The Fed Faces a New World

By Matthew C. Klein

Central bankers have no popular mandate. They are not elected and are only indirectly accountable to the public. Yet they are granted the “independence” to take unpopular decisions, at least up to a point. Their independence isn't guaranteed, nor does it always mean the same thing at different points in time. Rather, it is contingent on circumstances.

As Philipp Carlsson-Szlezak and Paul Swartz of Bernstein Research put it in a recent note, “Central banks cannot escape their political underpinnings.”
In the years after the financial crisis, the political environment probably constrained the Federal Reserve’s ability to boost the U.S. economy. Things may now be shifting in the other direction.

Consider Fed Chairman Jerome Powell’s latest experience testifying before Congress, which occurred this past week. On Tuesday and Wednesday, he took questions from the Senate and the House, respectively. While many of the questions focused on technical issues, such as the implementation of the new Current Expected Credit Loss accounting standard, the optimal level of bank reserves held on deposit at the Fed, and the Fed’s process for vetting proposed bank mergers, several members from both parties pushed Powell and his colleagues to focus on raising wages and altering the economic split between workers and investors.

Sen. Sherrod Brown (D., Ohio) told Powell that he believed “the Fed has the authority and the duty to be creative, to help workers share in the prosperity they create.” Sen. Tom Cotton (R., Ark.) wanted to know why “we’re seeing more income going into the hands of owners in this country and less into the hands of workers.” He then went on to clarify that he wanted “more of that economic pie going into the hands of our workers.”

Rep. Denny Heck (D., Wash.) wanted to know whether Powell and his colleagues would be “willing to let wage growth climb to 4% to begin to recover some of the decline that we’ve experienced in the labor share of income.” Heck also declared that “we need to place a greater emphasis on wage growth.” Rep. Roger William (R., Texas) warned Powell to “be careful when you start raising the interest rates because it can affect the economy.”

These are only a few legislators, but they could be a harbinger of a shift compared with the recent past. It wasn't long ago that prominent politicians criticized Ben Bernanke for “printing money” and Janet Yellen for keeping interest rates too low. That external pressure could help explain why the Fed has been more willing to err on the side of undershooting its inflation objective by limiting the size of its asset-purchase programs and raising interest rates in response to strong employment data. Its efforts to boost the economy always came with caveats about upcoming exit plans.

The Fed’s hawkish critics have been replaced by a bipartisan coalition in favor of faster wage growth and a cautious approach to monetary tightening, with President Donald Trump the most obvious member.

The new perspective would be a return to normal. For most of the Fed’s history, U.S. politicians have preferred to push the central bank to lower interest rates to boost growth even if that would theoretically risk excess inflation. The first, and most extreme, example was in the 1930s, when President Franklin D. Roosevelt restructured the Fed’s governance and operations in response to the failure of the Depression. Reflation was the priority, which eventually included an explicit promise to cap interest rates during and after World War II.

The Fed temporarily regained some of its autonomy—and an anti-inflationary mind-set—in the 1950s, but by the mid-1960s it was once again being pressured by politicians to focus more on growth. President Lyndon Johnson accosted Fed Chairman William McChesney Martin and claimed that interest-rate increases were an affront to the men fighting in Vietnam. While Martin did raise rates after that meeting, his efforts were not nearly sufficient to arrest America’s inflationary trend.

President Richard Nixon successfully pressured Arthur Burns—with the help of Alan Greenspan, Burns’ former Ph.D. student—to boost the economy in advance of the 1972 election. Paul Volcker’s disinflationary campaign faced relentless attacks from across the political spectrum during his tenure. He eventually felt compelled to leave the Fed after it became stacked with officials he disagreed with.

Greenspan, who had gotten the Fed job in 1987 in part because of his reputation as a loyal political hack, soon found himself facing severe criticism for his perceived unwillingness to respond to the recession of the early 1990s. (Unlike his predecessors, Greenspan had the political smarts to cultivate allies in Congress and the business community.) By the mid-1990s, however, he was self-censoring.

