The Bard and the Bank Regulators

“Be wary then; best safety lies in fear,” said Laertes to Ophelia as she embarked on her doomed dalliance with Hamlet. That is sound advice for banks and their regulators, too, as they face the prospect of technological disruption.

Howard Davies

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LONDON – Banking supervision teams at the Bank of England “now receive the equivalent of twice the entire works of Shakespeare of reading each week.” So says Huw van Steenis, the author of a new report, “Future of Finance,” commissioned by the Bank’s outgoing governor, Mark Carney.

One might argue with the word “equivalent.” Few regulatory submissions rival the Bard’s output in their timelessness or vivid use of language: the Bank of England would probably send them winging straight back to their originators if they did. But van Steenis’s point about the volume of reporting is a valid one. The system of banking supervision has become highly complex, with a risk that the forest is entirely lost from view in the midst of thousands of trees.

The team that produced the report commissioned McKinsey and Company to assess the cost of all this reporting to banks in the United Kingdom. Their estimate is £2-4.5 billion ($2.5-5.7 billion) per year – rather a broad range, but even the lower bound is a big number, with a material impact on profitability.

Van Steenis argues that better use of technology – regtech – could make a difference. Regulators should be using artificial intelligence and machine learning to interrogate regulatory returns and identify risks and anomalies. He also points out that much of the complexity has its origin in the overlapping and sometimes conflicting priorities of different regulators. In comparison with the United States, the UK system is relatively streamlined, but banks must still satisfy the requirements of the Bank of England, the Financial Conduct Authority, the Competition and Markets Authority, the Payment Systems Regulator, and the Open Banking Implementation Entity. They are not always easy to reconcile.

The problem is particularly acute in relation to the payments system, which, owing to new entrants – perhaps soon to include Facebook with its Libra currency – has become far more complex to oversee. As a result, a number of regulators impose their own requirements.

Van Steenis argues for “a joined-up strategy to improve our payments infrastructure and regulation,” and an approach which he describes as analogous to air traffic control, to ensure that the demands of different regulators do not land on banks and others in an unmanageable and uncoordinated way. The UK government has responded positively to that idea, but it will not be easy to bring greater coherence to a range of regulators that each has its own legal obligations and political masters. Air traffic controllers can order a plane to enter a holding pattern, as anyone who has flown into Heathrow in recent years knows only too well. Who can tell a statutory regulator to get back in its box and wait for others to finish their work? We must hope that the government can answer that question.

The most interesting parts of “Future of Finance” concern how means of payment are changing. Cash is in decline in many countries, though the rate differs markedly from place to place. Cash usage has fallen by over 80% in Sweden in the last decade and is now dropping by 10% per year in the UK, while it is barely changing in Germany. Van Steenis warns that the “Swedish experience shows that without a coordinated plan, the pace of change risks excluding some groups in society.”

He is also a skeptic when it comes to cryptocurrencies: “crypto assets that are not backed by currency are an unreliable store of value, inefficient medium of exchange and simply won’t cut the mustard.” And he does not see a compelling case for a central bank digital currency, which puts him at odds with some others in the central banking world, who see attractions in the idea, not least greater leeway to impose negative interest rates.

But, despite skepticism about the viability of cryptocurrencies, bankers will not find “Future of Finance” reassuring reading. It points out that Ant Financial, which I visited in Shanghai last week, is now the world’s largest financial services firm, with over a billion customers, and not a single brick-and-mortar branch. There are more mobile and contactless payments in China each year – worth $15.4 trillion – than are managed by Visa and MasterCard combined. And in response to the report, the Bank of England announced that in the future, non-bank payment providers will be allowed to hold interest-bearing accounts at the central bank, a privilege previously available only to commercial banks.

Anyone working in finance knows that a revolution is under way, driven by disruptive technology. The full implications, for providers of finance and those who regulate them, are only dimly understood so far. The Bank of England’s report sheds valuable light on aspects of that revolution. It examines the threat to traditional banks’ core income streams in an analog world.

It is right to face up to that threat, and to be anxious. As Laertes said to Ophelia as she embarked on her doomed dalliance with Hamlet, “Be wary then; best safety lies in fear.” That warning probably does not appear in the Shakespeare-sized weekly reading of the Bank of England supervisors. Perhaps it should.


Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of the Royal Bank of Scotland. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.

Why War With Iran Isn’t in the United States’ Interests

The strategic calculus behind such a confrontation just doesn’t benefit the U.S.

By Xander Snyder

 

 
The U.S.-Iran standoff continues to evolve quickly, yet the blow-by-blow commentary covering tanker attacks, a downed drone, and reversed orders for airstrikes from the White House fails to consider the strategic logic behind an intervention, if in fact the Trump administration decides to intervene. With that in mind, it’s worth taking a moment to imagine what a war between the two would actually look like.
By now, the U.S. should have learned a thing or two from the Vietnam and Iraq wars. Distant foreign conflicts are difficult to win without a well-defined case for what success looks like and an overwhelming military commitment, the kind the American public is usually unwilling to provide unless faced with a massive and immediate threat. Small-scale engagements accomplish little and are instead more likely to evolve into larger conflicts. Installing foreign governments in the American image is more difficult, costly, time-consuming and even deadly than leaders are likely to claim. Backing a local proxy is often unpalatable for the country’s sense of ethics, but U.S. adversaries often have no such qualms.

Those proxies are often an ineffective substitute for a U.S. military presence when it comes to pursuing U.S. objectives. And without a substantial, long-term commitment of U.S. forces, such wars are more likely to open a power vacuum when the U.S. withdraws. The result: a collapsed government, an invasion by a neighbor, a revolution that creates new and uncertain structures – or some combination of these. In fact, the U.S. has had few true victories in the wars it has fought since World War II.
 
 
Limited Airstrikes
Consider the U.S. government's options, then, for a war with Iran. If the U.S. chooses a kinetic response, the first and most likely option would be a limited strike, similar in scale to or perhaps somewhat greater than the strikes on Syria that the Trump administration ordered on Syria in April 2017 and 2018. But Iran is not Syria. Iran has a sophisticated air defense infrastructure and plenty of air denial capability, increasing the chance of U.S. casualties. Further, a limited air strike probably wouldn’t accomplish anything meaningful. It might take out a handful of radar and air defense installations, sending a political signal but affecting in no real way the strategic reality on the ground. The only time U.S. air power alone has significantly shifted the reality on the ground was in Kosovo, but Iran today is far more powerful than Serbia in 1999.
Instead, a limited strike has a good chance of working against US interests. Iran’s economy is hurting, and its society appears more divided as citizens continue to grow frustrated with the government. The U.S. has deployed sanctions as a strategy to hobble the economy enough to create social pressure on Tehran, forcing the government to spend less on its defenses and its funding of militias in Syria and Iraq. And so far, they’ve been effective. If the U.S. sustained this tactic, over time Iran’s domestic situation would worsen, and its citizenry would be more likely to blame its leadership for their problems. And that would likely intensify the divisions within the government that are already emerging, resulting in either a more Western-friendly government or one dominated by the Islamic Revolutionary Guard Corps.
Even limited U.S. airstrikes, however, would increase the probability of the IRGC consolidating power. Where sanctions may help create division, an attack would unite Iran’s hard-liners and reformers against the U.S. That unity would likely occur under the aegis of the hard-liners who have been warning all along that this day would come if Iran were foolish enough to trust the U.S. As the most powerful entity in the county, the IRGC would probably take over, and do so with popular support.
 
