#20. Janet, normality and the end-game

America and the World Economy

Janet Yellen is nothing if not bold. As well as seeming to confirm that quantitative easing (QE) will be wound down (“tapered”) by $10bn each month, the new Fed chief has indicated that American interest rates may begin to move upwards about six months after the termination of QE, heading towards an eventual level of about 4%.

What Yellen is trying to do here is to set out a road-map back to economic normality. Can the US (and, by extension, the world as a whole) follow this route successfully? In other words, is this “the beginning of the end” of the Great Recession, or is it “the end of the beginning” of the post-growth denouement?

I’d like ask for your indulgence as, in a longer-than-usual post, I (a) summarise the economic state-of-play as I see it, (b) set out the principal risk factors, and (c) try to reach some conclusions about what happens next – and when.

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If successful, the Yellen Plan (as I’ll call it) would restore a measure of normality to a US economy that has been anything but normal since the 2008 banking crisis. You see, normal economies do not depend on printing money (which, if it is not reversed, is what QE really amounts to). Normal economies also have real (above-inflation) interest rates, because negative real rates largely preclude capital formation by disincentivising savers.

If Yellen’s bold move is successful, the normality to which the American economy would return would be “a new normal”, quite unlike that of most of the post-1945 era. Like much of the West, America is heavily indebted, and has become dependent on debt-financed consumer spending. Moreover, globalisation has gone a long way towards turning the US into a low-wage service economy.

Longer term, these weaknesses could be overcome, by expanding manufacturing, by driving productivity upwards, and by improving real wages so that American consumers (for which also read American workers) no longer have to depend on borrowing to sustain their standards of living.

But none of this can happen without capital investment, which in turn means that it cannot happen without saving. This is why, on anything other than a short-term perspective, the restoration of positive real interest rates is so important.

Yellen’s policy objectives, then, are emphatically the right ones. But what are the odds on her plan succeeding?       

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To answer this, we need to look first at where we’re starting from. The 2008 banking crisis was partly psychological, in that it resulted from an almost-overnight panic at the sheer scale of debt in the financial system. But the underlying problem was that the escalation in the cost of energy had undermined the forward growth assumptions in which the system’s previously-relaxed attitude to the debt mountain had been founded. Debt isn’t a problem if your income is rising – but the equation changes completely if the price of oil surges from $20/bbl to $100/bbl. Significantly, oil prices haven’t slumped (or even fallen at all) since then, despite the worst economic downturn for at least 80 years.

The response to the 2008 crisis amounted to the rescue of the banking system by governments; the slashing of policy interest rates by central banks; and the cranking up of the printing presses. Debt has been transferred from the banks to the balance sheets of governments, savers’ returns have been pulverised by the low rates which have bailed out borrowers, and huge amounts of money have been added to the system.

The reality, though, is that hardly anything has really changed. Despite huge cash injections, the economy has done nothing more than limp along. QE hasn’t created inflation – yet, anyway – but it hasn’t created growth either. Total debt remains as high as ever, and quasi-debt commitments (such as pension and welfare promises) remain wildly unrealistic. Banks’ reserve ratios remain dangerously slender. With the solitary exception of US natural gas, the energy cost screw continues to tighten.

QE has had severely distorting effects. Japan has almost doubled its money supply (whilst simultaneously running a huge fiscal deficit), and the effect has been the opposite of what was intended (the trade balance has crashed, not improved, and growth hasn’t been restored).

Newly-minted US dollars have kept capital markets buoyant (in defiance of economic gravity) and have also flowed into emerging economies, but a string of these countries (including India, Turkey, Indonesia and South Africa) have now had to hike interest rates, sometimes to economically-crippling levels, to prevent that money flowing back out again in response to the Fed’s “taper”. Britain has returned to growth, but seemingly on the back of borrowing a lot more than £1 for each £1 of GDP increase.

In short, this looks like a case of “falling over a cliff in slow motion”. First it was the debt-addicted US and UK that got into trouble, as the “Anglo-American model” of unfettered credit creation detonated. Next came the Eurozone, where the economic illiteracy of the single currency (one monetary policy, seventeen budgets) was exposed by debt escalation and default risk. Now it’s the turn of the emerging economies, caught up in taper back-wash, and next could be China, where debt could turn out to be as much as US$24 trillion.  