Even though he believed it would ultimately hurt the economy, Greenspan felt the Fed lacked the political capital to lean against the stock market bubble. Despite being at the peak of his prestige, he therefore chose to do nothing. “Independence” was only worth so much.

The changing political environment could cause a shift in Powell’s stated priorities. He has repeatedly claimed that wage growth should equal inflation plus productivity growth, but not exceed it. That, however, is a recipe for keeping the labor share of income constant. It would not reverse the decline since 2000. The only way to raise workers’ pay relative to the value of what they produce is for wages to grow by more than inflation plus productivity.

Paul McCulley, then Pimco’s chief economist, made this point in 2014, citing his colleague Richard Clarida and dubbing the labor share of income “Rich’s Ratio.” After years in which workers bore the brunt of the Fed’s “war” on inflation, McCulley judged that the time had come for a “peace dividend.” Shortly thereafter, Clarida argued that real wages could rise faster than productivity without risking inflation because the growth would manifest in a higher labor share of income. Clarida, of course, is now the Fed’s vice chairman.

Europe’s Leaders Are Aiding Italy’s Populists

The fact that Italy’s public debt has a lower credit rating than private debt is a reflection not of public debt’s intrinsic inferiority but of a political choice made by European leaders. And, by bolstering an authoritarian politician, that choice is now blowing back on them.

Yanis Varoufakis

ATHENS – Italy is now the frontline in the battle of the euro. Deputy Prime Minister Matteo Salvini is being propelled by a political tailwind that may, after the European Parliament elections in May, enhance his capacity to inflict serious damage on the European Union. What is both fascinating and disconcerting is that the xenophobia underpinning Salvini’s ever-increasing authority is being generated by the eurozone’s faulty architecture and the ensuing political blame game.

In its recent report on the economic imbalances afflicting each EU member state, the European Commission blames the Italian government for its failure to rein in debt, which, it says, results in tepid income growth. According to the Commission, the government’s reluctance to cut its budget deficit has spooked the bond markets, pushed interest rates up, and thus shrunk investment.

Salvini could not be more pleased. The report presents a splendid opportunity to blame the Commission itself for Italy’s travails, by arguing that it was actually the EU’s fiscal austerity policies which constricted growth, pushed the economy to the brink of a new recession, and led to the election of the populist government now dominated by Salvini. And, as if that were not enough, it was the Commission’s threats of penalizing Italy unless it imposed even greater austerity that unnerved bond traders and pushed interest rates up.

Italy’s tragedy is that the Commission and Salvini are both right – and also both wrong. It is correct that Salvini’s announcement that the government would rescind its promise to impose pre-agreed levels of austerity alarmed investors, made Italian debt less viable, and caused capital flight. But it is also correct that the Commission’s fiscal rules, were they to be implemented fully, would have caused a recession that would have made Italian debt less viable anyway.

When two clashing explanations of the same phenomenon are both correct, they must be incomplete, even if they capture different aspects of observed reality. In such cases, it is useful to adopt a new vantage point from which to take a fresh look at the problem. When it comes to the Brussels-Rome clash, I believe, that vantage point is on the other side of the world: Tokyo.

Italy is, in an important sense, Europe’s Japan. Both economies are typified by a strong export-oriented industrial sector, a current-account surplus, similar terms of trade, terrible demographics, and, following years of imprudent lending, zombie-like banks. Moreover, they are also alike in the composition of their financial liabilities, featuring relatively low private debt and very high public debt.

Unlike Italy, Japan’s political center is still holding because median incomes have risen a little as the economy was being stabilized by a central bank that printed money as if there were no tomorrow and governments that implemented one fiscal stimulus after another. Had Japan’s government labored under the type of restrictions imposed on Italy by the EU treaties and the eurozone’s fiscal and monetary rules, Japanese society would now be in tumult.

