Despite the Fed’s efforts, the repo market risks more turbulence

A challenge awaits the central bank on December 31st

From one perspective, the Federal Reserve is expecting a quiet 2020. Of the 17 rate-setters at America’s central bank, 13 expect that it will not change interest rates at all during the coming year.

But monetary-policy inaction does not mean that central bankers will enjoy a relaxing festive season.

In another area for which they are responsible, there is trouble looming. The so-called repo market, through which financial firms lend each other more than $1trn every day, could cause the Fed a headache on December 31st—and a hangover in the new year.

During 2019, as the Fed partially unwound the quantitative-easing (qe) programme under which it had bought Treasury bonds to stimulate the economy, the supply of cash reserves to the banking system dropped (see chart). Meanwhile, a large fiscal deficit—the result of America’s tax cuts and spending increases in recent years—prompted more Treasury issuance.

Because buying Treasuries means handing over money to the government, demand for cash reserves rose. The repo market faced a supply squeeze and a demand surge at the same time.

At first banks, of both the investment and the commercial variety, brought things into balance. According to a recent study by the Bank for International Settlements (bis), a network of central banks, although they had hitherto been net borrowers from the repo market, as it tightened they became net lenders to it, easing the strain.

But in September banks too found themselves short of cash when companies’ quarterly tax payments fell due and past Treasury purchases had to be settled. Both factors drained cash from the banking system and channelled it into the government’s coffers.

The repo rate, that is, the interest rate charged overnight in the repo market, jumped above 10%.

Since then the Fed has been firefighting. At first it offered to lend $75bn-worth of cash in repo markets overnight, every night—an offer that was lapped up. Then it began lending for periods of up to one month and increasing its limits on overnight operations to at least $120bn.

Then it sought to replace these temporary fixes with an enduring solution. It began to increase its balance-sheet again, thereby permanently raising the volume of cash reserves in the banking system. It has done this by buying $60bn-worth of short-dated Treasuries per month. (It argues this operation is not another round of qe, which mostly involved buying long-dated Treasuries.)

This week the new regime passed its first test. December 16th saw a repeat of the factors that had driven the repo rate higher in September. Payments for Treasuries and quarterly taxes were once again due, but the day passed without drama. The repo rate rose just 0.08 percentage points above recent levels, suggesting that the Fed’s efforts to make the market more resilient had succeeded.

But at the end of 2019 a bigger hurdle looms. Regulators will determine the penalty the biggest banks—those deemed “global systemically important” institutions—must pay in the form of higher capital requirements.

The penalty varies in increments, starting at 1% of risk-adjusted assets and rising depending on five gauges of riskiness. Among these are banks’ size and their reliance on short-term funding, which are judged throughout the year or final quarter.

But the other three gauges—complexity, interconnectedness, and global activity—are measured just once annually, on New Year’s Eve.

Dressing up for the occasion

That once-a-year measurement encourages big banks that are close to a regulatory boundary to take temporary measures in order to shrink activities, such as lending in repo markets, that can push up their riskiness scores. These financial gymnastics matter because big banks have an outsize effect on repo markets. According to the bis, the lenders most likely to scale up or down their repo-market activity in response to changing demand are the four biggest banks. Their apparent reluctance to lend in September was a central reason for the spike in interest rates.

In 2018 end-of-year regulatory pressure caused the repo rate to reach 6% on December 31st. Fearing a similar episode, which could compound the more recent market stress, the Fed will offer to lend almost $500bn in repo markets over New Year’s Eve. But it might not work if banks, with an eye on their risk scores, are unwilling to perform their usual role as middlemen between the Fed and market participants who want cash.

The spectre of further turmoil in the repo market is uncomfortable for the central bank. It has been trying to calm nerves. In a press conference on December 11th Jerome Powell, its chairman, acknowledged the probable upward pressure on repo rates to come, but was relatively sanguine. The Fed’s goal, he said, was “not to eliminate all volatility”.

Yet regulators should not introduce volatility, either. It would be relatively easy to fix the problem in future years. Measuring banks on all five regulatory factors throughout the year would remove the pressure on them to try to look their best on New Year’s Eve. And varying the capital surcharge smoothly, rather than in steps, would eliminate regulatory arbitrage at the boundaries.
The big picture is that there is a common culprit behind the sudden dysfunction in September and the prospect of further turmoil at the end of the year. Since the financial crisis, regulators have created a world in which compliance is a major influence on banks’ balance-sheets. That can interfere with the normal functioning of money markets and bring unintended consequences.

The problem becomes most obvious at pinch points, such as December 31st, but is true more generally. And it is making the business of operating the financial plumbing—which was always low-margin and balance-sheet intensive—less appealing.

“Big banks used to operate as the lender of second-to-last resort,” says Bill Nelson of the Bank Policy Institute, an industry lobby group. “That buffer is now gone.”

Without it the Fed may need to get used to intervening more often.

Last of the Great Central Bankers

Doug Nolan

Oregon’s economy was at the time ravaged by our nation’s high inflation and Paul Volcker’s battle to rein it in. The state’s unemployment rate was over 10% when I graduated from the University of Oregon in 1984. I don’t recall having animus toward the Federal Reserve but was instead frustrated with Washington’s huge deficits.