Use of Ground Force
Ground force is a less likely choice for the U.S., even with limited objectives (like eliminating specific military equipment or securing passage through the Strait of Hormuz). But it would be more likely to achieve what the U.S. really wants: for Iran to recall its foreign militias so that they will defend the home front. But when a military force is rapidly removed without a replacement ready to take its place, it creates a power vacuum and, therefore, an opportunity for others to fill the void. In this case – the Islamic State and other jihadist groups. Timing matters too. The pace at which Iran withdraws its militias from Syria and Iraq, states that are already precariously fragile, will create an outsized risk to violently alter the regional balance of power.
 
 
If the Islamic State moves back into the space vacated by Iran, it would be the U.S. that would have to again deal with this problem, which would require reoccupying parts of Iraq while fighting Iran. That, in turn, would likely entail support from Syrian and Iraqi Kurdish forces, which would again put pressure on U.S.-Turkey relations. But the Syrian Kurds may not see a long-term alliance with the U.S. as in its best interest after the U.S. threatened to leave them high and dry in December 2018. They could instead seek out a political resolution with Damascus, backed by Russia, that would protect them from Turkey. It’s possible that if the Islamic State re-emerged, Russia could step in to back Kurdish groups such as the Syrian Democratic Forces to fight back. But that would mean the U.S. would be depending on Russian assistance to cover its western flank, and in exchange for such cooperation Russia would likely demand U.S. concessions in places like Ukraine. In short, going all-in with Iran would require either a large-scale U.S. occupation or dependence on Russia in Syria and Iraq to prevent the Islamic State from coming back. Neither of those are appealing options for Washington.
If it’s regime change that the U.S. is after in Iran, the risks are even greater. The fallout would look much like that of the second Iraq war, but on a far greater scale. Installing a pro-American regime isn’t easy, but it can easily fail. The U.S. would have to commit to an indefinite occupation of Iran or again risk the emergence of a power vacuum. And it would still have to deal with the rest of the Middle East. In the best-case scenario, the U.S. would install a new head of government while facing a lengthy insurgency, which would likely include the vestiges of the IRGC and its heavy weaponry. After a long, costly occupation, the U.S. would withdraw, leaving Iran’s leaders to face opposition on their own. The half-life of U.S.-installed leaders in the Middle East is not long – just ask the shah of Iran.
Whether limited airstrikes or a full-scale invasion, a U.S. military confrontation with Iran would create more problems for the U.S. than it solves. As barbs are traded on the international stage, it’s these kinds of strategic considerations that Washington will need to consider before going to war.

Investors should expect central banks to do the unexpected

Modern monetary theory may seem unlikely now, but things can change quickly

Katie Martin


Some investors fear we will look back on these messages from Mario Draghi and the Fed with a sense that we were at the peak of global monetary madness © AP


We now know what weary, miserable investors want to hear. The answer came just minutes after last week’s fund manager survey from Bank of America Merrill Lynch showed that investors were the most gloomy since the financial crisis of 2008. As they sat sobbing into their lattes, wracked by fears of trade wars and a global slowdown, a hero came along to turn that frown upside down: Mario Draghi.

The outgoing European Central Bank president managed finally to make investors listen to the message he has been trumpeting for the past couple of weeks: he is prepared to cut rates and buy more bonds in an effort to support the eurozone economy in the sunset weeks of his tenure.

Suddenly those forlorn fund managers were wiping away their tears, cracking smiles, and punching the big green button marked “buy stocks”.

“In two to three hours, we had a complete change,” says a bemused-sounding Kasper Elmgreen of Amundi Asset Management. The refreshed exuberance was bolstered further when the US Federal Reserve added its loud voice to the dovish choir later in the week.

Not to spoil the party, but some investors fear that, in the coming years, we will look back on these messages from Mr Draghi (or “Mario D”, as US president Donald Trump labelled him on Twitter) and the Fed with a sense that we were at the peak of global monetary madness.

The concern here is that central banks have tried all this before with, by some metrics, limited success. Since the global financial crisis central banks have slashed rates and pumped trillions into the bond markets, and they still cannot hit their inflation targets.

In fairness, central banks are using the only tools at their disposal, but it is striking that they are revving up to take broadly the same steps yet again. “For me, we are into the realms of the insane,” says James Athey of Aberdeen Standard Investments. “We are doing the same thing over and over again and expecting different results.”

Amid this sense of exasperation, investors are starting to wonder what is next. If yet more rate cuts and yet more bond buying fail to do the trick, then what? That is why some previously fringe concepts of how monetary policy could work might are starting to hit the mainstream.

Jim Cielinski of Janus Henderson suggested at an event last week that central bankers could be close, very close, to effectively ripping up their mandates and trying something new. This possibly includes so-called modern monetary theory: crudely, a project centring on printing cash to fund fiscal expansion.

“Think how brazen that idea was just a year ago. It was ludicrous. What a silly concept,” he said, describing some elements of the framework as “bunk”.

Over dinner in a plush corner of Mayfair — an unlikely forum for a serious discussion about what many see as a lefty pet project — Mr Cielinski noted that while MMT may seem unlikely now, “things move fairly quickly”.

“I can promise you that in ‘09, I wouldn’t have talked to anybody who said rates were going negative, anybody who said wait a year or two and there will be $13tn of negative yielding bonds. You will pay somebody to take your money, central banks will be buying trillions of dollars of assets . . . including corporate bonds. You would laugh them out of the room.”

Now, of course, all that is the bedrock of global markets. We consider it to be normal. Why not push the boundaries just that bit further? “Even central bankers, when their backs are against the wall, they do look for things in the toolkit that weren’t there before,” Mr Cielinski said.

If conventional policy, which was thought to be unconventional such a short period of time ago, does not work this time, then it may be time for investors to brace for a brave new world. Some are already starting to.

The Real Reason the Deep State Hates Russia... And What it Means for Gold

by International Man


For years, the Deep State in the US—the permanently entrenched bureaucracy that runs the show no matter which party is in power—has labelled Russia "public enemy number one."

To help us better understand the situation we’re turning to Doug Casey’s friend, Mark Gould.

Mark is an executive for a company in the oil industry, also working on several media projects. He also has 30 years of experience in Russian telecommunications as co-founder of CTC Media (previously NASDAQ:CTCM); and afterwards pioneering digital compression for TV (the core technology for video streaming) on the Soviet Satellite system, Moscow Global. Mark currently lives in Moscow.