In this situation, risks abound. In Japan, Abenomics could end in disaster. Renewed debt escalation might undermine markets’ faith in the UK. The scale of Chinese debt could spook the markets. The severe over-valuation of capital markets could be undermined either by the taper or by a long-overdue global re-pricing of risk. One or more major currencies could crash. Recognition that the shale boom is a case of hype over substance could undercut economic confidence in the US. Finally, there is the risk of external shocks (at the moment, the Ukraine situation obviously comes to mind).

In other words, risks to the system are multiplying. If someone is walking through a field with one land mine in it, he might get lucky, but plant enough land mines in the field and the likelihood of at least one going off rises exponentially.   

 

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In this situation – and Janet Yellen’s good intentions notwithstanding – about the most that the authorities globally can hope for is to keep plodding forward in the hope that we’ll learn new bomb-disposal techniques before we actually tread on a land mine.

Yellen may want to restore real interest rates, but that may not seem a realistic option for the UK, the Eurozone countries or many other economies, where the introduction of higher rates could be very painful indeed. If the US goes it alone on rates, the dollar could strengthen, with adverse effects on American trade.

In this situation, there are two ways that this could end. First, governments around the world could accept the need for higher rates, and could co-ordinate their monetary policies with the Yellen Plan – even though this would cause significant pain in the near-term, it could create a softer landing than the second option, which is to carry on with artificially-low rates in an effort to co-exist with excessive debt.

In fact, I think, the decisive factor here could be capital markets. At the moment, many asset classes (including equities and bonds) are defying economic gravity, resulting in a severe under-pricing of risk. The law of equilibrium suggests to me that, if risks are huge but the price of risk is abnormally low, risk pricing has to rise sharply, bringing markets tumbling down.

That, at any rate, is my conclusion. Something – Japan, perhaps, or Chinese debt, or political developments in Ukraine or elsewhere – could spook the markets.

At that point, Janet Yellen may have to execute a manoeuvre that, in the Vietnam war, was famously described as “a strategic advance to the rear”.        

 

 

10 thoughts on “#20. Janet, normality and the end-game

  1. Clarity once again Tim; thanks. I’m extraordinarily busy with my work at the moment and have been quiet on my own blog. In my head, I’ve written my next post, and will get around to committing it to paper/the ether presently. Please keep up the good work – and remember to swing past the Moray Firth when you can!

    Spent this evening at a Business for Scotland event in Aberdeen listening to a group of very successful (wealthy) businessmen talking unmitigated boll**ks about how Scotland would fare economically if it was independent. Their ignorance of our current geopolitical and macro-economic circumstances almost beggared belief and made me gasp (suppressed) from time to time.

    All the best …

    • Hi, thanks M. Being busy at work must be good. Thankfully I don’t have to take a view on independence. I must admit that if Wales had the chance I’d be tempted, though that might be heart trumping head…. Actually, re. Scotland, I’m finding some of the anti-independence stuff coming out of Whitehall and big business somewhat nauseating. The best option might be for Scotland, England, Wales and N. Ireland all to declare collective independence from London?

    • When’s your next post Moraymint? I thoroughly enjoyed reading your blog, your posts also explain the current situation well.

  2. Dr. Morgan,

    Your commentary is top-notch and I look forward to all your blog entries. Thanks to people such as you, Charles Hall, and others, I have a difficult time reading mainstream economic writing that ignores the energy aspect of the economy.

    I wish that you had a column in the Telegraph or Times.

    Thanks,
    Bob

    • Thanks Bob, you are very kind. I don’t think I’ll get a column in either, though it would be nice. One paper did offer me a column once and I might remind them of it….

      Yesterday I read an article saying that EROEI is nonsense, the economy isn”t about energy, and all that matters is money. Just double the money supply, then, as Japan has done, and we’ll all be rich? Hilarious!

  3. Yellen might talk the talk, she might even take a couple of wobbling steps forward but she won’t walk the walk.

    Since 2008 the debt imbalance has accelerated and the ability of the debtors to withstand rate increases has only diminished. The small rate rises from 2004 onwards that returned rates to “normal” after the dot-com recession were enough to throw the global financial system into complete chaos. The idea we could return to “normal” over the next few years is an obvious fallacy, Even if the US did attempt to go it alone then you can take your pick of major economies around the world that would crash and burn with US rates at 4%. It would be deja-vu all over again and Yellen would indeed beat a hasty advance to the rear.

