The Crisis of 2020

It doesn't take much to spark corrections in vulnerable economies and markets, and big shocks to highly vulnerable systems are a recipe for crisis. That's why the vulnerability of today's global economy – reflected in real economies, financial asset prices, and misguided monetary policy – needs to be taken seriously.

Stephen S. Roach

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NEW HAVEN – Predicting the next crisis – financial or economic – is a fool’s game. Yes, every crisis has its hero who correctly warned of what was about to come. And, by definition, the hero was ignored (hence the crisis). But the record of modern forecasting contains a note of caution: those who correctly predict a crisis rarely get it right again.

The best that economists can do is to assess vulnerability. Looking at imbalances in the real economy or financial markets gives a sense of the potential consequences of a major shock. It doesn't take much to spark corrections in vulnerable economies and markets. But a garden-variety correction is far different from a crisis. The severity of the shock and the degree of vulnerability matter: big shocks to highly vulnerable systems are a recipe for crisis.

In this vein, the source of vulnerability that I worry about the most is the overextended state of central-bank balance sheets. My concern stems from three reasons.

First, central banks’ balance sheets are undeniably stretched. Assets of major central banks – the US Federal Reserve, the European Central Bank, and the Bank of Japan – collectively stood at $14.5 trillion in November 2019, which is down only slightly from the peak of around $15 trillion in early 2018 and more than 3.5 times the pre-crisis level of $4 trillion. A similar conclusion comes from scaling assets by the size of their respective economies: Japan leads the way at 102% of nominal GDP, followed by the ECB at 39%, and the Fed at a mere 17%.

Second, central banks’ balance-sheet expansion is essentially a failed policy experiment. Yes, it was successful in putting a floor under collapsing markets over a decade ago, in the depths of the crisis in late 2008 and early 2009. But it failed to achieve traction in sparking vigorous economic recovery.

Central banks believed that what worked during the crisis would work equally well during the recovery. That didn’t happen. The combined nominal GDP of the United States, eurozone, and Japan increased by $5.3 trillion from 2008 to 2018, or only about half their central banks’ combined balance-sheet expansion of $10 trillion in over the same period.

The remaining $4.7 trillion is the functional equivalent of a massive liquidity injection that has been propping up asset markets over most of the post-crisis era.

Third, steeped in denial, central banks are once again upping the ante on balance-sheet expansion as a means to stimulate flagging economic recoveries. The Fed’s late 2018 pivot led the way, first reversing the planned normalization of its benchmark policy rate and then allowing its balance sheet to grow again (allegedly for reserve management purposes) following steady reductions from mid-2017 through August 2019.

Asset purchases remain at elevated levels for the BOJ as a critical element of the “Abenomics” reflation campaign. And the recently installed ECB president, Christine Lagarde, the world’s newest central banker, was quick to go on the record stressing that European monetary authorities will “turn (over) each and every stone” – which presumably includes the balance sheet.

So why is all this problematic? After all, in a low-inflation era, inflation-targeting central banks seemingly have nothing to fear about continuing to err on the side of extraordinary monetary accommodation, whether conventional (near zero-bound benchmark policy rates) or unconventional (balance-sheet expansion).

The problem lies, in part, with the price-stability mandate itself – a longstanding, but now inappropriate, anchor for monetary policy. The mandate is woefully out of sync with chronically below-target inflation and growing risks to financial stability.

The potential instability of the US equity market is a case in point. According to the widely cited metrics of Nobel laureate economist Robert Shiller, equity prices relative to cyclically adjusted long-term earnings currently are 53% above their post-1950 average and 21% above the post-crisis average since March 2009.

Barring a major reacceleration of economic and earnings growth or a new round of Fed balance-sheet expansion, further sharp increases in US equity markets are unlikely.

Conversely, another idiosyncratic shock – or a surprising reacceleration of inflation and a related hike in interest rates – would raise the distinct possibility of a sharp correction in an overvalued US equity market.

The problem also lies in weak real economies that are far too close to their stall speed. The International Monetary Fund recently lowered its estimate for world GDP growth in 2019 to 3% – midway between the 40-year trend of 3.5% and the 2.5% threshold commonly associated with global recessions.

