Central banking has never looked more daunting

The line between fiscal and monetary policy is increasingly blurred

 Charles Bean


The Bank of England's Mark Carney, the ECB's Mario Draghi and the Fed's Janet Yellen. Central banks will need to continue to set policy against the background of a low natural rate for some while yet © AFP


The Bank of England’s Monetary Policy Committee has just celebrated its 20th birthday. In its first decade, growth was steady and inflation close to target. We — along with our peers — thought we had this central banking business cracked. Nemesis arrived in the shape of the global financial crisis. Rates have been rock bottom ever since and central banks’ balance sheets have ballooned. Banking regulations are being tightened. And macro-prudential policy is still a work in progress. Central banking has never looked more daunting.

The past couple of decades have witnessed a remorseless fall in the real rate of interest consistent with macroeconomic equilibrium — the “natural” rate. The causes are still a matter of debate. Some point to higher savings, others to the impact of slow productivity growth on investment. Balance-sheet repair has surely been important, too.

While central banks can set any policy rate they want in the short run, if they are to achieve their objectives over the long term it must converge to the sum of the natural rate and their target inflation rate. Criticism from politicians that central banks’ policies are penalising savers and driving up asset prices misses the point: the decline in interest rates ultimately reflects forces that central bankers are powerless to change.

Does the current state of affairs represent a new normal? Some rebound in the natural rate may be in the offing. The global demographics are at a turning point, with a substantial fall in the share of the middle aged relative to the elderly in prospect. And the former are the big savers, while the latter typically run their savings down. Moreover, a pick-up in the demand for funds to invest may materialise as new technologies such as artificial intelligence and nanotechnology come to fruition.

But any resulting rise in the natural rate seems likely to happen gradually. Central banks will need to set policy against the background of a low natural rate for some while yet. That means more episodes when policy rates are near their lower bound. Further large-scale asset purchases may be needed.

Broadly speaking, the monetary arrangements introduced in 1997 have served us well. But two aspects are worthy of note. The distinction between monetary and fiscal policy has become increasingly blurred. And the distributional consequences of monetary policy have become increasingly contentious.

Monetary policy has fiscal consequences even in normal times, but issues are starker when large quantities of government bonds or private sector assets sit on the central bank’s balance sheet. Even small changes in the yield curve have significant consequences for the public finances. Fiscal considerations become more prominent if the central bank buys risky private credits. And purchasing equities is potentially even more contentious since it involves the acquisition of control rights.

For these reasons, the fiscal authorities need to own the fiscal consequences of the central bank’s asset purchase decisions. Happily, the BoE’s Asset Purchase Facility meets that requirement, with the Treasury holding the economic interest, even though the MPC decides the amount of assets to buy. Moreover, whenever the MPC wants to increase the stock of assets there is an exchange of letters with the chancellor.

Adding distributional concerns to the MPC’s objectives would be worrying. It is one thing for the MPC to use its “constrained discretion” to limit output volatility. It is quite another to refrain from cutting interest rates or undertaking asset purchases to protect one segment of society at the expense of another. That goes to the heart of politics; such decisions should not be delegated to technocrats.

If the government of the day is unhappy about the side effects of the monetary policies necessary to maintain macroeconomic stability, then it is better for them to take mitigating fiscal action. And, if a government is really set upon the need for a different monetary policy, it should do so directly and openly by invoking the monetary policy override clause.


The writer was deputy governor of the Bank of England, 2008-14. This article is based on this year’s Wincott Memorial Lecture


You're Just Not Prepared For What's Coming

by: Chris Martenson

I hate to break it to you, but chances are you're just not prepared for what's coming. Not even close.
 
Don't take it personally. I'm simply playing the odds.
 
After spending more than a decade warning people all over the world about the futility of pursuing infinite exponential economic growth on a finite planet, I can tell you this: very few are even aware of the nature of our predicament. An even smaller subset is either physically or financially ready for the sort of future barreling down on us. Even fewer are mentally prepared for it. And make no mistake: it's the mental and emotional preparation that matters the most. If you can't cope with adversity and uncertainty, you're going to be toast in the coming years.
 
Those of us intending to persevere need to start by looking unflinchingly at the data, and then allowing time to let it sink in. Change is coming - which isn't a problem in and of itself. But it's pace is likely to be. Rapid change is difficult for humans to process.
 
