Meek and mild

The title refers to the article that Greg Ip had written in Wall Street Journal on how asset prices are again driving the U.S. economy. The article cites Gail Fosler, a private economics consultant as saying the following:

Those inflated prices make it more treacherous to return interest rates to normal, the task facing the Fed as it meets this week.

Assets didn’t always matter so much. From 1952 to 1996, wealth fluctuated around 400% of national income, according to Gail Fosler, a New York-based economic consultant. Finance was highly regulated and monetary policy mostly worked by dictating how much banks would lend, at what rate. [Link]

Monetary policy that keeps an eye (or both) on asset prices is eventually trapped by asset prices to stay the course and become abnormally loose. It becomes a hostage to asset prices. That is what I wrote in my MINT column three weeks ago, while praising Mervyn King on his book and his message:

The combination of low inflation, low real investment and high speculation traps central banks in a policy of low interest rates forever. Low inflation and low investment justify interest rates remaining low, and high speculation and asset bubbles induce fear of the economic consequences of them popping. Asset markets are decoupled from economic fundamentals. Rational expectations, therefore, do not restore equilibrium but perpetuate and worsen disequilibrium. This is the reality of G-7 countries today. [Link]

Greg Ip is too polite. This is the problem the world faced in 2006-07 and people who instinctively sense that not all is well are neither bold nor loud. They are drowned out and they feel sorry that they did not shout out when it was still possible to do so. They realise it when it is too late and after the damage is done by asset prices that eventually pop.

Income inequality and Milanovic

The contrast between the unambiguous success of people at point A and the relative failure of people at point B allows us to look at the effects of globalisation more broadly. Not only can we see them more clearly when thus juxtaposed, but it enables us to ask whether the two points are in some sense related: is the absence of growth among lower middle classes of the rich world the ‘cost’ paid for the high income gains of the national middle classes in Asia? It is unlikely that one can provide a definitive answer to that question, since establishing causality between such complex phenomena that are also affected by a host of other variables is very difficult and perhaps impossible.

However, the temporal coincidence of the two developments and the plausible narratives linking them, whether made by economists or by politicians, make the correlation in many people’s mind appear real. [Link]

This explains Trump, Sanders and Corbyn and a whole host of other politicians including Marie La Pen in France.

Branko Milanovic, in his paper, rightly places emphasis on the rise in incomes in the global median and in the 45th to 65th percentile calling it the biggest since the Industrial revolution. He is anxious not to draw attention to Point B in his paper.

Further, he is right that correlation is taken as causation somewhat thoughtlessly, stoking anti-foreigner and anti-immigration sentiments. The absolute stagnation in middle America (they are the single largest chunk of the global 70th to 85th percentile) is real and the cause  is the dominance of capitalists’ interests over labour since 1980s. Trickle down did not happen.

But, the tug-of-war between capital and labour is cyclical and the pendulum would swing again but robotics might spoil the return of the pendulum. That is a different story.

It is not necessarily the income gains in the emerging world in China, India, Brazil, etc. But, that conclusion is hard to resist. Far easier to direct the anger at foreigners than capitalists of the local variety. Their support may be needed in other areas.

Are capital flows contractionary?

In my earlier blog post, I had referred to the work by Blanchard and his co-authors on whether capital inflows were contractionary. The full paper is here. Have not read the full paper yet. Here are some expanded thoughts:

The policy implications drawn are convenient in theory and they are hard to execute in practice. They had conveniently ignored the political economy dynamics and the power of international portfolio investors to keep markets open, especially now that their opportunities and avenues to make returns have shrunk dramatically.

Further, non-bond flows (FDI) are dwarfed by the size and speed of bond flows. Hence, they are a problem for developing countries. For developed countries, currency appreciation should matter relatively less than for small, open and developing economies. They should be happier with bond inflows because it depresses interest rates across the yield curve, something that their policymakers aim for and hence, should welcome! This is particularly true for the United States.

The situation, hence, is this: capital inflows are not contractionary for the developed world. The authors say that they found bond inflows to have slightly negative effect on output. We need to see how big the effect was, what the lag was and for what countries. The devil may be in the details.

In general and, on balance, capital inflows are expansionary for them through the asset market effect. They stoke bubbles in bond and stocks. The currency effect is not important, by and large, for developed countries.

Capital inflows are expansionary for the developing world too, through credit and capital misallocation.

Mundell-Fleming might have been right and appropriate for periods when capital flows had not grown to such Frankenstein proportions. The problem is to deal with the excess stimulus and undesirable side effects of capital inflows and not the other way around.

Global financial integration – especially of the portfolio variety – has to be rethought and urgently too.

Underwhelming and porous

Summers and his co-author present a summary of their thesis on addressing secular stagnation in a VoxEU article. My final opinion on the article is summed up in the title of this post.