International Man: Naturally, Americans have a lot of misconceptions about Russia. And that’s what we want to help clear up today. The importance of Russia to world affairs is simply too important to ignore or to not understand properly.

Also, this perception gap about Russia could be key to finding interesting investment opportunities—particularly in the natural resources space—that are off the radar of the mainstream financial media.

John McCain used to call Russia a gas station masquerading as a country. This is a childish and overly simplistic characterization. Others in the US media and government have made similar comments. What does the mainstream image of Russia get wrong?

Mark Gould: The US perspective is stuck in the 1960s and even earlier, going back to the 19th century.

Russia is a unique society. It’s a normal place, operating under its own rules and customs.

Viewing it through the prism of the Soviet past is not concurrent with present realities. Russia is an independent state that has its own concerns, people, leaders, and problems just like America does. And the people are patriotic and so is the president.

Russia is charting its own path. It doesn’t want to be under the thumb of the IMF or the World Bank.

Americans think that Russians are warlike or devious, because they’re mixed Eurasian. But what they really are is descended from the Viking Rus that swept down from northern Europe all the way to Kiev and then founded Moscow in the 9th century.

So, it’s a group-oriented society, as the Vikings were. Despite the image of Vikings as warlike and terrible, they really weren’t. They were traders. Everybody pillaged, raped, and stole, but there’s also a lot of trading going on—despite what TV shows want to say it was all about.

It’s a real modern, upwardly mobile society. This whole image of oligarchs and kleptocrats, that really is a thing of the past. The overall ambiance would be shocking to most Americans.

There are fancier and better restaurants, better fashions, beautiful women, less out-of-shape people, and so forth.

International Man: What makes the Deep State in the US so hostile to Russia?

Mark Gould: Conceptually and politically, sanctions don’t work as a political solution or a diplomatic solution.

It’s an international insult to suspend a fellow member of the G8 for an internal matter in what Russia considers its near-abroad the same way the US considers Cuba or Nicaragua its near-abroad. I’m referring to the situation with Crimea.

Whenever you screw around with another country’s access to the sea, it means war. Always. Not 99% of the time, not 98% of the time, but 100% of the time.

In 1965, Khrushchev gave back Crimea to Ukraine when he was drunk and likely because he had governed Ukraine under Stalin. In 2010 Ukraine extended Russia’s lease until 2042 for its Black Sea Fleet centered in the port city of Sevastopol in Crimea, which gives Russia access from the Black Sea to the Mediterranean and thus to the Atlantic.

Leaving Crimea in the hands of a hostile power is like a knife to Russia’s throat. And Russia responded accordingly.

NATO was looking for a reason to justify its continued existence after the end of World War II and after the end of the Cold War. And if you think there weren’t CIA operatives and State Department operatives fomenting for Ukraine to join NATO, you’re naïve.

International Man: Is there any hope for better relations, or are relations likely to get worse? And what are the consequences of that?

Mark Gould: I don’t think it’s going to get better fast. I think neoliberals and neoconservatives are the bane of existence of mankind, especially with the two-party system in America. So, I’m not sanguine about it at all.

I do not see it getting better unless some enlightened individual gets into office in the US and actually does the bold things that need to be done, and that is: End the sanctions, get back in communication, recognize that Russia has a human face, and let it rejoin the G8.

And don’t be afraid of the rise of Russia. It’s a normal thing.

I’m saying all that in the face of the fact that the entrenched military-industrial complex wants war, and I think a series of wars. In my entire life as an American, I think there’s maybe been eight years that there haven’t been wars. And that’s absurd.

Frankly, if you want to talk about the only adult in the room… Vladimir Putin is the only adult in the room.

A lot has been made about his being part of the KGB.

But the same people who complain about that don’t make a peep about George H.W. Bush, who was head of the CIA.

International Man: The Central Bank of Russia has been the world’s largest buyer of gold in recent years. What do they see coming, and what are they preparing for?

Mark Gould: Russia is hedging its bets. That’s my simple answer.

If you go back in history a little bit, you can get the Russian perspective on gold.

The Russian ruble has always been backed by gold. It’s not a new idea. And Russia has more reserves in gold that backs the currency than almost any other country.

Russia is also the world’s largest producer of oil; it’s the second largest producer of natural gas; it’s number two in sunflower oil.

Kicking Russia out of SWIFT or doing anything like that would be basically cutting off your nose to spite your own face. The US government would be complete idiots to do that.

Money is an idea backed by confidence, and gold has held that for many years for many people and for many countries.

Russia is hedging its bets. It’s building its own trade alliances. For example, recently Russia signed a deal with Huawei, the Chinese company that’s been banned from American markets.

International Man: Russia has been building alternatives to Western-dominated systems. This includes measures to protect itself from sanctions involving the US financial system, an alternative to the SWIFT system, alternative trade deals with other BRICS countries, the Eurasian Economic Union, and integration with China’s New Silk Road program. Where do you see this trend going?

Mark Gould: Well I think it’s going to continue.

Russia is building alliances; who doesn’t? To expect Russia not to look after its own economic self-interest is absurd. It’s the same thing the US or the UK or France or Indonesia do.

Russia’s building alliances with those countries—especially BRICS countries—that have a similar perspective.

I think the trend is going to continue. I don’t think it’s a hostile thing toward the US. Russia is just doing what it considers necessary to survive.

And US perspective is, "You don’t have any right to do that, because we are the arbiters of what is fair and correct in national self-interest for the world." And that’s a pretty arrogant perspective.

So, I don’t see Russia disappearing or growing smaller. The US sanctions are actually encouraging the development of the agricultural, high-tech, and other aspects of the Russian economy.

International Man: By many valuation metrics, Russia is one of the cheapest markets in the world. What investment opportunities do you see in Russia?

Mark Gould: Mark Feldman is a friend and one of the partners in the Standard Capital Group in Moscow.

I asked him the other day, "What is your number-one recommendation to invest in?"

He said, "That’s an easy one. Russian government bonds."

And then afterward he said, "Commodity-producing assets."

Russian gold companies can be bought for four to five times EBITDA.

Or real estate, or retailers. You can still buy those at four to five times EBITDA also.

There’s only one public real estate company in Russia, called PIK; they build apartment buildings.

And there is Petropavlovsk, a publicly traded Russian gold company. All of these companies are good buys in this market.

International Man: Is there anything else you would like to add in regard to investing in Russia.

Mark Gould: The time to invest is when it’s still a mystery, and Russia has been a mystery way before Churchill came up with his, "Russia’s a riddle wrapped in a mystery inside an enigma."

Going back to Voltaire, it was still a mystery. And Communism just made it even more confusing.