As the year comes to a close, real GDP growth in the US is tracking below 2%, and the 2020 growth forecasts for the eurozone and Japan are less than 1%. In other words, the major developed economies are not only flirting with overvalued financial markets and still relying on a failed monetary-policy strategy, but they are also lacking a growth cushion just when they may need it most.

In such a vulnerable world, it would not take much to spark the crisis of 2020. Notwithstanding the risks of playing the fool’s game, three “Ps” are at the top of my list of concerns: protectionism, populism, and political dysfunction. An enduring tilt toward protectionism is particularly troubling, especially in the aftermath of a vacuous “phase one” trade accord between the US and China.

Prime Minister Narendra Modi’s “Hindu nation” crusade in India could well be the most disturbing development in a global swing toward populism.

And the great American impeachment saga takes Washington’s political dysfunction further into uncharted territory.

Quite possibly, the spark will be something else – or maybe there won’t be any shock at all. But the diagnosis of vulnerability needs to be taken seriously, especially because it can be validated from three perspectives – real economies, financial asset prices, and misguided monetary policy.

Throw a shock into that mix and the crisis of 2020 will quickly be at hand.

Stephen S. Roach, a faculty member at Yale University and former Chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

The Post-Suleimani View from Iran

One hopes that Iranian leaders' domestic woes and deep desire for self-preservation will lead them to embrace symbolic acts of retaliation in response to the recent assassination of the security and intelligence chief Qassem Suleimani. And one hopes that the US, too, will act prudently in responding to Iran’s next move.

Abbas Milani

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STANFORD – The assassination by the United States of Qassem Suleimani, the commander of Iran’s Quds Force, was certainly a major escalation in the two countries’ long-running conflict. But it need not beget World War III (as some pundits are already predicting).

Moreover, while the US may have achieved a short-term tactical advantage by killing Suleimani, the Iranian regime could yet benefit from recent developments.

Iran has been taking drastic steps to ameliorate the severe regional and domestic challenges it currently faces. For example, it recently confronted a sudden upsurge in Iraqi nationalist fervor over its influence in that country.

Iran’s diplomatic outposts were burned, and its goods boycotted. Even the Iranian-born Ayatollah Ali al-Sistani, Iraq’s highest Shia cleric, has spoken out against foreign (meaning Iranian) interference in Iraqi affairs.

In a clear effort to divert this anti-Iranian sentiment, Suleimani’s allies in Iran – particularly the newspaper Kayhan, a mouthpiece for Iranian Supreme Leader Ayatollah Khamenei – suggested in October that Iraqis should occupy the US embassy in Baghdad.

Iran needed to change the discourse in Iraq by redirecting nationalist fervor toward the US.

And in the event, the conversation in Iraq has indeed changed following the drone strike on Suleimani: many Iraqis are now wondering not when Iran will leave, but when the US will.

Meanwhile, Iran has also been dealing with a significant domestic challenge. The regime has moved with shocking brutality to repress massive demonstrations over deteriorating economic conditions, killing several hundred people and arresting thousands more.

Since then, Khamenei has been besieged, drawing criticism even from his traditional base over his mishandling of the situation. As with the explosion of discontent in Iraq, he needed a way to change the story, and the US has now temporarily obliged.

To the outside world, Suleimani was the mastermind of the regime’s terrorist activities outside Iran, and the puppet master of its proxies across the region, not least Hezbollah in Lebanon.

Yet to Iranians, he was a more complicated figure. While regime hardliners regarded him as a hero, many Iranians who have lost loved ones in peaceful demonstrations, or who object to the regime’s attacks on Iranian dissidents in the diaspora, saw him differently.

Nonetheless, over the past few years, the regime has pushed a clever public-relations campaign to depict Suleimani as a Napoleon- or Caesar-like warrior-poet. And as one of the few Islamic Revolutionary Guard Corps (IRGC) commanders not tainted with allegations of corruption, he was mooted as a likely presidential candidate in the next election. Thus, inasmuch as there was public sympathy for Suleimani, it will now extend to the regime, at least in the short run.