Paul Volcker was a courageous public servant. From the New York Times: “He prevailed by delivering shock therapy, driving the economy into a deep recession to persuade Americans to abandon their entrenched expectation that prices would keep rising rapidly.”

Much has been written over the past week honoring an extraordinary life.

My thoughts returned to heart-felt comments uttered a couple months back by Chairman Powell:

“I’ve known Paul Volcker since I was an Assistant Secretary in the Treasury in 1992 or 1991. Of course, at that time, he had just relatively recently left the Fed - and I was frightened of even meeting him. I was just so intimidated by this global figure. And he couldn’t have been nicer and more interested in helping me and supporting me and we kind of kept up. He was really a great person to know. I read numerous accounts of his life. This book, if you haven’t read it, really sums it up really well. I don’t think there has been a greater public servant in our broad area in our lifetimes. He really just did exactly what he thought was the right thing – all the time. And he lets the chips fall where they may. He was famously booed at a Washington Bullets basketball game when he had rates very high… He’s a great man. I’m still in touch with him. I actually thought that I should buy 500 copies of this book and just hand them out at the Fed. I didn’t do that. It’s a book I strongly recommend, and we can all hope to live up to some part of who he is.”

And from Ben Bernanke (quote from NYT): “He came to represent independence. He personified the idea of doing something politically unpopular but economically necessary.”

“Paul Volcker was the most effective chairman in the history of the Federal Reserve.” Alan Greenspan

The Financial Times’ Martin Wolf began Paul Volcker's tribute article with the opening lines from his review of Mr. Volcker’s memoir, “Keeping At It: The Quest for Sound Money and Good Government.” “Paul Volcker is the greatest man I have known. He is endowed to the highest degree with what the Romans called virtus (virtue): moral courage, integrity, sagacity, prudence and devotion to the service of country.”

Somehow Wolf allowed his memorial to descend (pathetically) into inflationist propaganda: “When demand is weak and inflation low, however, central banks must ease monetary policy. But expansionary policy is technically difficult once short-term interest rates reach zero. Central banks have to consider various unconventional alternatives: expansion of balance sheets via ‘quantitative easing’; negative interest rates; and what the monetarist Milton Friedman called ‘helicopter drops’ of money to the public through direct payments or permanent monetary financing of fiscal deficits.”

Spare us (especially when honoring a noble sound money proponent).

The passing of Paul Volcker marks the end of “the greatest generation” of monetary policy stewards. To be sure, the periods from McChesney Martin to Volcker were far from perfect.

But they were also a far cry from reckless.

It’s now a profoundly changed era.

Chairman Volcker was resolutely determined to pop the consumer price inflation Bubble. He was intensely criticized and, of course, faced political backlash. Yet there was a strong constituency that recognized inflation’s deleterious effects. No one would dare contemplate popping today’s inflationary asset price Bubble. An incredibly powerful constituency is resolute in perpetuating one of history’s most threatening inflations.

I believe Chairman Powell had hoped “to live up to some part of” the Volcker legacy. Powell’s courage to stand up to the markets was rather decisively quashed in a few short weeks. The lesson here – that would be vehemently scorned if only the world wasn’t so hopelessly oblivious – is that Bubbles not repressed grow progressively powerful.

Dr. Bernanke may admire Volcker’s independence and determination to pursue a politically unpopular policy course. Just imagine the fortitude necessary to drive interest rates to 20%, as equities and bonds tanked and the economy gasped. It’s infinitely easier to slash rates and expand the Fed’s balance sheet (creating electronic “money” and captivating bull markets in the process).

Volcker is a true policy hero whose virtues and accomplishments have withstood the test of time. He was willing to inflict acute short-term pain for the prospect of long-term gains. Volcker accepted being a villain with no expectation of vindication. He steadfastly followed his moral and ethical guiding light. In a financial world colored with seductive variations of gray, Paul Volcker’s “sound money” framework readily distinguished right from wrong.

He would take a stand and withstand the wrath. Our world today is desperately lacking such leadership. Sounding hopelessly archaic, I foremost blame the current disheartening state of the world on decades of increasingly unsound finance, with inescapable financial and economic fragilities along with social and geopolitical strains (having taken root soon after Volcker departed the Fed). A world devoid of a sound money and Credit anchor is inevitably a world unhinged.

I ponder Paul Volcker’s career path had he been born in 1957 instead of thirty years earlier. It’s difficult picturing him qualify for a position as a top Fed official in our era. He would call BS on QE and zero/negative interest rates. It would be a decisive “hell no!” to propping up highly speculative financial markets. Volcker would be repulsed by the notion of the Fed accommodating Trillion dollar federal deficits in a non-crisis environment.

It’s more than a challenge envisaging how Volcker’s exemplary personal attributes would be showcased in this day and age. Some unfairly associated his contentious views over the past decade with senility. Such notions from a more junior Volcker would have been chalked up to the rantings of a nutball. He was a disciple of sound money principles from a bygone era. Operating in today’s world of rank inflationism, this great man would have been relegated to the unexemplary.