But the bottom line is that the right time to invest is while it’s still a mystery. If you come here, it’s like riding on a bus. You get on the bus, you get off the bus, and your eyes are opened. You go, "Oh my god, who knew you would find superstores bigger than any IKEA or Costco you’ve ever seen in America? Or that they run for blocks and blocks and blocks?"

The time is now. It’s not tomorrow, it’s now.


Living Life Near the ZLB

Doug Nolan


There must be members of the FOMC that feel they are about to be railroaded into a 50 bps cut a week from Wednesday. Chairman Powell essentially pre-committed to a reduction last week in testimony before Congress. For a Federal Reserve preaching “data dependent” for a while now, the less dovish contingent at the Fed must be asking, “But what about the data?”

It was interesting to see headlines Thursday afternoon from a speech by the President of the New York Fed, John Williams: “Williams: Lesson With Zero Rates is to Take Swift Action,” “Williams: Currently Estimates Neutral Rate in U.S. Around 0.5%.” Soon afterward, headlines from Fed vice chair Richard Clarida reinforced the point: “Fed’s Clarida: Central Bank Needs to Act Preemptively,” and “Clarida: You Don’t Necessarily Want to Wait Until Data Turns.” Things turned rather boisterous ahead of the Fed’s “quiet period.”

Markets were all ears. The implied yield on August Fed Funds futures dropped a quick nine basis points to 1.98%, a full 43 bps below the current rate. The Market’s Thursday afternoon pricing of a high probability of a 50 bps cut elicited an unusual backtrack: “Fed Says William’s Speech ‘Not About’ Potential Policy Actions.” (The President tweeted he liked Williams’ “first statement much better than his second.”) The implied rate on August Fed Funds futures closed the week at 2.10%, with market odds (60%) back to favoring a 25 bps cut. Ten-year Treasury yields dropped seven bps this week to 2.06%, with bund yields down 11 bps to negative 0.32%.

William’s speech, “Living Life Near the ZLB,” deserves of some attention: “My wife is a professor of nursing, and she says one of the best things you can do for your children is to get them vaccinated. It’s better to deal with the short-term pain of a shot than to take the risk that they’ll contract a disease later on. I think about monetary policy near the zero lower bound—or ZLB for short—in much the same way. It’s better to take preventative measures than to wait for disaster to unfold… Over the past quarter century, a great deal of research has gone into understanding the causes and consequences of the zero lower bound.”

[Note to PhD economics students: the clearest path to the upper echelon of the Federal Reserve System is to formulate some crackpot theory justifying aggressive monetary stimulus] How much “ZLB” Fed research has been conducted for environments characterized by record stock prices, strong Credit growth, booming corporate Credit markets, and a world with $13 TN of negative-yielding debt? Williams references a 2002 paper (co-authored with Dave Reifschneider) that evaluated “effects of the ZLB on the macro economy and examined alternative monetary policy strategies to mitigate the effects of the ZLB.”

“This work highlighted a number of conclusions based on model simulations. In particular, monetary policy can mitigate the effects of the ZLB in several ways: The first: don’t keep your powder dry—that is, move more quickly to add monetary stimulus than you otherwise might… When you only have so much stimulus at your disposal, it pays to act quickly to lower rates at the first sign of economic distress. …My second conclusion, which is to keep interest rates lower for longer. The expectation of lower interest rates in the future lowers yields on bonds and thereby fosters more favorable financial conditions overall… Finally, policies that promise temporarily higher inflation following ZLB episodes can help generate a faster recovery and better sustain price stability over the longer run. In model simulations, these ‘make-up’ strategies can mitigate nearly all of the adverse effects of the ZLB.”

There would be outrage if the Fed was using similar “model simulations” to justify a policy course at odds with the markets. In a world of unprecedented complexity, model simulations are basically worthless. If the Fed cannot even effectively model consumer price inflation from actual policy measures, how are models simulating impacts on future economic and inflation outcomes (from untested experimental policy) supposed to be credible? Besides, how have the ZLB experiments been progressing in Europe and Japan?

Williams: “An added impetus to this research has been the growing evidence that the neutral rate of interest rate has fallen significantly. I... have devoted a significant chunk of my academic career to studying r-star, or the long-run neutral rate of interest, and its implications for monetary policy. Our current estimates of r-star in the United States are around half a percent.”

What happened to the traditional central bank focus on money and Credit? This “natural rate” framework is problematic – and particularly so in Bubble environments. What was the estimate of r-star last November with 10-year Treasury yields at 3.24% and December ’19 futures implying a 2.93% Fed Funds rate? R-star is defined as the “interest rate that supports the economy at full employment/maximum output while keeping inflation constant.” In a world where loose financial conditions and booming securities markets are required to sustain the global Bubble, one can indeed make the argument that r-star is quite low. R-star is today only relevant in the context of a policy objective of sustaining the Bubble.

I thought it was outrageous in 2013 when chairman Bernanke stated the Fed was ready to “push back against a tightening of financial conditions”. It was as if I was the only analyst that had an issue with Bernanke essentially signaling that the Fed would not tolerate risk aversion or market pullbacks. Now the Fed and global central banks are taking another giant leap – the latest iteration of New Age experimental central banking: The “insurance rate cut” – “an ounce of prevention is worth a pound of cure.”

This is not about prevention, and William’s vaccine analogy is misguided. The world is suffering from chronic (debt) illness. An individual with diabetes, heart disease or cancer will find a cure in a vaccine. Over the years, activist monetary policies have been likened to giving an alcoholic another shot of whiskey or a drug addict another hit of heroin. While these have obvious merits, to counter Williams analogy I’ll instead use antibiotics. Global central bankers have been fighting the world’s chronic debt and economic maladjustment disease with steady doses of antibiotics. Not surprisingly, these pathogens have built up strong resistance to medication.

More stimulus at this point in the cycle is not for prevention – but instead a narcotic for sustaining unsound financial and economic booms (i.e. “extend the expansion”). The Fed and central bankers are again crossing a dangerous red line – compelled to aggressively administer antibiotics hoping to prevent a plague that has evolved to the point of thriving on antibiotics.

It wasn’t that long ago that Fed policy stimulus operated through a mechanism of adding reserves directly into the banking system, with additional reserves working to reduce rates while encouraging borrowing and lending. Policy would act to provide a subtle change in lending conditions that over time would reverberate throughout the economy. The Federal Reserve under Alan Greenspan increasingly shifted to using the markets as the mechanism to loosen financial conditions and stimulate the economy. The 2008 crisis unleashed the policy of direct market intervention, with Bernanke later doubling-down with his “push back” comment.

The U.S.’s coupling of market-based finance with market-directed monetary stimulus created a powerful – seemingly miraculous - combination. Others wanted in on the action. It was pro-Bubble for the U.S., but nonetheless took the world by storm. It became Pro-Global Bubble, and the world today is engulfed in historic market and financial Bubbles.