Before these latest developments, Iran, increasingly isolated internationally, was looking for ways to flex its muscles on the world stage. In December, it held its first-ever joint naval operations with Russia and China, and officials have announced plans to lease the Persian Gulf port of Bushehr to Russia.

It is hard to overstate the long-term strategic implications of a robust Russian and Chinese naval presence in the Persian Gulf, given that these two counties are the most likely to challenge the US in the years and decades ahead. With the change in mood following Suleimani’s death, the Iranian regime has a window in which to consolidate its ties with both.

To be sure, in prodding its Iraqi proxies to swarm the US embassy, the regime clearly overplayed its hand and underestimated US President Donald Trump’s willingness to respond with force. But by targeting Suleimani, the US, too, might have miscalculated, by underestimating Iran’s own ability and willingness to respond.

Given the state of the economy and the level of discontent in Iran, Khamenei must keep the IRGC and loyal militias firmly on his side. And right now, those forces are clamoring for revenge. For Khamenei, then, the key will be to find a response that is forceful enough to satisfy his base, but not provocative enough to incite full-scale escalation.

For its part, the Trump administration has been operating under the assumption that the Iranian regime is so bereft of legitimacy and enfeebled by domestic discontent that it could never countenance a major war with the US.

And this dangerous assumption has been reinforced by Trump’s own oft-stated belief that a war with Iran would be very short. But, in fact, the Iranian regime has deep cultural, economic, and intelligence ties throughout the region, and particularly in Iraq. It has mastered the art of asymmetrical war, and it now has no choice but to respond in some way to Suleimani’s death.

One hopes that their domestic woes and deep desire for self-preservation will lead Khamenei and his government to embrace symbolic acts of retaliation, rather than escalatory measures.

And one hopes that the US, too, will act with strategic prudence in responding to Iran’s next move.

Otherwise, we could end up with a war that almost no one wants, and for which the endgame would be entirely unpredictable.

Abbas Milani, Research Fellow and Co-Director of the Iran Democracy Project at the Hoover Institution, is Director of Iranian Studies at Stanford University.

Smaller banks turn to currency derivatives for short term liquidity

Volume of currency swaps trading by non-reporting banks increased by 139% over 3 years

Philip Stafford and Anna Gross in London

London also increased its share of trading euro-denominated interest rate swaps

Rapid growth in the volume of foreign exchange swaps handled in London over the past three years has been fuelled in part by smaller European banks and hedge funds using currency derivatives to fund their short-term liquidity requirements, the Bank of England said.

Demand for short-term funds meant the volume of currency swaps trading by non-reporting banks increased by 139 per cent over the past three years, according to a BoE study published late last week. That takes the total volume of currency swaps traded in London to $1.8tn a day. Around two-thirds of contracts last for just a week, it added.

The move underlines how banks are increasingly turning to derivatives — which mimic the underlying markets — when liquidity in securities markets dries up. Unlike securities, the deals do not have to be reported on banks’ balance sheets.

The findings are part of a deeper examination by authorities into the trends underpinning the Bank for International Settlements’s latest triennial survey into the vast global derivatives markets. The latest study, released in September, found that London had strengthened its grip on the market and pulled away from New York.

Half of all currencies market turnover globally and in the UK is attributable to derivatives such as swaps and forwards, in which two investors agree swap payment of loans in different currencies. For many banks it is a cheaper alternative than borrowing directly or hedging their loans.

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Authors Harry Goodacre and Elias Razak at the BoE said banks and other institutions, based in countries where liquidity was cheap, “may have swapped their local currency liabilities into dollars via the FX market in order to lend US dollars at a higher rate.”

Their conclusions chime with findings earlier this month by BIS researchers, which found that many smaller banks have turned to the currency swaps market in the last few years because they have limited direct access to US dollar funding.

The trading of these smaller and regional banks outside the group of global FX dealers accounted for about half, or $404bn, of the total increase in swap turnover. “The actual need to fund longer-term dollar-denominated assets, by contrast, was reportedly a lesser consideration,” the BIS concluded.