Those frightened by today's over-inflated asset prices fear how quickly the current bubbles throughout our financial markets will deflate/implode. Who knows when they'll pop? What will the eventual trigger(s) be? All we know for sure is that every bubble in history inevitably found its pin.
 
These bubbles - blown by central bankers serially addicted to creating them (and then riding to the rescue to fix them) - are the largest in all of history. That means they're going to be the most destructive in history when they finally let go. Millions of households will lose trillions of dollars in net worth. Jobs will evaporate, causing the tens of millions of families living paycheck to paycheck serious harm.
 
These are the kind of painful consequences central bank follies result in. They're particularly regrettable because they could have been completely avoided if only we'd taken our medicine during the last crisis back in 2008. But we didn't. We let the Federal Reserve - the institution largely responsible for creating the Great Financial Crisis - conspire with its bretheren central banks to 'paper over' our problems.

So now we are at the apex of the most incredible nest of financial bubbles in all of human history.
 
One of my favorite charts is below, which shows that even the smartest minds among us (Sir Isaac Newton, in this case) can succumb to the mania of a bubble: 
 
 
 
It's enormously difficult to resist the social pressure to become involved.
 
But all bubbles burst -- painfully of course. That's their very nature. Mathematically, it's impossible for half or more of a bubble's participants to close out their positions for a gain. But in reality, it's even worse. Being generous, maybe 10% manage to get out in time. That means the remaining 90% don't. For these bag holders, the losses will range from 'painful' to 'financially fatal'.
 
Which brings us to the conclusion that a similar proportion of people will be emotionally unprepared for the bursting of these bubbles. Again, playing the odds, I'm talking about you.
 
How Exponentials Work Against You
 
Bubbles are destructive in the same manner as ocean waves. Their force is not linear, but exponential.
 
That means that a wave's energy increases as the square of its height. A 4-foot wave has 16 times the force of a 1-foot wave; something any surfer knows from experience. A 1-foot wave will nudge you.
 
A 4-foot wave will smash you, filling your bathing suit and various body orifices with sand and shells. A 10-foot wave has 100 times more destructive power. It can kill you if it manages to pin you against something solid.
 
A small, localized bubble -- such as one only affecting tulip investors in Holland, or a relatively small number of speculators caught up in buying swampland in Florida -- will have a small impact. Consider those 1-foot waves. A larger bubble inflating an entire nation's real estate market will be far more destructive. Like the US in 2007. Or like Australia and Canada today.
 
Those bubbles were (or will be when they burst) 4-foot waves.

The current nest of global bubbles in nearly every financial asset (stocks, bonds, real estate, fine art, collectibles, etc) is entirely without precedent. How big are these in wave terms? Are they a series of 8-foot waves? Or more like 12-footers? At this magnitude level, it doesn't really matter. They're going to be very, very destructive when they break.
 
Our focus now needs to be figuring out how to avoid getting pinned to the coral reef below when they do.
 
Understanding 'Real' Wealth
 
In order to fully understand this story, we have to start right at the beginning and ask "What is wealth?" Most would answer this by saying "money", and then maybe add "stocks and bonds". But those aren't actually wealth.
 
All financial assets are just claims on real wealth, not actually wealth itself. A pile of money has use and utility because you can buy stuff with it. But real wealth is the "stuff" -- food, clothes, land, oil, and so forth. If you couldn't buy anything with your money/stocks/bonds, their worth would revert to the value of the paper they're printed on (if you're lucky enough to hold an actual certificate). It's that simple.
 
Which means that keeping a tight relationship between 'real wealth' and the claims on it should be job #1 of any central bank. But not the Fed, apparently. It has increased the number of claims by a mind-boggling amount over the past several years. Same with the BoJ, the ECB, and the other major central banks around the world. They've embarked on a very different course, one that has disrupted the long-standing relationship between the markers of wealth and real wealth itself.
 
They are aided and abetted by both the media and our educational institutions, which reinforce the idea that the claims on wealth are the same as real wealth itself. It's a handy system, of course, as long as everyone believes it. It has proved a great system for keeping the poor people poor and the rich people rich.
 
But trouble begins when the system gets seriously out of whack. People begin to question why their money has any value at all if the central banks can just print up as much as they want.

Any time they want. And hand it out for free in unlimited quantities to the banks. Who have their own mechanism (i.e., fractional reserve banking) for creating even more money out of thin air. Pretty slick, right?
 