Mr. Volcker’s passing is a sad reminder of how severely the world has lapsed. It’s similar for individuals, corporations, governments and the markets: add a significant amount of debt and you lose flexibility – you sacrifice freedom, independence and more. Well-tested traditional values and principles are too easily abandoned. The corrosion starts subtly only to end outrageously. Pushing short-term rates these days to 20%? Ten-year Treasury yields above 15%? Inconceivable. But almost as farfetched today would be any imposition of tight monetary conditions. At this point, 3% Fed funds and 4% ten-year yields would surely spark financial crisis.

The irony of it all. A more youthful Paul Volcker would be a pariah – a wretched antagonist naysayer in today’s world of market-dominated loose finance and central bank kowtowing to the almighty markets. Yet those that would deride a young Volcker these days absolutely cherish his legacy. Because the Volcker Fed slayed the beastly inflation dragon, policymakers now enjoy the prerogative of doing whatever it takes to sustain bull markets and economic expansions.

With inflation eradicated, the sky’s the limit as to the optimal size of central bank balance sheets. No amount of deficit spending (bond issuance) risks a spike in market yields, not with the annihilation of inflation risk. Asset inflation is to be actively promoted rather than feared.

Meager inflation ensures central bankers can aggressively reflate faltering market Bubbles without concern for unleashing inflationary pressures. Volcker’s accomplishment laid the groundwork for the abdication of business and market cycles: the wonder of Capitalism free from the hinderance of corrections and adjustment. It’s a narrative befitting of Volcker’s inflationist successors, while dishonoring the legacy of The Last of the Great Central Bankers.

Excerpt from a recent Paul Volcker writing published in the December 11th, 2019, Financial Times:

“By the late summer of 2018, it was already clear that the US and the world order it had helped establish during my lifetime were facing deep-seated political, economic, and cultural challenges. Nonetheless, I drew reassurance from my mother’s reminder that the US had endured a brutal civil war, two world wars, a great depression, and still emerged as the leader of the ‘free world’, a model for democracy, open markets, free trade, and economic growth.

That was, for me, a source of both pride and hope.

Today, threats facing that model have grown more ominous, and our ability to withstand them feels less certain. Increasingly, by design or not, there appears to be a movement to undermine Americans’ faith in our government and its policies and institutions. We’ve moved well beyond former president Ronald Reagan’s credo that ‘government is the problem’, with its aim of reversing decades of federal expansion.

Today we see something very different and far more sinister. Nihilistic forces are dismantling policies to protect our air, water, and climate. And they seek to discredit the pillars of our democracy: voting rights and fair elections, the rule of law, the free press, the separation of powers, the belief in science, and the concept of truth itself.

Without them, the American example that my mother so cherished will revert to the kind of tyranny that once seemed to be on its way to extinction — though, sadly, it remains ensconced in some less fortunate parts of the world…

Monetary policy is important, but it cannot by itself sustain global leadership. We need open markets and strong allies to support economic growth and the prospects for peace. Those constructive American policies have been a large part of my life. Instead, confidence in the US is under siege.

Seventy-five years ago, Americans rose to the challenge of vanquishing tyranny overseas. We joined with our allies, keenly recognising the need to defend and sustain our hard-won democratic freedoms. Today’s generation faces a different, but equally existential, test. How we respond will determine the future of our own democracy and, ultimately, of the planet itself.”

Statesman to the end.

Goodbye to all that creative destruction

In 16 years of columns on business, the only constant has been disruptive innovation

John Gapper

web_capitalist cornucopia tornado
© Ingram Pinn/Financial Times

One Financial Times article that caught my eye this week concerned the success of Meituan Dianping, whose “Everything app” enables Chinese consumers to have their meals delivered, review and book hotels, and even order at-home massages. After the company’s revenues rose by 44 per cent in the third quarter, it is now worth about $75bn.

Sixteen years ago, this would have been difficult to imagine, given that China was much poorer and the iPhone and phone apps had not been invented. But, as Karl Marx and Friedrich Engels observed in the Communist manifesto in 1848, “The need of a constantly expanding market for its products chases the bourgeoisie over the entire surface of the globe.”

I do not pick 16 years at random: I started this column in 2003 and this will be the last one. It is more au revoir than goodbye since, after a sojourn in Tokyo with Nikkei Asian Review, I will return next year to a new column about business from the point of view of consumers and citizens.

As the end of the year and this column coincide, it is a good moment to reflect on what changed in that decade and a half. Quite a lot, naturally. The month I started, for example, the Recording Industry Association of America filed 261 suits against fans for illegal music downloading. It was desperate then, but the industry thrives again, thanks to Spotify and streaming.

The only constant has been disruptive innovation, the term used by the management author Clayton Christensen in 1995 to describe how incumbents are bypassed by technology upstarts. Rapid technological change was accompanied by globalisation and (until recently) lowering of barriers to trade. Innovators such as Facebook, Google and Uber sprinted around the world.

Marx and Engels wrote at a similarly protean time for enterprise, during the Victorian era of globalisation. They did not approve, but they recognised its revolutionary appeal: “The bourgeoisie, by the rapid improvement of all instruments of production, by the immensely facilitated means of communication, draws all, even the most barbarian, nations into civilisation.”

Similar changes brewed as I wrote in September 2003 on finance: “It could be the little guys — at hedge funds and investment boutiques — who emerge the stronger.” I later wrote of credit default swaps (with unknowing irony) that “complaining about the growth of the derivatives market is as futile as protesting against a rising tide”.