They also concluded that volumes in FX swaps market were skewed by the reliance on short-term contracts, as extending or rolling the contracts would boost overall totals.

The BoE also said the large increase in volumes was “consistent” with the long-term trend to move to electronic trading. “The shift to electronic relative to voice tends to favour London as a financial centre because many major firms run their global e-trading from London,” it said.

The UK has long been established as the frontrunner in and main hub for trading interest rate derivatives.

The UK was also the largest centre for over-the-counter interest rate derivatives, according to the BIS survey. The UK’s market share increased to 50 per cent in 2019 from 39 per cent in 2016, returning to a longer-term trend. London had been displaced at the top in 2016 by New York, owing to the timings of new regulations.

Housing Joins The Everything Bubble

by John Rubino

When people tick off the components of the “everything bubble” they usually omit US housing, for a couple of reasons. First, bubbles don’t normally recur immediately in the same asset class, because memories of past carnage need to fade before investors can be seduced back into irrational optimism. Since housing was the epicenter of the last boom/bust cycle, no one is looking there for evidence of new bubbles.

Second, the action in housing has been more gradual than in the 2000s, so it hasn’t generated a lot of breathless headlines about speculators making killings with other people’s money.
But this expansion has gone on for such a long time that even modest annual price gains have taken home prices back into bubble territory. And now the news is starting to reflect it.

From today’s “Real Estate” links list:

Southern Cal home prices surge 5.6% to record $549,000 in November
Oakland home values surge 261 percent in 20 years
Broward real estate leads rebound in decade after downturn
San Diego median home price hits all-time high of $594k
Phoenix home prices still outpacing wage growth
Dallas-Fort Worth median home prices unaffordable for average wage earners
An average worker can’t afford a median-priced home in the Denver metro
Median home prices are still unaffordable in majority of U.S.
Blue-state voters feel harshest squeeze from soaring home prices
Millennials have no place to turn? Rising home prices
Housing shortage hits new record low, igniting prices

To recap, home prices are above their 2007 bubble peaks in many places while the wages of potential homebuyers have barely risen, which is squeezing ever-larger numbers of people out of the market.

Yet somehow the buying continues. This may not qualify as a mania, but it’s definitely looking dysfunctional, because where can a sector go from “record low affordability” if it wants to keep rising?

Going forward, one of two things has to happen. Either buyers go on strike, as they (and their mortgage lenders) recognize that houses are a bad deal at current prices and mortgages written at those prices are unlikely to be paid off. Or the government tries to keep the party going by lowering interest rates to make future mortgages easier to manage.

Since a dramatic slowdown in the housing market would take the rest of nominal GDP down with it, that will of course be seen as unacceptable, leading calls for lower rates, a weaker dollar and various other kinds of stimulus like tax cuts paid for with bigger deficits.

Put another way, even if housing doesn’t crash, the need to keep prices elevated is one more impetus for what looks like a tidal wave of monetary ease coming our way.

Farewell to Paper Money?

by Jeff Thomas

A decade or more ago, I began to discuss with associates the possibility of governments and banks colluding to eliminate physical cash. Back then, the idea struck most everyone as poppycock, that governments could never get away with it.

I didn’t write on the subject until 2015, when several countries had begun to limit the amount of money a depositor could extract from his bank account. At that point, the prospect that central banks might conceivably eliminate cash was looking less like an alarmist fantasy, and it became possible to write on the nascent issue.

In a nutshell, today, in most of the world’s most prominent countries, the people who control banking are the same people who pull the strings in government. A cashless system therefore seemed to me to be a natural, as it dramatically increased both profit and power for both banking and government – an opportunity that can’t be passed up.

The Benefit to Banking

Some banks have been delving into negative interest rates, which is a euphemism for charging you to keep your money in the bank, so that they can loan it out for their own profit. You actually lose money annually by having it on deposit.

Of course, some people accept negative interest rates in order to retain the imagined safety of having their cash in a bank vault, rather than at home. Others tolerate it because they value the convenience of using ATMs and chequing.