Indeed, if financing for Japan’s economy and banking system had been provided by an external central bank bent on enforcing fiscal austerity by threatening to withhold liquidity, then a doom loop of insolvent banks, rising bond yields, and recessionary forces would have been inevitable. Politically toxic populism would not lag far behind, occasioning the same kind of clashing-though-compatible narratives that we now hear from the European Commission and Italy’s government.

An intra-European comparison sheds additional light on the conundrum facing Italy and the eurozone. Spain and Italy have almost identical debt-to-GDP ratios (298.3% and 301%, respectively). So, why is everyone talking about Italy’s debt and not Spain’s? The answer is that 67% of Spain’s debt is private, whereas 64% of Italian debt is public.

In theory (and in law), the European Central Bank is not allowed to monetize any debt, public or private. In practice, however, the ECB has been able and willing to monetize private debt fully, simply by accepting as collateral private debt not even worth the paper it is printed on (for example, stressed Italian mortgages and Greek banks’ IOUs). In contrast, the ECB spent years refusing to buy government debt and, when it did, chose to exclude large swaths of bonds from its asset-purchase program. Put simply, any country whose debt was tilted toward the private sector, like Ireland and Spain, did much better than a country like Italy.

The eurozone’s defenders will reply that it is right that countries are penalized for allowing a high proportion of public debt. The ideological bias against anything public is not limited to the realm of utilities and railways. The credit rating agencies’ readiness to downgrade the bonds of any government that challenges conventional wisdom reinforces the neoliberal assumption that private debt is, by definition, less problematic than public debt.

But even free-market fundamentalists should realize how unsafe this assumption is. If the 2008 financial crisis taught us anything, it is that risks are too endogenous for comfort. Even if no corruption is involved, credit ratings and political choices are co-determined: If the ratings agencies get a whiff that the ECB will choke off Italian liquidity, they have a duty to their customers to downgrade Italian bonds. And if the ECB predicts that Italian bonds will be downgraded, its rules instruct it to diminish liquidity in the Italian banking sector.

When some infrastructure project is to be built, why should it matter whether it is the state or private developers that borrow to fund it? In the eurozone, this matters, because the ECB has much greater leeway to refinance stressed private debt than public debt. But this is a political choice, not an economic reality. The fact that Italy’s public debt has a lower credit rating than private debt is a reflection not of public debt’s intrinsic inferiority but of a political choice by European leaders. And, by bolstering an authoritarian politician, that choice is now blowing back on them.

Yanis Varoufakis, a former finance minister of Greece, is Professor of Economics at the University of Athens.

Quantitative easing was the father of millennial socialism

Federal Reserve’s bid to stave off depression sowed the seeds of a generational revolt

David McWilliams

Former Federal Reserve chair Ben Bernanke’s quantitative easing scheme spawned a new generation of socialists, such as Alexandria Ocasio-Cortez © Bloomberg/Getty

Is Ben Bernanke the father of Alexandria Ocasio-Cortez? Not in the literal sense, obviously, but in the philosophical and political sense.

As we mark the 10th anniversary of the bull market, it is worth considering whether the efforts of the US Federal Reserve, under Mr Bernanke’s leadership, to avoid 1930s-style debt deflation ended up spawning a new generation of socialists, such as the freshman Congresswoman Ms Ocasio-Cortez, in the home of global capitalism.

Mr Bernanke’s unorthodox “cash for trash” scheme, otherwise known as quantitative easing, drove up asset prices and bailed out baby boomers at the profound political cost of pricing out millennials from that most divisive of asset markets, property. This has left the former comfortable, but the latter with a fragile stake in the society they are supposed to build.

As we look towards the 2020 US presidential election, could Ms Ocasio-Cortez’s leftwing politics become the anthem of choice for America’s millennials?

But before we look forward, it is worth going back a bit. The 2008 crash itself didn’t destroy wealth, but rather revealed how much wealth had already been destroyed by poor decisions taken in the boom. This underscored the truism that the worst of investments are often taken in the best of times.