On pharmaceuticals: “Science, patent law and the stock market are ensuring that Big Pharma does more than simply rework old hits.” On film and television, during Comcast’s unwanted approach to Walt Disney in 2004: “The old ways of delivering [content] — those that suited studios and networks — are losing ground to methods that this generation of consumers prefers.”

None of this was visionary (and I got some things wrong, including calling for Lehman Brothers to be allowed to fail in 2008, and being complacent this year about two Boeing 737 Max crashes). The significance of other events, such as the US opioid epidemic, passed me by. But the pace of change across many industries could not be ignored.

Nor could anyone fail to notice the cornucopia of new products and services, topped by the iPhone in 2007, and an eruption of wealth in emerging regions including Asia and the Middle East. That year, I was in Dubai, “standing in the local franchise of Trader Vic’s, the California Hawaii-themed bar, with a Mai Tai cocktail in hand, watching people dance to a salsa band.”

The tumult was spurred on by advances in science and technology, from machine learning and artificial intelligence to genetic medicine. The human genome map was completed in 2003 and cancers are now treated with immunotherapy drugs such as Merck’s Keytruda. Taxis can be summoned on apps; in another 15 years they may drive themselves around.

But this whirlwind of enterprise had a cost. The unleashing of finance led to the 2008 crisis and encouraged corporate rootlessness, with profits being moved to low-tax jurisdictions. Labour’s share of national income has fallen in many countries, with casual contracts becoming the norm as the power of capital has been enhanced.

The abundance of stuff, from fast fashion to cheap flights, has caused a backlash against environmental damage, with global warming heading young people’s worries. Growth through what the economist Joseph Schumpeter dubbed “creative destruction” of inefficient companies should not concern us; growth that involves the destruction of the planet is frightening.

Businesses adapt to regulation and changing demand, of course. Energy companies are turning to alternatives and vegan disruption of the hamburger led this week to International Flavors and Fragrances’ $26.2bn deal for DuPont’s nutrition and biosciences business. The merged company hopes to make meatless burgers with the texture and scent of the real thing.

This consumer revolution will offer plenty to chew over on my return next year. Meanwhile, thank you for reading and Merry Christmas.

The Peronist predicament

How Alberto Fernández plans to cope with Argentina’s economic crisis

The new president wants to boost growth and curb inflation. That will be hard

Alberto fernández drove himself and his girlfriend, Fabiola Yáñez, to congress for his inauguration as Argentina’s president in their Toyota. That gesture, as much as anything he said in his hour-long speech, signalled that he intends to swiftly help ordinary Argentines who are suffering from recession, high inflation and rising poverty.

But some wondered, as the Peronist accepted the presidential sash and baton from Mauricio Macri, his centre-right predecessor, whether he would drive the country forwards or backwards.

The question was provoked in part by the presence of Cristina Fernández de Kirchner, the new vice-president, who preceded Mr Macri as president. Ms Fernández, a populist who governed from 2007 to 2015, created the economic mess whose clean-up Mr Macri botched. She has been indicted in nine separate court cases for acts of corruption and other misdeeds.

In the new administration she has already amassed unprecedented influence for a vice-president. The new president (no relation to Ms Fernández) wants to be a crowd-pleaser as she was, at least for poor Argentines, but without repeating her mistakes. That will be tricky.

The “social catastrophe” that Mr Fernández promises to end is real. Two-fifths of Argentina’s citizens cannot afford a monthly basket of staple goods. The year-on-year inflation rate exceeds 50%. Argentina’s $57bn bail-out from the imf is the largest in the fund’s history. Mr Fernández promises to put the economy “back on its feet”. But an adviser to the new president admits: “There are no easy answers on the economy, and no good options.”

Mr Macri’s bet was that he could restore the confidence that Ms Fernández had battered, which would lead to growth. On taking office in 2015 he lifted exchange controls brought in by Ms Fernández, reached an agreement with foreign creditors (with whom she had fought) and lowered her punishing taxes on exporters. That approach failed, largely because Mr Macri did not cut the budget deficit fast enough to keep investors calm when global interest rates rose.

The peso slumped and inflation soared (see chart). The imf agreement in 2018 was a second stab at reviving confidence. But the austerity it demanded hit just as Argentina’s political season was getting under way, weakening the economy and driving voters to Mr Fernández.

That knocked the peso again.

The new president’s big idea is to reverse Mr Macri’s sequence: growth will lead to a revival of confidence rather than the other way round, he argues. To boost growth, he intends to bring back tools employed by Ms Fernández’s administration—but to wield them more deftly.

The centrepiece of the economic programme is likely to be a restructuring of Argentina’s $105bn debt to foreign bondholders (which does not include debt to the imf). This is to be carried out by the new economy minister, Martín Guzmán, an academic with little political experience who specialises in debt negotiation. He has proposed that Argentina defer payment of both interest and principal for the next two years.

Analysts assume he will end up demanding bigger concessions from creditors. Bond prices suggest the markets are expecting an implicit haircut—a discount on the bonds’ face value—of nearly 50%. “Every dollar we don’t use for debt will go to consumer-led recovery at home,” Mr Guzmán has told his new colleagues.