But anyone else may simply decide to store their money at home and save the "reverse interest" charges.

But what if cash were eliminated? No one would have a choice. They’d have to have a bank account and use it for all transactions, or they couldn’t purchase goods or pay bills.

Once everyone accepted the concept that bankers had total control of transactions, that this was "normal," banks would be in the catbird seat. They could raise the transaction fees considerably over time and the depositors would be unable to exit the system.

The Benefit to Governments

Governments would thoroughly endorse the idea, because it would mean that, for the first time, they’d have access to all information on your economic activity. The necessity of allowing people to file for income tax would vanish. In future, they could assess your annual tax themselves and take it from your account by direct debit. They could also begin taxing you monthly rather than annually, "for your convenience."

And in the bargain, we could anticipate that the charges would be numerous, confusingly worded on the monthly statement and difficult to figure out. That would allow both the banks and the government to periodically effect incremental increases.

Once all your transactions were monitored, those that are "suspect" could be noted and even refused.

Purchases at gun shops could be classified as "terrorist-related." A transfer to a realtor in Panama could be classified as "money-laundering."

Since the War on Cash has become recognized in the last few years, many people have turned to cryptocurrencies as a means of retaining monetary freedom.

However, as the future of financially pillaging the populace depends on ensuring that the populace have no option other than banks, will governments allow cryptos to flourish?

Not if they can stop it. But can they?

It’s been my contention that banks will at some point, launch their own cryptos, whilst doing all they can to discredit non-central bank cryptos as being potentially criminal.

The Bank of Canada is now considering launching a digital currency that it says would help it combat the "direct threat" of cryptocurrencies. It would initially coexist with paper money, but would eventually replace it completely.

They state further that banknotes are becoming obsolete as a means of payment, creating problems for the banking system as a whole: "The time may come that merchants/banks find it too costly to accept banknotes."

Translate that to mean that, if you insist on using banknotes, the bank will have no choice but to charge you a premium for their use.

This has come on the heels of the plan by Facebook to release libra, its own cryptocurrency. The Bank of Canada states that "Facebook’s digital offering is losing key backers and facing scrutiny from regulators worldwide, including the Bank of Canada."

It suggests that central bank digital currencies allow banks to collect more information on Canadians than is possible when people use cash. "Personal details not shared with payee, but could be shared with police or tax authorities."

And if there are any remaining uncertainties to the benefits of non-central bank cryptos, they added, "Cryptocurrencies may become a direct threat to our ability to implement monetary policy and lender of last resort role."

On the surface, the statement from Bank of Canada appears to be an announcement of banking progress, for the betterment of depositors. But it’s the first report, to my knowledge, in which a bank declares bitcoin and other non-central bank cryptos as a "direct threat."

The above statement is a forerunner to declaring non-bank cryptos to be criminal in nature. Cryptos offer the hope of monetary freedom and that can’t be allowed.

At some point, we can expect banks to disallow any payment for cryptos such as bitcoin through central bank cryptos and refuse accounts to anyone who has a history of dealing in non-central bank cryptos. The objective will be to eliminate the possibility that your grocer or gas station, along with any other bank depositor, might accept bitcoin. The intent will be to send bitcoin to the crypto graveyard.

Unlike gold, bitcoin is intangible and cannot simply be stuffed in the mattress until such time as it regains its acceptance for convertibility, as gold has in the past. It doesn’t exist in physical form and only has a perceived value if another party is prepared to accept it in payment.

The War on Cash is a war on your economic freedom. At present, most people still retain the ability to remove their wealth from the system, move it to a more wealth-friendly jurisdiction and hold it to forms that will retain value in the future.

That window may close sooner, rather than later.

Editor's Note: It’s no secret that governments are eager to eliminate cash. Part of the reason is that it would enable them to devalue their currencies faster.

That’s precisely why, as the calls to eliminate cash grow louder, we’ve seen a massive increase in currency creation and inflation all around the world.

It's created an economic situation unlike we've ever seen before, and it's all building up to a severe crisis on multiple fronts.