Summers + 1 seem to be more concerned about the spillover of capital inflows into developed countries already at ZLB by competitive exchange rate policies followed by developing countries more than about the other type of spillover from the developed to emerging that Raghuram Rajan was concerned about!

In a sense, they are somewhat stealthily arguing for vigilance on the exchange rate policies of the developing world! That is protectionism.

Their main plank is that monetary stimulus has negative externalities for both the developed world and the developing world and that fiscal stimulus is better. I agree with the former and have questions about the latter.

But, the negative externalities of monetary policy that they talk about are not the ones we are worried about. They are missing how the real world works.

It is not in spite of cutting rates that the developed world attracts capital inward. Theory would argue that it should send capital out seeking higher returns. That too happens. But, because they cut interest rates they attract capital for a different reason. That happens because zero or negative rates tend to cause currencies of the emerging world to appreciate leading those central banks to resist it. That causes reserve accumulation and capital inflows. So, stimulative policies attract capital flows through a different mechanism.

Therefore, one can agree with their observation that stimulative policies in the presence of financial integration leads to unpredictable and unpleasant consequences for both the countries pursuing such policies and others. That is true. That means that the world has to rethink on financial integration, especially of the short-term variety. That inference is not stressed by the authors. But, it should be.

[Blanchard and co-authors argued that bond inflows are contractionary and that non-bond inflows (think FDI) are not contractionary and even positive. See here and here. Theoretically correct and countries, they concluded, can choose policies to attract the latter and repel the former. How convenient in theory and how hard in practice! They had conveniently ignored the political economy dynamics and the power of international portfolio investors to keep markets open, especially now that their opportunities and avenues to make returns have shrunk dramatically].

Back to Summers and his co-author.

But, at the same time, they argue that the Federal Reserve should not normalise monetary policy because it would attract capital inflows and ‘amplify the contractionary effect of tighter monetary policy’. The theoretical case for it is weak. Usually and under normal circumstances, capital inflows are stimulative. They can, under some circumstances, be contractionary. But, those are quite rare.

What Summer and his co-author seem to argue for is no action from the Federal Reserve. So, no monetary tightening but fiscal stimulus too!

They  argue that fiscal policies ‘leak’ their benefits to other countries and hence countries followed monetary stimulus. That is flawed. In fact, monetary stimulus, in the presence of open capital account, leaks as capital flows out to overseas assets and that is the spillover that RR was talking about. Eventually, it is not beneficial for either the country that sends capital out and those that receive them. Monetary policy stimulus, in the presence of open capital account, is arguably more porous.

Their emphasis is on coordinated fiscal policies as policy responses to address secular stagnation. As for coordinated fiscal policies, when saving rates are not rising in the world and, in fact, demographic developments are bringing them down, who will finance them? If it is helicopter money, then the risk of the public losing confidence in fiat money is real. That actually amounts to co-ordinated debasement of fiat currency and co-ordinated ‘competitive’ devaluation.

Further, the politics of fiscal policy would lead to pork-barrel spending and all kinds of wasteful spending. Japan has engaged in fiscal stimulus with little effect. Will it boost public confidence or undermine it, even if financed by central banks, so that the fear of future taxation is supposedly removed? Public may fear simply that it will have unknown consequences down the road.

Now, that even long-term bond yields are negative, what if the bond yields back up by 40-50 basis points or more as they did in 2013? It will cause havoc to mutual funds and ETFs which have loaded up big time in recent years on corporate bonds.

Overall, theoretically porous. Fits arguments to support preconceived conclusions. Ignores market reality. That is why I found the paper underwhelming.

Inch by inch

I stumbled upon this speech by David Lipton, the first deputy Managing Director at the International Monetary Fund, when I was searching for the latest Article IV report on China by the Fund. The speech was delivered some two months ago.

His prescription for a EM safety net is similar to what Raghu has been advocating and it is good to see him make it very clear that it should be in the control of EMs. But, there is no direct mention of the logical consequence of that – a change in the governance of international and multilateral institutions.

On capital flows, he blurs his lines.

There is no mention of the pernicious role of monetary policy in stoking the ills in all that is happening. In fact, in its latest briefing note for G-20, it had endorsed negative rates and calls for more of it, including asking the Federal Reserve to go slow in returning to normal. Not that the Federal Reserve needs much convincing on that one. That is why in my MINT column today, I wrote that the Fund endorsed snake oil.

The cozy incestuous consensus among policy-academic elites in the world is rather strong. Or, to put it somewhat more positively, it takes a lot of push to move an inch.