The idea of paying foreign creditors less than they are owed is bound to be popular. So, too, will be Mr Fernández’s plans to boost wages for public-sector and low-paid workers and raise pensions.

Ideas for reining in inflation are unorthodox. The new government may keep a cap on utility prices that was due to expire at the end of 2019. It is expected to keep capital controls introduced by Mr Macri as an emergency measure to curb the depreciation of the peso, and to reach a pact with employers and trade unions to hold down prices and wages. (This may mean that salaries will rise by less than Mr Fernández has implied.)

The big question is whether such a package can exclude the growth-clobbering stuff that the Peronists campaigned against. That is unlikely. The new government does not want to draw down the remaining $11bn of its imf loan, but will still have to deal with the fund. The imf is likely to welcome a cut in the private-sector debt burden (making it easier for Argentina to repay the fund).

Both sorts of creditor are likely to insist on a primary fiscal surplus, ie, before interest payments, which means more austerity than Mr Fernández has in mind. There is worried speculation that the central bank will pay for promises such as higher pensions by printing money, even though its new president, Miguel Pesce, is thought to be a safe choice. If either fiscal or monetary policy is too loose, that will push up inflation in spite of the bodges being planned to contain it.

Although Mr Fernández is bringing back into use some of the techniques used by his Peronist predecessor, he is keen to signal that he will not repeat her excesses. “This is Alberto’s economic team, and he will be in charge on this front,” says an adviser. Yet the new president has not laid to rest fears that Ms Fernández will have undue influence. Mr Guzmán got the economy ministry after she vetoed two other candidates, says the presidential adviser.
She had a hand in the choice of the ministers of interior, defence and security. Her supporters will be in charge of the agencies that handle taxation, pensions and care of old people, which have big budgets and jobs to offer political allies. Her clout in these areas suggests that reforming the state will not be a priority. As vice-president, Ms Fernández is the senate’s leader and commands the Peronist bloc in the chamber, where it has a majority. Her son, Máximo, leads the Peronists in the lower house of congress.

Ms Fernández also helped arrange the appointment of Carlos Zannini, one of her closest associates, as attorney-general. Mr Zannini was held in preventive detention for his alleged role in covering up a deal that Ms Fernández had made with Iran to absolve it of blame for the bombing of a Jewish centre in Buenos Aires in 1994 in which 86 people, including the bomber, died.

His trial has been delayed indefinitely. Alberto Nisman, a prosecutor who was murdered in 2015, had indicted Mr Zannini. As attorney-general Mr Zannini, who was released from jail in 2018 and denies all charges, will lead the government’s anti-corruption unit and its team of lawyers.

Mr Fernández has already made clear that he is not concerned about the alleged misdeeds of his senior officials. He contends that Ms Fernández and jailed members of her government are victims of “political persecution”. He has pronounced Mr Zannini innocent. “We vindicate you,” he told the new attorney-general.

Mr Fernández will revive aspects of his Peronist predecessor’s foreign policy. The incoming foreign minister, Felipe Solá, has signalled “re-engagement” with Nicolás Maduro, Venezuela’s leftist dictator, who will now be less of a regional pariah. Argentina’s new government will not accept in its current form a trade deal negotiated by Mercosur, a four-country trade bloc, with the European Union.

This will dampen Argentina’s growth prospects in the long run and increase tension with Brazil, the bloc’s biggest member. Mr Fernández and Jair Bolsonaro, Brazil’s populist president, speak of having “pragmatic relations”. But there is no hiding the frostiness. Mr Bolsonaro did not attend Mr Fernández’s inauguration, sending his vice-president instead.

The Macri government is proud of having ended the economic isolation that Ms Fernández imposed on Argentina. “We’ve spent four years taking Argentina out of the deep freeze,” says Jorge Faurie, the outgoing foreign minister.

“The fear is we’re going back.”

Optimists think that the leftward shift in diplomacy will make it easier for Mr Fernández to adopt a moderate economic policy.

Argentines must hope so.

Tackling Inequality from the Middle

The rise of populist movements and street protests from Chile to France has made inequality a high priority for politicians of all stripes in the world's rich democracies. But a fundamental question has received relatively little attention: What type of inequality should policymakers tackle?

Dani Rodrik

rodrik167_Matt McClainThe Washington Post via Getty Images_farmerstobaccotruck

CAMBRIDGE – Inequality looms larger on policymakers’ agenda today than it has in a long time. With the political and social backlash against the established economic order fueling the rise of populist movements and street protests from Chile to France, politicians of all stripes have made the issue an urgent priority.

And whereas economists used to fret about the adverse effects of egalitarian policies on market incentives or the fiscal balance, now they worry that too much inequality fosters monopolistic behavior and undermines technological progress and economic growth.

The good news is that we have no shortage of policy tools with which to respond to rising inequality. At a recent conference I organized with Olivier Blanchard, a former chief economist of the International Monetary Fund, a group of economists advanced a wide range of proposals, covering all three dimensions of an economy: pre-production, production, and post-production.

Important pre-production interventions are educational, health, and financial policies that shape the endowments with which individuals enter markets. Tax and transfer policies that redistribute market income fall within the post-production category.