Convince everyone that something you literally make in unlimited quantities out of thin air has value.
 
So much so that, if you lack it, you end up living under a bridge, starving.

Let's express this visually.
 
"GDP" is a measure of the amount of goods and services available and financial asset prices represent the claims (it's not a very accurate measure of real wealth, but it's the best one we've got, so we'll use it). Look at how divergent asset prices get from GDP as bubbles develop:
 
 
 
What we see in the above chart is that the claims on the economy should, quite intuitively, track the economy itself. Bubbles occurred whenever the claims on the economy, the so-called financial assets (stocks, bonds and derivatives), get too far ahead of the economy itself.
 
This is a very important point. The claims on the economy are just that: claims. They are not the economy itself!
 
Yes the Dot-Com crash hurt. But that was the equivalent of a 1-foot wave. Yes, the housing bubble hurt, and that was a 2-foot wave. The current bubble is vastly larger than the prior two, and is the 4-foot wave in our analogy -- if we're lucky. It might turn out to be a 10-footer.
 
The mystery to me is how people have forgotten the lessons of prior bubbles so rapidly. How they cannot see the current bubbles even as the data is right there, and so easy to come by. I suppose the mania of a bubble, the 'high' of easy returns, just makes people blind to reality.
 
It used to take a generation or longer to forget the painful lessons of a bubble. The victims had to age and die off before a future generation could repeat the mistakes anew. But now, we have the same generation repeating the same mistakes three times in less than 20 years. Go figure.
 
In this story, wishful thinking and self-delusion have harmful consequences. It's no different than taking up a lifelong habit of chain-smoking as a young teen. Sure, you may be one of the few who lives a long full life in spite of the risks, but the odds are definitely not in your favor.
 
The inevitable destruction caused by the current froth of bubbles is going to hurt a lot of people, institutions, pensions, industries and countries. Nobody will be spared when these burst.
 
The only question left to be answered is: Who's going to eat the losses?

This is not a future question for a future time; it's one that's being answered daily already.
 
Pensioners are already taking cuts. Puerto Rico will not be fully rebuilt. Shale wells drilled when oil was $100/barrel, but being drained empty at $50/barrel, represent capital already hopelessly betrayed. Young graduates with $100,000 of student debt face lost decades of capital building. The losers are already emerging.
 
And there's many more to follow. This story is much closer to the beginning than the end. The bubbles have yet to burst. We're just seeing the water at the shore's edge beginning to retreat, wondering how large the wave will be when it arrives. Hoping that it's not a monster tsunami.
 
The End Is Nigh
 
History's largest bubbles have had the exact same root cause: an expansion of credit that causes leverage to go up faster than the income available to service it.
 
Simply put: bubbles exist when asset price inflation rises beyond what incomes can sustain. They are everywhere and always a credit-fueled phenomenon.
 
 
 
Look at the ridiculous trajectory of the S&P 500, especially since Trump got elected. I don't know about you, but pretty much everything that has happened in the US over the past year has been either a diplomatic clown show or a financial cruelty to the average citizen. And yet prices have risen at their highest pace in two decades?
 
My view is that the Trump election was a totally unexpected black swan shock for the global central banking cartel, and it freaked out. With the Dow down -1,000 points in the late night hours following Trump's surprise win, the central banks dumped gobs and oodles of money into the equity markets to prevent carnage.

All that money calmed investors and sent prices roaring higher over the following months. The resulting 80-degree rocket launch will hurt a lot when it comes back to earth. Good going central Banks!
 
This is all happening when we're as close as ever to a military (if not nuclear) confrontation with North Korea, Russia is busy beefing up its war machine, Saudi Arabia has pivoted away from the US towards China and Russia, and most of our European allies are inching away from us.
 
Meanwhile, the FCC is about to rule against the vast majority of the public and allow US corporations to turn the internet into a pay-for-play toll road -- completely undermining the core principle of the most transformative and useful invention of the millennium. By eliminating net neutrality the FCC has ruled 'against' you, and 'for' the continued usurious profits of the cable companies.
 
Worse, heath care premiums continue to increase by double-digits each year. They're going up by a horrifying 45% in Florida and 57% in Georgia, to name just two unfortunate states out of many. And to really rub salt in the wounds of the nation, the DC swamp is busy passing a tax change that will further drive an enormous gap between the 0.1% and everybody else by lowering taxes on corporate profits (already the lowest in the world if you measure both tax on profits and value-added taxes).
 