Missing the wood for the trees

This morning, I read a story written by one Gavin Jackson of FT on July 21, 2016 on the ‘effectiveness’ of the European Central Bank (ECB) bond buying programme. Is the programme effective merely because the prices of the bonds that the ECB buys have appreciated more than that of the bonds that the ECB does not buy? Was the aim of ECB to act as a campaign manager or lead banker for these companies? Or, was it to ensure that the companies used their lower cost of capital to borrow, to invest in real assets and to create jobs?

Indeed, the so-called effectiveness that the journalist talks about may actually be ‘ineffectiveness’. It may be distorting markets and creating more moral hazard than causing good to the economy. It is evident that pension plans are hurting and so are insurance companies. More zombie companies might be staying alive and longer than they deserve to.

In the ABFER conference in Singapore in May, a paper was presented by Prof. Christian Eufinger, Assistant Professor at the IESE Business School from the University of Navarra i Barcelona, Spain. It was a co-authored paper. The other authors were Viral V. Acharya, Tim Eisert and Christian Hirsch.  The paper clearly noted that the intended real economy effects of ECB bond buying programme were not coming through. Instead, there were perverse consequences. You can download the paper from here.

By missing the wood for the trees, financial journalists, in their ignorance, are harming the public and encouraging unwise and bad public policy. They should reflect on their contribution to the state of angst in the world today.

IMF brief for G-20

The International Monetary Fund (IMF) had prepared a 17-page note for the G-20 meeting in Chengdu, China. This is what the Fund had to say about BRIC countries:

In China, the government again resorted to boosting credit and infrastructure spending, supporting near-term growth but further raising vulnerabilities. As a result, the economy is expected to continue to grow strongly this year, at 6.6 percent, exceeding the IMF’s recommended range of 6–6½ percent, before slowing to 6.2 percent in 2017.

India’s economy is on a recovery path, helped by lower oil prices, positive policy actions and improved confidence. Growth is projected at 7.4 percent in both FY2016/17 and FY2017/18. But headwinds from weaknesses in India’s corporate and bank balance sheets, a decelerating pace of reforms, and sluggish exports will weigh on growth.

Finally, conditions in Brazil and Russia are starting to improve gradually, with a return to positive growth expected for 2017. [Link]

The comment about ‘decelerating pace of reforms’ in India is interesting as is the observation on ‘again resorted to’ for China.

On monetary policy, what the Fund wrote was disappointing, however:

Monetary policy. Central banks should continue to use all available instruments to raise inflation, including negative interest rates (emphasis mine), where appropriate, while carefully monitoring the potential impact on banks, pension funds and insurance companies as well as market functioning. In the United States, Federal Reserve policy should remain data dependent. There is a clear case for the Fed to proceed along a very gradual upward path for the fed funds rate, conscious of global disinflationary trends and confirming along the way that wage and price inflation are indeed maintaining their steady upward momentum. [Link]

The open encouragement to negative interest rates is astounding. There is nothing much to show for it, in terms of real economic outcomes. Not nearly commensurate enough whereas the distortions it causes are plenty. A recent Bloomberg article on the difficulties that CALPERS pension fund faces in generating returns on its investments commensurate with its pension obligations is just the tip of the ice-berg. In addition, when it presented its Economic Outlook in June, OECD noted that retirement savings fetched 40% less income in 2015 than they did in 2010. It would have declined further now.

I happened to watch a conversation between a Bloomberg economist and Alberto Gallo who used to be with the Royal Bank of Scotland and now with a hedge fund. Gallo points out that negative rates widen inequality and are deflationary because people with a target savings for retirement are forced to save more as their savings less and less returns. In that sense, it is actually deflationary!

Further, there is no mention of the distortions (and price bubbles) that the monetary policy stance is creating in stock and debt markets, etc. No matter how much head-nodding is done towards including financial market feedback loop into macro policy framework, in the final analysis, they are omitted. Such a shame and such a bad thing for the world.

Short-term demand support still has an important part to play in advanced economies, but needs greater emphasis on growth-friendly fiscal policies.

This renewed emphasis on fiscal policy tends to ignore the long-run balance sheet effect. Accumulated government debt is high and so are unfunded obligations on pensions and social security. Further, this is also likely a hint of the shape of things to come – monetary policy supported fiscal stimulus. We have to wait and see what the Bank of Japan does on July 28-29 meeting.

My hunch is that some new measures would be unveiled in this meeting. Not for nothing did Bernanke visit Tokyo recently. China has used the Brexit as an excuse to weaken its currency. So, I think the United States has given its green signal to Japan to do its part with currency debasement. Down the slippery slope they go.

It is not surprising that the Chinese yuan’s ranking in international payments has slipped to the sixth position with the Canadian dollar pipping it to the fifth position. The yuan is well on its way to becoming a global funding currency and stay that way for a very long time, as the yen had been for a long time.