What is the “r-star” for economic equilibrium today in China? Chinese Bubble finance evolved to become the marginal source of finance globally and the Chinese economy the marginal source of global demand. With Aggregate Finance expanding almost $2.0 TN during the first half, Chinese Credit is again leading a global Credit upsurge.

July 16 – Bloomberg: “China’s efforts to shore up sagging economic growth are leading to a resurgence in indebtedness, underlining the challenge President Xi Jinping’s government faces in curbing financial risk. The nation’s total stock of corporate, household and government debt now exceeds 303% of gross domestic product and makes up about 15% of all global debt, according to a report published by the Institute of International Finance. That’s up from just under 297% in the first quarter of 2018.”

July 15 – Bloomberg (Alexandre Tanzi): “Global debt levels jumped in the first quarter of 2019, outpacing the world economy and closing in on last year’s record, the Institute of International Finance said. Debt rose by $3 trillion in the period to $246.5 trillion, almost 320% of global economic output, the Washington-based IIF said… That’s the second-highest dollar number on record after the first three months of 2018, though debt was higher in 2016 and 2017 as a share of world GDP. New borrowing by the U.S. federal government and by global non-financial business led the increase.”

July 15 – Financial Times (Jonathan Wheatley): “Debt in the developing world has risen to an all-time high, adding to strains on a global economy flagging under the weight of rising trade protectionism and shifting supply chains. Emerging economies had the highest-ever level of debt at the end of the first quarter, both in dollar terms and as a share of their gross domestic product, according to… the Institute of International Finance. The figures include the debts of companies and households. The IIF said that lower borrowing costs thanks to central banks’ monetary easing had encouraged countries to take on new debt. In recent months the US Federal Reserve has changed its policy outlook and a string of emerging market central banks have cut interest rates… ‘It’s almost Pavlovian,’ said Sonja Gibbs, the IIF’s managing director for global policy initiatives. ‘Rates go down and borrowing goes up. Once they are built up, debts are hard to pay down without diverting funds from other goals, whether that’s productive investment by companies or government spending.’”

Only “almost Pavlovian”? I’ve been closely monitoring Bubbles going back to Japan’s late-eighties experience. It’s always the same: Everyone is happy to ignore bubbles when they’re inflating. Bubble analysis, by its nature, will appear foolish for a while. But bubbles inevitably burst. There is no doubt that China’s historic bubble will burst, and I expect this will prove the catalyst for faltering bubbles across the globe – including here in the U.S.

The obvious transmission mechanism will be through the securities markets. Global markets have become highly synchronized – across asset classes and across countries and regions. Market-focused monetary stimulus has become highly synchronized, essentially creating a singular comprehensive global bubble.

July 18 – Bloomberg: “A cash crunch at one of China’s best known conglomerates is getting worse as the company said it will not be able to pay its upcoming dollar notes. China Minsheng Investment Group Corp.’s offshore unit said in a filing that it won’t be able to repay the principal, as well as the interest on the 3.8% $500 million bond due August, after considering its liquidity and performance. On Thursday, the property-to-financial conglomerate announced it only managed to repay part of the principal on a 6.5% 1.46 billion yuan note. The development underscores the liquidity crisis that has been pressuring the… company that aspired to become China’s answer to JPMorgan... It will be the first time that the firm’s dollar bond creditors will miss out on repayment.”

“Repo Rate on China’s Govt Bonds Briefly Hits 1,000% in Shanghai,” read an eye-catching early-Friday Bloomberg headline (picked up by ZeroHedge). Repo rates were back to normal by the end of the session, yet it sure makes one wonder… Aggressive PBOC liquidity injections have for the past several weeks calmed the Chinese money market after post Baoshang Bank government takeover (with “haircuts”) instability. The implicit Beijing guarantee of virtually the entire Chinese Credit system is now being questioned. This greatly increases the risk of Chinese money market instability – with ominous ramifications for China and the world.

With this in mind, there’s a particular circumstance that could catch global markets and policymakers by surprise: A dislocation in China’s “repo” securities lending market that reverberates throughout repo and derivatives markets in Asia, Europe and the U.S. This latent risk, in itself, could help explain this year’s global yield collapse and market expectations for aggressive concerted monetary stimulus. When Chairman Powell repeats “global risks” in his talks these days, I think first to global “repo” markets, global securities finance and global derivatives.

Markets are these days are luxuriating in impending Fed rate cuts and global rate reductions that have commenced in earnest. Liquidity abundance as far as eyes can see… What could go wrong? It’s already started going wrong. The flow of Chinese finance to the world is slowing.

July 18 – CNBC (Diana Olick): “Challenging conditions in the U.S. housing market, along with tighter currency controls by the Chinese government, caused a stunning drop in foreign demand for American homes. The dollar volume of homes purchased by foreign buyers from April 2018 through March 2019 dropped 36% from the previous year, according to the National Association of Realtors. The decline was due to a drop in the number and average price of purchases. Foreigners bought 183,100 properties with a total value of about $77.9 billion, down from 266,800 valued at $121 billion in the previous period. They paid a median price of $280,600, which is higher than the median for all existing homebuyers ($259,600), but it was down from $290,400 the previous year. ‘A confluence of many factors — slower economic growth abroad, tighter capital controls in China, a stronger U.S. dollar and a low inventory of homes for sale — contributed to the pullback of foreign buyers,’ said Lawrence Yun, NAR’s chief economist. ‘However, the magnitude of the decline is quite striking, implying less confidence in owning a property in the U.S.’”

Trade War Casualty: Why the Days of Cheap Chinese Goods Are Over

Flexport’s Phil Levy and Mary E. Lovely from Syracuse discuss what’s ahead in the U.S.-China trade dispute.



As President Trump and his Chinese counterpart, Xi Jinping, are set to meet at the G20 summit in Osaka, Japan, on June 28-29, expectations are low for a meaningful truce on the trade war that has defined their relationship over the last three years. More than 640 U.S. businesses and trade groups — including giant retailers like Walmart and Target — sent a letter to President Trump on June 13 asking him to cancel his threat to increase tariffs on some $300 billion worth of imports from China. That is on top of tariff increases the U.S. imposed in May on $200 billion worth of Chinese imports, after several attempts to forge a trade deal.

The U.S. has had several sticking points in its negotiations with China, such as Chinese government subsidies to local enterprises, controls on U.S. businesses operating in that country, and China’s laws on intellectual property rights. China has attempted to placate the U.S. on some fronts. In March, it announced a new foreign investment law where it promises a level playing field for foreign investors.

The businesses that wrote to Trump — organized under a group called Tariffs Hurt the Heartland — warned of disruptions to supply chains, higher consumer prices and erosion of U.S. competitiveness in global markets if the Trump administration goes ahead with its threat to extend tariffs.

If the Trump administration proceeds with higher tariffs on the remaining $300 billion worth of imports from China, the damage to businesses and consumers would be greater than in earlier rounds of such tariff increases, said Phil Levy, chief economist at logistics firm Flexport.