How to pay for the massive cost of this deficit-exploding bill? Easy, just eliminate deductions for average people (such as the state and local tax deductions) and begin taxing the waived tuition of graduate students. That's right, the government helped to massively bloat tuition fees via massive lending to students and then wants to squeeze the poorest and hardest-working among them.
 
I wish I were kidding here. But like a cruel joke re-told at the wrong moment, the GOP is busy destroying the meager and precarious financial situation of our citizens just so it can toss a few more dollars into the already-bloated wallets of the richest people in the country.

The long rise of the ultra-wealthy is not some mystery. It arose as a predictable consequence of the financialization of, well…everything that began in the 1980s:
 
 
US Wealth Inequality chart
 
 
The above chart speaks to a deeply unfair system that punishes hard working people in order to give more to those who merely shuffle financial instruments around or own financial assets.
 
This is the system that the Fed is working so hard to preserve. This is the system that Washington DC is working so hard to sustain.
 
It's flat out unfair and punitive. It both punishes and rewards the wrong folks, respectively. Debtors are provided relief while savers are punished. The young are saddled with debts and face impossible costs of living mainly to preserve the illusion of wealth for a little longer for the generation in front of them.
 
For so many reasons, folks, none of this is sustainable. If the system doesn't crash first under the weight of its excessive debts or the puncturing of its many asset price bubbles, the brewing class and generational wars will boil over if the status quo trajectory continues for much longer.


Think of a number

Europe’s banks face a glut of new rules

Ten years after the financial crisis, the regulatory revolution continues




FOR those oddballs whose hearts sing at the thought of bank regulation, Europe is a pretty good place to be. No fewer than five lots of rules are about to come into force, are near completion or are due for overhaul. They will open up European banking to more competition, tighten rules on trading, dent reported profits and boost capital requirements. Although they should also make Europe’s financial system healthier, bankers—after a decade of ever-tightening regulation since the crisis of 2007-08—may be less enthused.

Start with the extra competition. On January 13th the European Union’s updated Payment Services Directive, PSD2, takes effect. It sets terms of engagement between banks, which have had a monopoly on customers’ account data and a tight grip on payments, and others—financial-technology companies and rival banks—that are already muscling in.

Payment providers allow people to pay merchants by direct transfer from their bank accounts.

Account aggregators pull together data from accounts at several banks, so that Europeans can see a broad view of their finances in one place—and maybe find better deals for insurance, mortgages and so forth.

The new entrants need not only their customers’ permission to take money and data from their accounts but also co-operation from their banks. They worry that banks won’t play fair. Banks, for their part, have fretted that opening up their systems may expose customers to fraud and themselves to lawsuits. On November 27th the European Commission adopted technical standards intended to balance competition and security. Although the directive applies from next month, the standards may not take effect until September 2019. Banks and their rivals will meanwhile have to rub along.

The standards demand that customers supply two out of three types of proof of identity before transactions are approved: something they know (a password or code); something they own (a card or a phone); and something they are (eg, a fingerprint). This approach is already common, though not universal, online.

To communicate with payment-services providers and account aggregators, banks have two options. They may allow them access through their online customer interfaces. Or they can build dedicated interfaces into which the newcomers can plug their applications. Almost all banks are expected to choose the latter. To guarantee fair play, they must have a fallback, in case the dedicated interface fails.

While retail banks grapple with PSD2, investment banks and asset managers have been bracing themselves for MiFID2, the refreshed Markets in Financial Instruments Directive, which takes effect on January 3rd. Intended to make financial markets more transparent—and thus, in theory, safer and more competitive—MiFID2 will restrict trading in securities on banks’ internal venues and force more derivatives hitherto traded “over the counter” onto centralised exchanges. It also obliges banks to charge clients separately for research, rather than bundle it in with other services. Some are swallowing the cost; some are cutting analysts.

One way or another, the other three changes are all about safety. From January banks in Europe (and many other places, but not America) must apply a new accounting standard, IFRS 9, obliging them to make provisions for expected loan losses, rather than wait until losses are incurred. That is likely to knock earnings next year. Most banks surveyed by the European Banking Authority, a supervisor, said they expected profits to become more volatile. The same could happen to lending.

Floor polished?