Mr Bernanke, a keen student of the 1930s, understood that a “balance sheet recession” must be combated by reflating assets. By exchanging old bad loans on the banks’ balance sheets with good new money, underpinned by negative interest rates, the Fed drove asset prices skywards. Higher valuations fixed balance sheets and ultimately coaxed more spending and investment. However, such “hyper-trickle-down” economics also meant that wealth inequality was not the unintended consequence, but the objective, of policy.

Soaring asset prices, particularly property prices, drive a wedge between those who depend on wages for their income and those who depend on rents and dividends. This wages versus rents-and-dividends game plays out generationally, because the young tend to be asset-poor and the old and the middle-aged tend to be asset-rich. Unorthodox monetary policy, therefore, penalises the young and subsidises the old.

When asset prices rise much faster than wages, the average person falls further behind. Their stake in society weakens. The faster this new asset-fuelled economy grows, the greater the gap between the insiders with a stake and outsiders without. This threatens a social contract based on the notion that the faster the economy grows, the better off everyone becomes.

What then? Well, politics shifts.

Notwithstanding Winston Churchill’s observation about a 20-year-old who isn’t a socialist not having a heart, and a 40-year-old who isn’t a capitalist having no head, polling indicates a significant shift in attitudes compared with prior generations.

According to the Pew Research Center, American millennials (defined as those born between 1981 and 1996) are the only generation in which a majority (57 per cent) hold “mostly/consistently liberal” political views, with a mere 12 per cent holding more conservative beliefs.

Fifty-eight per cent of millennials express a clear preference for big government. Seventy-nine per cent of millennials believe immigrants strengthen the US, compared to just 56 per cent of baby boomers. On foreign policy, millennials (77 per cent) are far more likely than boomers (52 per cent) to believe that peace is best ensured by good diplomacy rather than military strength. Sixty-seven per cent want the state to provide universal healthcare, and 57 per cent want higher public spending and the provision of more public services, compared with 43 per cent of baby boomers. Sixty-six per cent of millennials believe that the system unfairly favours powerful interests.

One battle ground for the new politics is the urban property market. While average hourly earnings have risen in the US by just 22 per cent over the past 9 years, property prices have surged across US metropolitan areas. Prices have risen by 34 per cent in Boston, 55 per cent in Houston, 67 per cent in Los Angeles and a whopping 96 per cent in San Francisco. The young are locked out.

Similar developments in the UK have produced comparable political generational divides. If only the votes of the under-25s were counted in the last UK general election, not a single Conservative would have won a seat. Ten years ago, faced with the real prospect of another Great Depression, Mr Bernanke launched QE to avoid mass default.

Implicitly, he was underwriting the wealth of his own generation, the baby boomers. Now the division of that wealth has become a key battleground for the next election with people such as Ms Ocasio-Cortez arguing that very high incomes should be taxed at 70 per cent.

For the purist, capitalism without default is a bit like Catholicism without hell. But we have confession for a reason. Everyone needs absolution. QE was capitalism’s confessional. But what if the day of reckoning was only postponed?

What if a policy designed to protect the balance sheets of the wealthy has unleashed forces that may lead to the mass appropriation of those assets in the years ahead?

The writer is an economist, author and broadcaster

Trump’s China Deal Could Punish U.S. Allies

America first in a U.S.-China trade pact could deal a serious blow to the economies of friends around the world

By Nathaniel Taplin

Beijing and President Trump appear near to a trade deal: China buys a lot more U.S. stuff, gives some ground on auto-industry protections and intellectual property, and mostly ignores other U.S. complaints.

What would that mean in practice? Mainly, a boost to already-competitive U.S. industries like natural gas, agriculture and autos—and a big hit to other major exporting nations.

Some details emerged Sunday. As part of any deal, China could commit to buying $18 billion worth of gas from U.S. exporter Cheniere . LNG -0.70%▲ The period isn’t clear, but liquefied natural gas purchase agreements are often signed for 10 years or longer.