“When the Trump administration was putting its tariffs on China, it went first with the products that were supposed to be least painful and easiest to handle,” Levy pointed out. “That means the stuff that is left is harder and more painful. That is what these companies are describing as serious interruptions to supply chains, which will really hit consumers in the pocketbook.”

Numerous companies are set to give their testimonies before the U.S. Trade Representative beginning Monday to protest the proposed tariff extensions. Those testimonies are important because they explain “how they’re using these complementary inputs and how difficult it is to find alternative supplies,” said Mary E. Lovely, economics professor at Syracuse University’s Maxwell School of Citizenship and Public Affairs; she is also a nonresident senior fellow at the Peterson Institute for International Economics.

In earlier rounds of the trade dispute, the administration’s belief that firms would be able to find alternative suppliers was not entirely accurate, which is why it attempted “to reduce the pain” with some rollbacks, Lovely said. “One can very glibly say, ‘Well you can just get it someplace else,’ and that just seems to be completely ignorant of the reality that there aren’t alternative suppliers.”
 
The U.S. was comfortable with China in earlier years as long as it produced low-cost goods for U.S. consumers, said Wharton emeritus management professor Marshall W. Meyer, who is also a longtime expert on China, in a separate interview. “However, once China announced that it would compete at the high end of the value chain and directly with us, U.S. policy shifted sharply and the Trump administration took actions aimed at thwarting Chinese aspirations.”

The current tariff war and U.S. actions like declaring that Chinese firms like Huawei are agents of the Chinese government are manifestations of that shift, he explained.

Erosion of Business Confidence

If the proposed new tariffs take effect, the biggest impact would be on U.S. “business confidence and business expectations,” said Lovely. In the initial stages of the tariff moves against China, U.S. businesses viewed them as “preliminary and temporary,” she recalled. “The administration has always promised us a big win and a reset of the relationship [with China] that would open up new opportunities for American businesses. As it gradually becomes clearer that that’s not where this is going to end up, businesses start to rethink investments and they see their costs going up.”

As businesses pull back on their investments, U.S. economic growth could also slow down and have ripple effects elsewhere in the world, she warned. Some of that may also have been deliberate, Lovely suggested. “Making the Chinese economy grow more slowly may be part of a ‘make them-hurt-until-they-give’ strategy,” she said. “But it’s also bad for the global economy. We have to remember that the U.S. is the second-largest exporter in the world. So what happens outside of U.S. borders still remains important to U.S. businesses.”

Levy explained why businesses are also complaining that the new tariffs will hurt their competitiveness. “The secret to how many American businesses have managed to be competitive is that they do parts of the production process in the U.S. using those skills we have and the capital we have. But they complement that with work that occurs in other countries. You put it together and have a competitive product. If you cut the second part out of that, you don’t have a competitive product and you’re in serious trouble.”

Hastening China’s Slowdown

An escalating dispute with the U.S. would of course hurt China as well. However, China’s economy would hit headwinds even without a trade war, said Meyer. “The trade war makes the nearly inevitable slowdown in China a little more inevitable,” he added. The slowdown is inevitable because “China’s episode of high growth, above 6%, has been unusually long. Sooner or later, the law of regression to the mean operates and growth decelerates dramatically.”
Secondly, China’s GDP growth has been driven “as much or more by investment than by consumption,” said Meyer. He noted that investment as a percentage of GDP has remained above 40% since 2004 or 2005; a stimulus program now underway may increase that share. By contrast, private consumption as a percentage of GDP has dropped steadily since the 1970s and has remained below 40% since 2007, he added. “Excessive investment leads to declining returns on investment and declining productivity.”

According to Meyer, China’s growth has been at the expense of productivity in most sectors. Barring select industries such as information and communication technology, productivity has declined across industrial sectors, he said. “Sustainable economic growth isn’t possible without productivity growth. You can juice up GDP by injecting a lot of capital into the economy.” As returns on capital and productivity start to erode, China’s debt will increase, he warned.

Threat of Chinese Tech Leadership

That setting explains why the Chinese government is pushing investments in advanced technologies like AI, 5G, genomics and green energy, where there are opportunities for productivity improvement, he explained. “This shift, called Made in China 2025, is the source of the trade war,” he said. Through that program, China aspires for technological leadership, using tools like subsidies and acquisition of intellectual property rights

“If China becomes a global leader in advanced technologies, this will go hand in hand with developing sophisticated capabilities in the likely tools of 21st century warfare,” Wharton Dean Geoffrey Garrett wrote in Knowledge@Wharton last December when Huawei’s CFO Meng Wanzhou was arrested in Canada at the request of U.S. authorities. “This is why Huawei is so central to U.S. concerns. Huawei is poised to be a world leader, if not the world leader, in the rollout of 5G digital networks in the next few years — not American companies like AT&T and Verizon.” The U.S. has charged Wanzhou with multiple offenses including bank fraud and wire fraud; she faces extradition hearings in Canada beginning January 2020.

Do Business Protests Work?

Lovely said that in the first rounds of tariff increases, protests by U.S. businesses did result in some “very small adjustments” to placate them, but other than that, their complaints have been “largely ignored.” Trump has often looked at stock market sentiments as endorsement of his policies. He may feel emboldened this time around, too, as the markets have stayed “fairly steady” while businesses oppose the tariff moves, she added.

At the same time, as business testimonies are heard on Capitol Hill, members of Congress sometimes are moved to intervene, Lovely noted. She pointed to the recent threat by the Trump administration to impose 5% tariffs on all imports from Mexico unless it complied with U.S. demands on curbing illegal immigration. That prompted opposition from members of Congress, especially behind-the-scenes moves by Republicans to speak directly to Trump, and he eventually “found an alternative route,” she added.

Nine days after it made the threat to impose those tariffs on Mexican products, the Trump administration dropped the plan, and Trump claimed a victory in securing an immigration agreement. As Levy saw it, the probability of Congress acting similarly on the proposed China tariffs is “significantly higher than six months ago.”

All the same, it is unlikely that Trump would fundamentally changes his views on tariffs, Levy said. “When he speaks out about this, he says our best solution is to bring in many billions of tariffs revenue from abroad. Never mind that that’s not quite how it works.”

What the Talks Could Produce

Meyer saw two likely outcomes of the current trade dispute – one later this month and another over the long term. At the upcoming meeting in Osaka, “Trump and Xi may announce a face-saving trade ‘deal’ but it’s likely to be little more than a temporary truce since the larger strategic issues won’t be addressed,” he said. He also foresaw longer-term price impacts for businesses and consumers. “Business people will grasp that the days of China as synonymous with cheap are over, and supply chains and prices will adjust accordingly.”

Lovely also did not expect the issues to be meaningfully resolved in the Trump-Xi meeting. “We see these high level meetings creating a lot of heat but very little light in it,” she said. She noted that “very little” has come out of other high profile meetings Trump has had with world leaders in the past. “You cannot negotiate a trade agreement or fundamental changes on very difficult issues like the role of state-owned enterprises in international trade with simply a meeting between the two heads of state.”