Chris Wood on Corbyn

…if Britain does opt for some form of “fiscal QE” in due course, for example via the monetisation of an infrastructure stimulus, there would be a certain irony. This is because the politician who first proposed such a policy in the British political context was widely ridiculed for his efforts at the time. GREED & fear refers to Labour Party leader Jeremy Corbyn’s championing of “People’s QE” in his successful campaign to become Labour leader last year.

Corbyn remains a figure of derision amongst the establishment commentariat even though GREED & fear read this week that he is still the favourite to win the forthcoming leadership contest in September where only party members can vote. GREED & fear wishes Corbyn well. GREED & fear has a soft spot for him because he actually believes in something, even though most of his beliefs are the opposite of GREED & fear’s. But the interesting point to note is that the Davos mob is now on the point of embracing the sort of policies which only last year Corbyn was being ridiculed for suggesting (i.e. “People’s QEs”).

That was from Christopher Wood of CLSA in his latest ‘Greed & fear’ missive dated July 21, 2016. It is this ability to state the politically incorrect stuff that makes Chris Wood an interesting read.

This paragraph reminded me of what I wrote in MINT two weeks earlier, on Bernie Sanders:

One could have made a case for Bernie Sanders. Regardless of whether one agreed with him, at least he stood for something. [Link]

Doubling down

On a quarterly basis, China’s official GDP grew by 1.8%. This was up from 1.2% in Q1, the slowest pace since quarterly growth figures were first  published at the beginning of 2011. Accordingly, both our CMI and official GDP data suggest that China’s dramatic slowdown bottomed out in the first quarter of this year. This is in line with our view that China’s policymakers are in the process of ‘doubling down’ on investment in a bid to kick-start the economy.

The monthly statistics released alongside last week’s GDP data reaffirm that view, pointing to China’s pursuit of short-term growth objectives at the expense of rebalancing. Indeed, indicators most closely linked to China’s tried-and-tested growth model, electricity production and bank lending growth, picked up last month. In addition, growth in fixed-asset investment by private enterprises fell to a record low in the first half of the year compared to the same six months a year ago. Meanwhile, the equivalent figure for state-owned enterprises rose by 23.5%. [Link]


A day after I had published my article in MINT on a manifesto for the global elites, Martin Wolf wrote a piece calling up on the global elites to heed the populist rage. He pegged his piece on a Mckinsey Global Institute – an institution of and for the elites, for the most part. He need not have waited to do so. Second, he has conveniently forgotten to admit that he is part of the elite against whom the people are raging.

He and I had a passionate exchange on this topic some months ago when he said that the ascent of Donald Trump signalled the end of the Republic.

In any case, better late than never. This was the topic of a rather passionate (in polite terms) email exchange between Yours truly and the columnist some months ago.

While Mr. Wolf is right to call on the Elites to see their own culpability in the current state of affairs, it is good if the cleanup begins at home – i.e., in the FT itself. Let me help.

Last week, FT wrote an Edit calling up on the Bank of England to cut rates by 0.25% and then follow it up with quantitative easing and helicopter drops of money. Such advice too is part of what has contributed to inequality and is indicative of all that is wrong with the world.

So, the best play to start to recognise the problem is for journalist-elites to begin with their columns and Edits.

One of the best comments, among the hundreds on this column by Mr. Wolf, was this by one ‘Brecon Clovis’:

Mr. Wolf

You have written a short essay on how to save the elites. But the majority of people in democracies and elsewhere, and perhaps a majority of people reading this paper, don’t want to save the elites. They want to replace them.

Your essay seems to revolve around the dissatisfaction you believe people feel because of economic causes. It is true that most people are concerned with their income and their financial future. It is also true that every now and then at elections people tend to judge governments on the economy, because they are at loss to know what other good governments may serve. But actually, short of a disaster, most people do not consider economic questions as the most important issue in their lives.

What is most important is that people should be able to organize their affairs in the way they want; granting that economic independence is one factor in this. Western culture has been built on political Protestantism. This is the idea that each family, each village, each ward of each city, and each country, should settle their own affairs without outside interference. Henry VIII objected to being dictated to from Italy; Elizabeth I objected to instructions coming from Spain; and people throughout the UK were not inclined to be dictated to from Brussels. They were especially annoyed when they found, like the people of James II’s time, that their elites were receiving instructions from foreign leaders. Although nationalism is sometimes joined to political Protestantism, local control and nationalism are quite separate issues.

In the last 10-15 years, people who thought they lived in democracies have suddenly woken up and found they have been made servants in their own homes. They have been told that if only they will enjoy the new media, take their drugs as instructed, and listen to the experts, everything will be all right. However, assumptions about the death of political Protestantism have been misguided. It is precisely because experts quite genuinely believe that it is irrational not to follow their advice, that people want them to go.