China might have ended up purchasing a lot of Cheniere’s gas anyway. Spot LNG prices in recent months have ranged between $6 and $12 per million British thermal units: Cheniere has previously estimated its break-even costs for Asian delivery from future projects at $7.50 to $8.50. If the purchase agreement is confirmed, Cheniere should be able to greenlight its sixth LNG train at Sabine Pass, La., which would lift the terminal’s annual capacity to 27 million metric tons—around 10% of current global demand.

So sorry, Australia.
So sorry, Australia. Photo: Lindsey Janies/Bloomberg News

The losers would be other big exporters that have invested or plan to invest billions in LNG, among them U.S. allies Australia and Canada. After years of waffling, investors approved a $30 billion LNG plant in British Columbia in 2018, and in eastern Canada another big project awaits a final investment decision. Australia, a dominant LNG supplier to China, has been banking on rising exports to offset falling coal revenue.

If the U.S. and China do conclude a deal, U.S. friends in Asia could get hit as well. An extra $1.35 trillion in U.S. exports to China over five years—close to the $1.2 trillion figure cited by Treasury Secretary Steven Mnuchin in December—would cost Japan $28 billion annually (3% of its exports), Barclaysestimates. Korea could lose $23 billion (3.1% of total exports); Taiwan, $20 billion (3.2% of exports).

Such a large diversion of trade may be impossible near-term. And some Japanese cars previously headed to China, for instance, would head to the U.S. instead. But the risk is that the U.S.-China pact will severely damage to the economies of the very allies the U.S. is counting on to help balance China’s rise in Asia.

For Beijing, that sounds like a very good deal indeed.

A Closer Look At Debt And The Economy

by: Charles Schwab
- This is an ongoing debate as to whether there are negative implications of a high and ever rising burden of debt.

- Looking back historically, when you're in a high debt zone and you have a high growth rate in debt, it has had - historically - negative implications for nominal GDP growth, real GDP growth, payroll growth, productivity growth, capital spending.

- This is not a forward-looking potential problem. This is a problem with which we are already dealing, and, unfortunately, is not a situation likely to improve.

LIZ ANN SONDERS: Today, I want to tackle a more evergreen topic, which is the implications on the economy of a high and ever-rising burden of debt. But I want to first differentiate between the deficit and debt.
Deficit - the budget deficit - is simply the differential between what's going out via spending and coming in via taxes. If you continue to run budget deficits, you add to debt. Debt is a cumulative effect of running deficits.
Now, this is an ongoing debate as to whether there are negative implications of a high and ever rising burden of debt. I'm here to suggest that there are implications, not just looking ahead, but implications that we have already been dealing with.
So let's talk about debt for a minute. A lot of focus off and on just federal government debt, which is getting up to close to 100% of GDP, but that's just one portion of debt. Even within government debt you've got federal debt, state debt, and local debt. Moving on to the private sector side, you, of course, have households. And then you have multiple varieties of corporate debt. You've got overall corporate debt, both financial debt and non-financial debt. Total credit market debt is the addition of all of those forms of debt. And if you add them all up and divide it into US economic growth, US GDP, you get a pretty surprising number: about 350% of GDP represented by total credit market debt. Now, that's improved - it's down from about 380% of GDP, but we shouldn't be cheering 350% of GDP.

Now, the implications that that has for economic growth are, frankly, ones that we have seen over the last 35 years or so since that debt burden has been increasing. Looking back historically, when you're in a high debt zone and you have a high growth rate in debt, it has had - historically - negative implications for nominal GDP growth, real GDP growth, payroll growth, productivity growth, capital spending.
So when people talk about when are we going to hit some sort of wall, when is it going to start to have an impact, I would argue that it has had an impact because we are seeing a lower rate of growth.
It helps to explain why this economic recovery we're in right now has been the weakest in post-World War II period. When you have that high burden of debt, the interest associated with that, the interest costs associated with that, really crowds-out the ability for the economy to grow at a more robust pace. So, this is not a forward-looking potential problem. This is a problem with which we are already dealing, and, unfortunately, is not a situation likely to improve.