The remaining category, production-stage interventions, includes perhaps the most pioneering ideas. Policies in this category directly target firms’ employment, investment, and innovation decisions by shaping relative prices, the bargaining environment between claimants to output (workers and suppliers, in particular), and the regulatory context. Examples are minimum wages, labor-relations rules, employment-friendly innovation policies, place-based policies and other types of industrial policies, and anti-trust enforcement.

Some policies – such as early childhood interventions, workforce development programs, and public funding of tertiary education – are well tested, and there is evidence that they work.

Others, such as a wealth tax, remain controversial, or, as with place-based policies, are accompanied by considerable uncertainty regarding their optimal design. Nonetheless, there is a growing consensus that some policy experimentation is desirable and necessary.

But a fundamental question has received relatively little attention: What type of inequality should these measures tackle? Policies to address inequality typically focus either on reducing incomes at the top, as with progressive income taxation, or on lifting the incomes of the poor through, say, cash grants to families below a poverty line.

Such policies should be expanded, especially in a country like the United States, where existing efforts are insufficient. But today’s inequality also calls for a different approach that focuses on the economic insecurities and anxieties of groups at the middle of the income distribution. Our democracies can minimize the threats of social strife, nativism, and authoritarianism only by boosting the economic wellbeing and social status of middle- and lower-middle-class workers.

The need for such an approach is reflected in the fact that conventional indicators of inequality are a poor predictor of economic and political discontent in democracies. In France, for example, the far right has made large gains and social protests (by so-called yellow vests) have been pervasive. Yet inequality (as measured by the Gini coefficient or top income shares) has not increased much, unlike in most other rich democracies.

Likewise, current street protests in Chile come after two decades of significant reduction in income inequality. US President Donald Trump’s election in 2016 was rooted not in the poorest states, but in those where economic opportunity and employment creation lagged behind the rest of the country.

Clearly, the discontent stems from inequality of a different kind, affecting mostly the middle of the income distribution. A key part of the problem is the disappearance (and relative scarcity) of good, stable jobs.

Deindustrialization has laid to waste many manufacturing centers, a process aggravated by economic globalization and competition from countries such as China. Technological changes have had particularly adverse consequences for jobs in the middle of the skill distribution, affecting millions of production, clerical, and sales workers. The decline of labor unions and policies to increase the “flexibility” of labor markets has further contributed to the casualization of employment.

Another part of the story, not reflected in conventional measures of inequality, is the increasing geographical, social, and cultural separation between large segments of the working class and the elites. This is reflected most immediately in spatial segmentation between prosperous, cosmopolitan urban centers, and lagging rural communities, smaller towns, and outlying urban areas.

These spatial gaps drive, and are reinforced by, broader social cleavages. Professional metropolitan elites are plugged in to global networks and are highly mobile. This makes their influence on governments all the stronger, while distancing them from the values and priorities of their less fortunate compatriots, who become estranged and resentful of an economic-political system that apparently neither works nor cares for them. The inequality manifests itself in the form of a perceived loss of dignity and social status on the part of less educated workers and other “outsiders.”

Economists are coming to recognize that combating the resulting polarization depends in large part on reinvigorating the economy’s capacity to generate good jobs. There is no shortage of ideas here, either. Labor-market institutions and global trade rules need to be reformed to strengthen the bargaining power of labor vis-à-vis globally mobile employers.

Firms themselves must take on bigger responsibilities for their local communities, employers, and suppliers. Government support of innovation must be directed toward explicitly employment-friendly technologies. We can envisage an entirely new regime of public-private collaboration in the service of building a good-jobs economy.

Many of these ideas are untested. But new challenges require new remedies. If we are not ready to be bold and imaginative in the service of creating inclusive economies, we will cede the ground to hawkers of old, tested, and disastrous ideas.

Dani Rodrik, Professor of International Political Economy at Harvard University’s John F. Kennedy School of Government, is the author of Straight Talk on Trade: Ideas for a Sane World Economy.

Central bankers must beware the political ‘lower bound’

Monetary policy risks losing public support in perceived clash with national values

Karsten Junius

Policy rates of less than zero seem to work more smoothly than many had feared. Even in countries such as Switzerland — where the benchmark deposit rate is minus 0.75 per cent — rates remain more than the much-discussed “lower bound”, below which their economic disadvantages start to outweigh their advantages. However, central banks have underestimated the political lower bound, under which public support erodes.

At this point, pension funds and households might not withdraw cash from their commercial banks but rather their political support for their central bank. Over the long term, this will threaten central bankers’ standing in the political arena. If governors want to use negative rates for longer or lower them even further, they must better explain their rationale.

For about five years, several central banks have been setting policy rates at less than zero. This practice provoked a few big concerns among investors. First, money markets might not work properly below zero. Second, investors and households might withdraw their deposits and store them in their vaults or under the mattress.

Third, economic disadvantages could outweigh their advantages if rates fall below the so-called reversal rate or lower economic bound.Money markets are still working smoothly. Deposits in the banking system have also remained stable, indicating that the economic lower bound has not yet been reached. This supports the argument made by the Swiss National Bank and the European Central Bank that deposit rates could be lowered even further.