    The pretence will be maintained for a couple of years whilst the shale boom lasts and there may be some small rate increases. But its only a matter of time before one of those land mines detonate, and the central banks leap to the rescue of the markets with money printing. In fact the markets are now hard-wired to expect such a response – if it didn’t come the we would truly have our financial armageddon. Asset classes defy gravity because of this expectation – the market is no longer a free market (if it ever was) but a corrupt, manipulated ponzi scheme.

    And unfortunately its too late for an exit strategy, its too late to rebalance western economies away from debt fuelled consumption and towards manufacturing. I am surprised you would think that possible given that the cliff we are falling over is indeed an energy cliff as you so expertly explain. We are in an end game and the old economic norms are already history, As I said before, I hope the end game lasts as long as possible.

    • I’m sure you’re right. There’s a generalised lack of connectedness where policy is concerned, not just in the US but globally.

      Some time back, when I wrote a report about financial bubbles, I noticed something that I thought very interesting. Bubbles aren’t new – Dutch tulip bulbs, British South Sea stock, the railway mania of the 1840s and so on – but all of these were discrete incidents, separated by time. It’s like we learned the lesson, and didn’t repeat our folly until the memory faded. But, in recent times, we’ve “sequential bubbles”, each immediately followed by another, and now we have reached the next logical step, “simultaneous bubbles” happening at once.

      Now, a common factor to all bubbles is debt – you can’t create a bubble without borrowing. Borrowing is at least in part a function of monetary policy. If you make borrowing easy and cheap, debt expands. Now, with real interest rates negative, borrowing is not just cheap, or even free – it actually pays you to borrow, because borrowers are subsidised by central banks!

      If you share my interpretation – a distinction between the real (energy) and the monetary economies – what is happening now is the artificial sustenance of the monetary economy because the real one is weakening.

      So I take your point about the end-game being prolonged – but can it be? Figures that I’ve seen put US total debt at about 360% of GDP, Japan at about 410% and Britain at just over 500%. Japan proves that you can live with a lot of debt for a long time, so the problem isn’t so much the absolute amount of debt, but your dependency on borrowing as an economic necessity. If the ability to borrow was to cease, each of the above economies would slump.

      Add interest on existing debt into the equation and you have a chart with two converging lines:

      – Absolute quantum of debt, as % of GDP; and

      – Cost of servicing existing debt.

      This problem explains low interest rates – taking Britain as an example, calculate a rate rise of just 1% on £7.2 trillion of debt, and compare that with GDP. Most of the UK’s net borrowing is taken on just to pay interest on existing debt (or, putting it the other way round, we might not need to borrow if we weren’t paying so much interest on existing debt).

      So, to shift my metaphor, what we have is a debt vortex. When any borrower – individual, family, government or economy – gets too far into a vortex, default becomes inevitable. It may even become desirable. One way or the other, it has to happen…….

      ………..and negative real rates, undesirable anyway because they stifle saving and investment, are a late-stage marker in the end-game.

  4. Pingback: End of the American dream? | Blog | Public Finance International

  5. Your writings are a beacon in the darkness. Thanks.
    Being richness and poorness a function of social behaviour, capitalism a cheap surplus energy set of rules to encourage optimal management of resources, and government administration inherently corrupt and ineficient, may be it’s time to do different.
    We can try assign nominal individuals in the elite -against tax rebates- the individual nominal care of the ones in need.
    Let’s say the 5% richest individuals taking compulsive care -not charity- of the 25% poorest individuals, being accountable for it by the beneficiaries.
    Socialism, comunism, and other collectivisms in different forms and masks never quite achieved any optimal welfare for the poor while energy was almost free.
    Now even capitalism imbalances and inequality get deeper by the day.
    If the system is doomed we should try innovative recipes not new forms of the old ones, to at least avoid a violent implosion in what looks like a transition.
    The very rich can resign some new fancy cars or skiweeks or parties. The very poor can have some accountable bone and flesh individual -not a burocrat- to ask to for their wellbeing and education.

    • Thank you.

      And here is a thought for you.

      In good times, governments try to share out growth in such a way as to please as many people as possible. That isn’t easy. But sharing out pain is proving to be much, much more difficult than sharing out growth……

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