Runs Out’