The negative side-effects feared by critics included accelerating inflation, financial market instability, and even a zombification of the corporate sector. Some also criticise the distributional consequences, as debtors benefit and creditors lose out. However, it seems that negative rates have served their purpose.

In the euro area this was to strengthen domestic demand and inflation expectations by complementing other monetary policy measures such as forward guidance, asset purchases and targeted long-term refinancing operations. Credit growth to households and companies has recovered since the crisis, non-performing loans have fallen and banks’ balance sheets have benefited from higher asset prices. Even better, unemployment rates have fallen significantly.

Despite this record, negative rates continue to be heavily criticised in public. In mid-November, a poll in Germany found that 58 per cent of those surveyed preferred higher interest rates even if that meant higher borrowing costs, while 32 per cent preferred lower interest rates. German policymakers are even debating whether to outlaw negative interest rates for private savings.

And newspapers nationwide report if a bank anywhere in the country dares to pass on negative policy rates to its clients. Many newspapers and policymakers blame the ECB for expropriating the savings of ordinary people. The Swiss Banking Association goes even further and claims that “negative interest rates are difficult to reconcile with Swiss values”, and that it is “immoral” to reward people for amassing debt.

The frequent use of the term “penalty rate” underlines this normative interpretation of policy rates. This is a problem and a communication failure of central banks. No empirical study on the advantages of negative rates will convince anyone who has a traditional approach. If you believe that amassing debt is bad or even immoral, and that saving is a virtue, you are hardly incentivised to alter your behaviour if interest rates change.

As a result, monetary policy becomes ineffective or at least inefficient. It focuses on stimulating borrowing, while stronger private consumption would have an even greater effect on aggregate demand and make investment spending naturally more profitable.

Central banks just need to be honest and state clearly that it is in their interest that commercial banks pass on policy rates to their customers — even if they are negative — as the intention of negative rates is that households save less and consume more.

Finally, it is of utmost importance to explain the need for unconventional monetary policies to private households, as the latter make up 100 per cent of voters. If the constituents do believe that central banks pursue policies that are not beneficial for them, and if they feel unfairly penalised, they are more likely to demand more democratic control over monetary policy.

Central banks should be aware that this threatens their independence. They should try to better explain the advantages of their policies to the general public, and thereby make them more acceptable and efficient. This approach might have a better chance of stimulating the economy than lowering rates further or keeping them negative for longer.

At current interest rate levels, the political lower bound appears to have been reached in Europe. It would take either a strong recession or a very successful communication strategy for central banks to lower rates again. So far, both look unlikely in 2020.

The writer is chief economist at private bank J Safra Sarasin

The Internet and the Tragedy of the Commons:

By George Friedman


Editor’s Note: With George Friedman traveling for a speaking engagement, we decided to use this opportunity to republish his analysis from 2017 about the internet and its discontents.
The tragedy of the commons is a concept developed by a British economist in the early 19th century and refreshed by ecologist Garrett Hardin in 1968. They were addressing different issues arising out of the commons, an area that is owned by no one but used by everyone. The commons could be a green space at the center of a town, public land used for agriculture or the atmosphere. The tragedy of the commons is that while many benefit from it, no one is responsible for it. Each person’s indifference has little effect. Everyone’s collective indifference will destroy the commons. The tragedy of the commons is that it is vital, vulnerable and destroyed by the very people who need it.

The internet has become the global commons. This has happened with lightning speed. In this case, the commons is not just one place. It is a collection of places where people meet, discuss the latest news and gossip, play games and perhaps do a little business. The internet, with its complex web of connections and modes of communication, from email to Twitter to Instagram, has had a profound effect on society. There used to be private life and the village green, where public life was lived. There is now private life and the lives we live online. We have lost intimacy but have gained access to a vast world.

Good manners and the desire to be well thought of by your neighbors mitigated the tragedy of the physical commons. Even if you were not motivated to care for the commons, you were motivated to behave properly while using the commons. The incentive did not come from law but a sense of community; the community could censure and shun you if you failed to behave appropriately. Embarrassment and shame were compelling forces that shaped your behavior. What made both possible was that you were known. You would have to live with the consequences of your behavior, while trying to develop that thing which all humans crave – a good reputation and even being admired. The worst thing, the ultimate punishment of the Greeks, was to be exiled. The commons were still exploited tragically but not wantonly savaged.

The problem with the internet is anonymity and the lack of privacy. This seems contradictory, since anonymity is derived from ultimate privacy, but the internet makes it possible. The world is now discussing whether the Russians hacked into the Democratic National Committee and John Podesta’s emails. This has evolved into a matter of geopolitics because the internet has become a battleground in several ways. One way is the constant invasion of privacy by hackers stealing emails and private correspondence. However, there is no way to know for certain who did it. The CIA may know, in rare circumstances, or may claim to know for political reasons. In general, it is difficult to find out who is violating your privacy and stealing your property.

Anonymity has another effect. On the village commons, everyone knows who you are and you are held responsible for what you say. On the global commons, you cannot be held responsible for what you say, because your identity is masked. The internet was created to function that way, less on purpose than by technical default. The consequence is that the most powerful human emotions, shame and the desire to be well thought of, don’t restrain what you say. False news has become a topic of discussion recently. False news has always existed, but it was readily distinguishable from reliable news by where it was published. An article from an unknown source was suspect. An article in the mainstream media was more respected.