Lovely is not optimistic about a breakthrough deal also because she did not see the right atmosphere for backroom negotiations. “What has transpired over the last six months has had a chilling effect on relations between the two countries,” she pointed out.

Typically, government officials do much of the spadework before such meetings between heads of state. “You have a lot of staff working for a long time setting everything up and then the leaders come together and they remove a few brackets and they close the deal,” said Levy. He added that it is not clear that such activity has occurred or is occurring now ahead of the Trump-Xi meeting. 
The stakes have also risen as the trade dispute has gathered momentum. Last month, it appeared that China might strike a deal by promising “some new market access, some purchases of liquid natural gas and stuff like that, but basically just accept something and call it a win,” said Levy. There was no sight of a solution that would address “deeper, structural issues,” he added.

Meanwhile, the dispute has gained other layers that make it more “compounded,” such as nationalism, animosity and national security risks, Levy noted. The U.S. had made the first move by voicing its concerns over security issues such as cyber espionage using Chinese telecom equipment, for example, and China responded that it would not be pushed around by U.S. aggression, he said. “Those [issues] are hard to peel back quickly,” he added.

Levy pointed out that no easy answers exist for issues like how China treats foreign investors, its plan to deal with cyber attacks or the acceptable level of government subsidies. For instance, with government subsidies, ”there is no chance that we’re going to snap to a right answer in six months even if we had one,” he said.

Previous U.S. administrations have attempted to achieve “slow and steady progress” to resolve those issues, but “with mixed success,” Levy said. “The Trump administration has been noted for a different approach [with China] which is, ‘We’ll hold the big stick and we’ll hit you with it if you don’t agree to the right answer.’” Lovely added: “Unfortunately, the big stick doesn’t work with big countries and particularly not with China.” According to her, that strategy is “doomed to failure.” She expected the Trump-Xi meeting to produce “a little bit of window dressing if there’s even any sign of a victory.”

Other countries are unlikely to support the U.S. strategy on China, nor are U.S. businesses, said Lovely. “It’s almost absurd on its face to think that the rest of the world will not want to be part of the growth of the Chinese economy,” she added. Along with China, businesses also have to take note of India, which is set to grow rapidly. “Businesses have to be looking at where they’re going to get their global sales and profit growth. American companies want to have better conditions for their businesses inside China. Unfortunately, they’re going to be sadly disappointed by what comes out of this in the end.”

Fresh Approaches

According to Levy, the correct approach would probably be a series of steps, such as “patient commercial diplomacy,” even if such tactics do not necessarily achieve dramatic results overnight. Here, he noted that the U.S. might have had better negotiating power with China had it stayed within the Trans-Pacific Partnership. The Trump administration pulled the U.S. out of the TPP in January 2017, shortly after Trump assumed office.

The upcoming U.S.-China talks could also cover issues such as China’s requirement that U.S. firms that desire to operate in the country must form joint ventures with local entities, instead of creating wholly owned subsidiaries. Lovely said the ability for U.S. companies to form wholly owned subsidiaries would also help address issues relating to intellectual property protection.

The U.S., on its part, must also refresh its thinking on some issues, such as government subsidies, said Lovely. “We need to have a clear view of what we think is fair trade,” she added. “Saying that all goods will be produced by private companies that have no subsidies from the government is on its face a nonstarter.” She pointed out that the U.S. might find fingers pointing at itself, where defense contracts to a company like Boeing might be characterized as a form of subsidies.

Sputnik Moment?

Meyer saw an opening for the U.S. to reclaim the narrative with China. “Why can’t the U.S. recognize that this is another Sputnik moment — that China is challenging the core of our economy, and that the U.S. will need to respond competitively rather than coercively?” The answer to that lies in the country’s leadership, he added.

According to Meyer, the immediate issues the U.S. and China are trying to resolve are merely the early signs of a larger contest. Describing them as a trade squabble is “our mis-framing of the problem,” he said. “It is a race for leadership in what are likely to be the critical technologies of the 21st century and beyond.”

Are Central Banks Losing Their Big Bet?

Following the 2008 global financial crisis, central banks bet that greater activism on the part of other policymakers would be their salvation, helping them to normalize their operations. But that activism never came, and central bankers are now facing a lose-lose proposition.

Mohamed A. El-Erian

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ZURICH – In recent years, central banks have made a large policy wager. They bet that the protracted use of unconventional and experimental measures would provide an effective bridge to more comprehensive measures that would generate high inclusive growth and minimize the risk of financial instability. But central banks have repeatedly had to double down, in the process becoming increasingly aware of the growing risks to their credibility, effectiveness, and political autonomy. Ironically, central bankers may now get a response from other policymaking entities, which, instead of helping to normalize their operations, would make their task a lot tougher.
 
Let’s start with the US Federal Reserve, the world’s most powerful central bank, whose actions strongly influence other central banks. Having succeeded after 2008 in stabilizing a dysfunctional financial system that had threatened to tip the world into a multiyear depression, the Fed was hoping to begin normalizing its policy stance as early as the summer of 2010. But an increasingly polarized Congress, exemplified by the rise of the Tea Party, precluded the necessary handoff to fiscal policy and structural reforms.

Instead, the Fed pivoted to using experimental measures to buy time for the US economy until the political environment became more constructive for pro-growth policies. Interest rates were floored at zero, and the Fed expanded its non-commercial involvement in financial markets, buying a record amount of bonds through its quantitative-easing (QE) programs.

This policy pivot was, in the eyes of most central bankers, born of necessity, not choice. And it was far from perfect.

The Fed knew it had no power to promote genuine economic recovery directly via fiscal policy, ease structural impediments to inclusive growth, or directly enhance productivity. This was the preserve of other policy actors, which, lacking the Fed’s political autonomy, were sidelined by the inability of a deeply divided Congress to approve such expansionary measures. (These disagreements subsequently led to three US government shutdowns.)

Faced with this unfortunate reality, the Fed tried to support growth in indirect, experimental ways. By injecting liquidity using multiple means, it raised financial asset prices well above what the economy’s fundamentals warranted. The Fed hoped that this would make certain segments of the population (asset holders) feel richer, enticing them to spend more and encouraging companies to invest more.

But such “wealth effects” and “animal spirits” proved quite feeble. So the Fed felt compelled to do more of the same, which led to a host of unintended consequences and risks of collateral damage that I discussed in some detail in my book The Only Game in Town.

The European Central Bank – second only in systemic importance to the Fed – has followed a similar path, though with even more unconventional monetary policies, including negative interest rates (that is, charging savers rather than borrowers). Again, the impact on growth has been rather subdued, and the costs and risks of such measures are mounting.