Next, it seems that the last big bit of Basel 3, a set of global capital standards revised after the financial crisis, may finally be complete. Officials had hoped for agreement a year ago, but haggling continued. The central-bank governors and supervisors who approve the standards are due to hold a press conference in Frankfurt on December 7th. Surely, they would not bother if they had nothing to say?

At issue have been the internal models big banks use to calculate risk-weighted assets (RWAs).

The lower the answer, the higher the ratio of equity to RWAs, a key gauge of capital strength, and the less equity banks need. To limit the discount from these models, Basel standard-setters proposed a floor for the ratio of banks’ RWA estimates to those yielded by a standard approach, at first between 60% and 90%. American negotiators, though their banks are little affected, favoured a high floor and Europeans a low one or none; the French were the most vocal. In October Bloomberg reported that negotiators were settling on a ratio of 72.5%.

Assuming the floor is agreed on, it will, like other Basel rules, be phased in over several years. The fifth and last change to Europe’s regulatory framework could take every bit as long. On December 6th the European Commission is due to propose a fortification of economic and monetary union. As part of that effort, in October it exhorted governments to complete the EU’s half-finished banking union.

Although the euro area now has—belatedly—a single supervisor, housed in the European Central Bank (ECB), and a single body to deal with insolvent banks, it still lacks a single deposit-insurance scheme, chiefly because German taxpayers do not want to be on the hook for the failings of lenders farther south. The commission hopes that the Germans can be won over, by introducing the scheme gradually and by tackling the bad loans that still burden banks in Italy and elsewhere. Both it and the ECB also want to be firmer on bad loans in future: the ECB has suggested that banks make full provision for unsecured duds after two years and secured ones after seven. The commission is also exploring the creation of new securities, backed by pools of sovereign debt from all euro-area countries, to weaken the link between European banks and national governments.

With all this to worry about—oh, and Brexit—Europe’s bankers may look enviously westward.

American banks and supervisors were faster to get their houses in order after the crisis, and under President Donald Trump the regulatory tide is turning. This week Jerome Powell, Mr Trump’s choice to lead the Federal Reserve, told senators that regulation was “tough enough”.

By now, Europe’s bankers know better than to expect much sympathy.


Economy Has Room To Grow, Here’s Why

Recent reports overstate how fast the U.S. economy is growing, but strength overseas and the tax plan should give it a boost

By Justin Lahart


The evidence that the U.S. economy has been accelerating is thinner than the headlines shout.

But with the rest of the world economy improving and a possible tax-cut jolt coming soon, the good news is there is room for a pickup in growth.

In the years since the financial crisis, the U.S. economy has been in a deep rut: Growth averaged just 2.1% a year from the end of the recession to the first quarter of this year, making it the most tepid expansion on record. But lately GDP has perked up, growing at a 3.1% rate in the second quarter and 3.3% in the third. Put that together with steady hiring and an ebullient stock market, the economy looks very strong.

But much of the strength in GDP over the past two quarters wasn’t actually the result of stronger domestic demand. Instead, the growth was driven by a narrowing of the trade deficit and an increase in inventories, both of which will likely prove temporary. Absent trade and inventory swings, demand grew at an average rate of 2.4% over the past two quarters, matching the average pace over the previous four quarters.

DEMAND PICTURE
Change in gross domestic product at anual rate



Meanwhile, hiring, though strong, has been slowing since 2015. And the stock market’s rise has been driven not so much by U.S. economic growth as an increase in valuations and a pickup in profits from overseas. The S&P 500 trades at 18.4 expected earnings, compared with 16.8 times at the start of the year. And in the third quarter, earnings at companies in the S&P 500 with greater than half their sales abroad were up 13.4% from a year earlier, according to FactSet, compared with 2.3% for companies with less than half their sales abroad.

Overseas economies have been looking better all year. The surprise is that hardly any countries are struggling. Deutsche Bank economist Torsten Slok points out that the International Monetary Fund forecasts only six of 192 countries will register an economic contraction next year. That would be the fewest on record.

A WORLD OF CALM
Number of global economies contracting



The global economic environment counts as good news for the U.S. It should continue to bolster companies’ overseas profits, and it could push up U.S. growth. Similarly, the tax cut, if it passes, would increase companies’ profits and would provide a boost of around 0.3 percentage points to GDP growth next year, according to a preliminary analysis by Bank of America Merrill Lynch.

These effects mean U.S. growth should stay healthy but not accelerate too much from here.

With all of the optimism, it is worth watching just where the growth comes from.