Mainstream media outlets used to be the arbiters of the commons and their opinions meant something. They were respected for their banker-like primness. Their right to judge other sources of news was rooted in their meticulous fairness and visible objectivity. It is said that complete objectivity is impossible. That is likely true. But perfect love is also impossible. The lack of perfection does not excuse you from making your best efforts.

In a recent poll by the Pew Research Center, only 5 percent of Americans surveyed said that they had a great deal of confidence in the news media. This is a stunningly low number, but it is not a new phenomenon. What is striking is that this consistent lack of confidence in the media hasn’t created an uproar in newsrooms. I doubt that many reporters at The New York Times or The Washington Post voted for President-elect Donald Trump. That is fine, so long as the newspapers maintain rigorous objectivity. I am sure that the staff of both papers think they do, and it is likely that their friends, who share their views, also feel that way. But the majority of the public has its doubts. Therefore, in the public’s mind, these media outlets have given up their role as overseer of the commons of public discourse.

The anonymity of the web allows people to act without shame and to tell lies without fear. I would urge everyone not to believe that this behavior only comes from people on the right. During the George W. Bush administration, I read many preposterous claims about him from people who appeared to be liberals. These kind of claims were also made by their right-wing friends. There is no accountability for what people say or do, no shame attached. Therefore, lies flourish, despicable charges are made, and some on each side are free to believe what they want to believe. The promise that the internet would create a democratic commons where all can be heard and the media loses the right to censor has been achieved. Censors and accountability no longer exist. Twitter is the place where malicious people with time on their hands can tell lies.

But in reality, the internet has not become more democratic. More fastidious citizens no longer visit the commons, or if they do, only to speak to those they know. It is increasingly the place of the marginal. It is interesting how the mainstream media has used Twitter to gain a sense of public opinion. I frequently wonder if the person from Twitter being quoted in a news story is a 12-year-old whose medications are no longer effective. The media doesn’t know. There are still worthwhile conversations to be had there, but many people now becoming less engaged.

The internet is a place with two problems, both masked. Some use it to steal private information and correspondence. Some use it to spew venom through the promise of anonymity. They are both destroying the global commons that had so much hope, in the same way that the village commons would be destroyed if it were invaded by people wearing masks, stealing people’s diaries and money and shouting obscene improbabilities. The tragedy of the commons today is not indifferent exploitation. The tragedy of the commons is that it can be dominated by criminals and those harassing others who want a civil conversation. It reminds me of Central Park in New York in the 1970s. Anyone who was there after dark was a mugger or crazy.

The right to privacy is an absolute, and in due course, as thieves keep breaking into people’s property (why thieves sometimes are called hackers is beyond me), we will simply return to older modes of communication. Perhaps phone calls and handwritten letters will be resurrected. Far better than having your secrets arrayed in public. But still, banks and companies like Geopolitical Futures have to do their business online, and the threat from criminals who can’t be identified is great.

But a greater problem is the media. The prestige press, as we used to call it, squandered its inheritance from prior generations of journalists and lost its right to pronounce the truth. Social media is now subject to Gresham’s Law: Bad ideas will drive out good ones. This can’t go on.

The first principle has to be to make masks illegal on the internet. Many countries and U.S. states have laws against wearing masks in public. In the United States, many of these laws were passed to stop the terrorism of the Ku Klux Klan, knowing that only anonymity and a large crowd made its members brave. But other countries passed similar laws on the reasonable assumption that someone hiding his face is up to no good. In the end, it came down to this: If you want to be in public, you must show your face. You have a right to privacy in your home and on your property. You don’t have a right to privacy when you choose to go into public spaces.

The problem is technical. Today’s computers descended without dramatic change from those available 20 years ago. The internet got larger with more bandwidth but is still as primitive as when it was first designed for a small group of scientists wanting to share information. The security that exists today consists of complex add-ons that require sophisticated managers, and they still can be broken into. Security can’t be an add-on. It has to be at the heart of the system, and its first requirement should be to eliminate anonymity, so that criminals can be identified and so that the vile will know shame.

The reason I am writing on this topic is that we are facing an international confrontation between Russia and the U.S. over whether Russia stole emails to help Trump become president. Some also claim that the Russians penetrated the U.S. power grid. The problem with this issue is quite simply that the system is so primitive that proving the Russians are responsible is impossible. An entity can penetrate a critical system like the power grid without anyone knowing who did it.

The situation is getting out of hand. The internet has become not just the commons for private individuals but the business and government center of the world. Therefore, some limits need to be put in place. Hiding your identity already is illegal in certain circumstances. You must provide ID to buy alcohol or get on a plane. I expect privacy in my home, but when I go into the world, I want assurance that the people out there don’t mean me harm. The design of the internet denies me that. The arbiters of propriety have themselves collapsed. Crazy people are making insane charges in public. This has to stop.

It is in the interest of the tech community to do something about this issue because if thieves run lose and social media is dominated by sociopaths, people will treat the internet like they did Central Park. And if the tech community believes that it is so dependent on internet privacy that it can’t budge on this issue, then it is as deluded as the major media has been. Someone broke into the power grid and we don’t know who. Enough is enough. Wars have been started over less.