Both central banks – and especially the ECB under outgoing President Mario Draghi – have stressed the importance of a timely policy handoff to more comprehensive pro-growth measures. Yet their pleas have fallen on deaf ears. Today, neither the Fed nor the ECB is anticipating that other policymakers will take over any time soon. Instead, both are busy designing another round of stimulus that will involve even more political and policy risks.

Other risks are already giving central bankers headaches. The protracted Brexit process is hampering the Bank of England’s longer-term policy strategy, while the short-term impact on global growth of governments’ weaponization of trade tariffs is complicating the task of both the Fed and the ECB.

Meanwhile, some pro-growth policies currently being mooted could, if not well designed, increase the risk of disruptive financial instability and thus further complicate central bankers’ task. The notion of a “people’s QE” – that is, a more direct channeling of central-bank funding to the population – is getting more attention from both sides of the political spectrum. So is the related Modern Monetary Theory, which would explicitly subjugate central banks to finance ministries at a time when the concept of a universal basic income is also attracting growing interest and there is a need to reassess the wage determination process.

Furthermore, some on the political left are exploring the extent to which returning to greater state ownership of productive assets and control of economic activity could improve prospects for faster and more inclusive growth. And populists in European countries with more fragile debt dynamics, including in the Italian government, seem willing to retest the markets’ vigilance by running larger budget deficits without a concurrent focus on balancing pro-growth initiatives.

Such policy proposals are the tip of a political iceberg that has been enlarged by fears about the impact of technology on the workplace, climate change, and demographic trends, as well as concerns about excessive inequality, marginalization, and alienation. These developments highlight how newly salient political issues are impinging on policymaking, rendering economic prospects even more uncertain. And with central-bank activism intensifying, the gap between asset prices and underlying economic and corporate fundamentals is likely to widen further.

Central banks bet that greater activism on the part of other policymakers would be their salvation. But these days, they are facing an increasing probability of a lose-lose proposition: either a policy response materializes but turns out to be one that risks eroding central banks’ credibility, effectiveness, and political autonomy; or nothing materializes, leaving central banks shouldering a policy burden that is already too heavy and exceeds the remit of their tools. Like seasoned gamblers, central bankers may soon discover that not all bets pay off over the longer term.


Mohamed A. El-Erian, Chief Economic Adviser at Allianz, the corporate parent of PIMCO where he served as CEO and co-Chief Investment Officer, was Chairman of US President Barack Obama’s Global Development Council. He is President Elect of Queens’ College (Cambridge University), senior adviser at Gramercy, and Part-time Practice Professor at the Wharton School at the University of Pennsylvania. He previously served as CEO of the Harvard Management Company and Deputy Director at the International Monetary Fund. He was named one of Foreign Policy’s Top 100 Global Thinkers four years running. He is the author, most recently, of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse.

A long economic recovery is not necessarily a better one

Recessions are a natural part of capitalism, not something to be avoided at all costs

Rana Foroohar




At the beginning of July, the US’s current economic expansion will officially become its longest one since 1854, the year National Bureau of Economic Research data on business cycles started. Unemployment is at a 49-year low. Asset prices are near record highs. And the US Federal Reserve signalled yet again last week that it was leaning towards lowering rates due to “uncertainties” in the economic outlook and muted inflation.

That intuitively makes sense when you consider how rocky geopolitics are at the moment, and how bifurcated this recovery has been, mostly favouring large multinational companies and individuals with lots of assets.

But it is also rather stunning how quickly the Fed has gone from tightening monetary policy to preparing to ease it, and concerning that the central bank will be working from a historically low rate base as it attempts to navigate the next recession, whenever it comes.

Even more disturbing, this oddly long economic cycle is not singular. A Deutsche Bank research paper looked at 34 US economic expansions over the past 165 years and found that the past four business cycles have been longer than average. In fact they account for four of the six longest cycles. Since 1982, longer cycles have become the new normal.

Why is this? Optimists would say that less frequent recessions are a result of positive structural shifts and better policy choices that have made the US economy less prone to downturns. A January Goldman Sachs research paper points to better inventory and supply chain management (much of it the result of technological improvements) and the declining share of the US economy that is linked to more cyclical sectors, thanks partly to offshoring of manufacturing. At the same time, the growth of the US shale industry has reduced the risk and impact of oil price shocks, once a major recession trigger.

Other explanations of the lengthening economic cycle highlight the ways the world economy has evolved. Technological advances and globalisation, particularly China’s reintegration into the market system and higher levels of cross-border trade, have increased productivity and growth while dampening inflation.

Meanwhile, the end of the Bretton Woods exchange rate system gave US central bankers more freedom to extend economic cycles, because they no longer had to worry about maintaining a fixed relationship between gold and the dollar.

The result was fewer recessions but also a rise in both public and private debt, as governments worldwide were able to fund more deficit spending, and companies took advantage of low rates set by central bankers who could be less focused on price stability, once Paul Volcker tamed inflation in the 1980s.

Debt has papered over myriad problems in the US economy in recent years, from rising inequality to stagnant wages. It also helps mediate squabbles between various political interest groups. Both Republicans and Democrats have largely embraced a “markets know best” approach since the 1980s because it allowed them to avoid making unpopular choices about dividing up the national wealth pie.

Why choose between guns and butter when you could simply deregulate markets, unleash the financial sector, and hope rising asset prices would let you turn the other way?

All this begs the question of whether longer really is better when it comes to business cycles. Recessions are a natural and normal part of capitalism, not something to be avoided at all costs. Indeed, the Deutsche Bank economists argue that productivity would be higher and American entrepreneurial zeal stronger if the US business cycle had not been artificially prolonged by monetary policy.

But the longer the period of expansion, the harder it is to take away the punch bowl. I agree that policymakers did have to intervene after the 2008 collapse of Lehman Brothers to avoid a bigger downturn — the human costs were already too high. But I also do not believe, as some optimists do, that “this time is different”.

Long periods of expansion invariably result in too much leverage, followed by a correction, and usually a recession. Non-financial corporate debt, which tends to rise until a recession hits, has exceeded prior peaks and gone from 35 per cent of US gross domestic product in 1985 to 46 per cent today. Yet corporate bond default rates have been at very low levels for a decade and a half.

I worry about what will happen when investors and traders put those two facts together and start pricing in a rise in defaults. It makes me wish that perhaps US policymakers had opted for smaller, more frequent doses of pain rather than brewing up history’s longest expansion.

The White House wants to keep the music playing at least through the 2020 election. President Donald Trump this week blasted the European Central Bank head Mario Draghi on Twitter for “unfairly” promising “more stimulus” and then hinted he might demote Fed chair Jay Powell if he failed to do the same. Mr Trump’s tirades remind me of my kids when I’ve let them stay up too late and eat too much ice cream. Maybe a tech productivity surge will eventually come along and turn this market-driven recovery cycle into something that spreads prosperity more widely. More likely there will be hell to pay for leaving the lights on too long.