Misguided answers for wrong diagnosis

A month ago, my friend Manu Bhaskaran asked me for my thoughts on the column by Martin Wolf in FT titled, ‘monetary policy has run its course’. See here. Martin Wolf’s article was a partial analysis of this paper that I have not read.

The article is one of the relatively better ones by Martin Wolf. It acknowledges the problems with monetary policy response to so-called deficient demand, policies aimed at creating ‘conventional’ inflation. Here is the relevant paragraph that most of us can agree with:

If the central bank wants to raise inflation in an economy with structurally weak demand, it will do so by encouraging the growth of credit and debt. It might then fail to raise inflation, but create a debt crisis. That is deflationary, not inflationary.

Thus, the pre-crisis monetary policy, aimed at raising inflation, has now created the opposite: a deflationary debt overhang that works via what Richard Koo of Nomura calls “balance-sheet deflation”. That in turn leads to still lower nominal (and real) rates. Thus, the financial mechanisms used to manage secular stagnation exacerbate it. [Link]

My feeling is that Martin Wolf meant to write ‘post-crisis’ and not ‘pre-crisis’ in the paragraph above. That is a relatively minor issue.

His intellectual dilemma is apparent in the paragraph preceding the above, in the FT article. He disagrees with Claudio Borio of BIS that monetary policy does influence real long-term interest rates. If monetary policy does not influence them, why take so much pains to cut or raise short-term policy rates? Except to those steeped in theory, those who watch the real world will agree with BIS. Incidentally, the BIS paper that Martin Wolf writes also highlights the spillover problem from developed country policies to other countries. Read the following extract from the abstract of the paper:

… external influences on countries’ real interest rates appear to reflect idiosyncratic variations in interest rates of countries that dominate global monetary and financial conditions rather than common movements in global saving and investment. [Link]

While disagreeing with the premise of Borio and BIS, Martin Wolf agrees with the implication that flows from their premise as cited in the quoted paragraph above! You can see his dilemma or contradiction.

Much of the problem lies in defining secular stagnation as deficient demand instead of defining it as a secular stagnation or decline in potential growth. The ‘deficient demand’ school calls for persistent stimulus – low rates, zero rates and negative rates. Now that they have not worked, the clamour has turned to fiscal policy and that is where the ludicrous modern monetary thoery kicks in.

But, before we evaluate the question of whether fiscal policy is the answer, let us acknowledge the full extent of the damage that the misguided monetary policy solution to the wrongly defined problem of deficient demand has wrought.

The problem with monetary policy solutions to the wrongly defined problem of secular stagnation or deficient demand is not just the creation of ‘deflationary debt overhang’ but far worse.

Engineered low interest rates have caused the decoupling of the financial economy from the real economy; have caused asset prices (including real estate and even bitcoin which is not an asset) to decopule from fundamentals (incomes of households and earnings of companies) and have fomented worker angst, income and wealth inequality and have even contributed to the rise of Big Tech and market concentration as cheap interest rates allow technology companies to use the currency of their overvalued stocks to buy upstarts and smother competition.

Fiscal policy, in the Western world, too has its limits. Contingent liabilities and pension obligations are not recognised. If they are added, the fiscal situation is dire. Finland showcases the problem. Read the following extract from another FT article:

The lesson from Finland may be that trying to make health and elderly care costs sustainable involves the types of political choices few governments are willing to make, raising questions about long-term economic growth and the health of public finances for increasingly cash-strapped governments across Europe. [Link]

The clamour for some stimulus or the other will go away if the problem of secular stagnation is correctly defined as the problem of secular decline in potential growth with declining labour force growth and with declining gains from productivity. Much of the technological improvements (you can charge your phone by keeping it on top of mine) are not frontier advancements in nature.

What would the answers to such a problem of a secular decline in potential growth?

Immigration is ruled out because of its political and social effects. Population growth is conditioned on public and private decisions made decades earlier. It cannot be engineered overnight.

Real investments that spark productivity gains are not made easily. Merger and acquisitions, stock buybacks, real estate investment are not the stuff of productivity gains. It is not as though low interest rates are being used to spur investments that deal with climate change. Instead, it is producing the short-term boost to aggregate demand that makes the climate problem worse.

My friend TCA Srinivasa Raghavan, on the evening of the 17th April, shared with me an article that he had written in October 2008. He has been prescient. On deficient demand, he wrote:

Perhaps things need to change now and we need to view macroeconomic policy not merely through the demand prism. After all, 80 years after the Great Depression, a situation of sustained globally deficient aggregate demand, on a scale comparable to the Great Depression, is unlikely to emerge because of three factors: Growth in China and India, the gains in productivity that new technologies are bringing and, of course, the removal of the restraint that Keynes’ ‘barbarous relic’ imposed on global liquidity.

There is really no limit to how much money can be pumped in to restore confidence. In that sense, the Keynesian deficient demand system could have gone past its expiry date. [Link]

His prescience was not just limited to dismissing the deficient demand argument but arguing that growth will be dicated by physical resources (think climate) and asset-price speculation created by excess capital looking for higher returns. If anything, in the last ten years, growth has been driven more by speculation (with all the attendant costs described earlier) than being dictated to by the limit of physical resources.

He anticipated the consequence of such an economic growth process:

Left ideas will begin to look smarter. [Link]

Writing in October 2008, he limited himself to the above extraordinary  one-line warning at the end of the article. Subsequent developments have shown that he has been spectacularly right on the Left!

He agreed that the solutions pursued in the immediate aftermath of the crisis (exemplified by the collapse of Lehman Brothers) were necessary but correctly concluded that the extant macro-economic framework was not equipped to handle the problem.

The solutions pursued in 2008 were not withdrawn in time and were kept in place for too long distorting incentives and much else.

So, are we in a cul-de-sac? Sort of. But, defining the problem correctly will at least avoid running up costs arising from the pursuit of wrong answers. The status quo is worse. We not only do not have answers but central bankers in advanced countries have also compounded the problem.

Redemption starts with acceptance that one has been wrong. Then, minds will open up and right solutions will begin to emerge, even if gradual, to begin with.

Gradual and cautious immigration of the sort that Japan is trying might work. There should be redistribution through higher rates of tax (but not usurious that it defeats the purpose) on higher incomes and through tax on capital gains. There should be some caps on technological developments that raise worker anxiety and lower wages simultaneously. Such technological innovations actually store up much bigger troubles. Business and commercial leadership must lead by example in rebalancing the economy between assets and income and between capital and labour. Finally, may be, the answer lies in higher interest rates!

(p.s: Do read Andrew Smithers’ letter in response to Martin Wolf’s article)

SOX and Fed conscience

Record high in the semiconductor (SOX) index (with rapidly slowing end markets for semis and collapsing industry fundamentals)! Extreme (manic) speculation is back. Does the Fed have no conscience? (that’s a rhetorical question). [Link]

That was a tweet by Fred Hickey. I learnt about Fred Hickey from the Global Investment Strategy Weekly of Albert Edwards. Fred Hickey’s tweets also pointed me to the rather shocking slide in the quarterly results of Micron Technologies. See their press release here.

As per this article by Martin Wolf, we learnt that the Federal Reserve has done the following:

We learnt this month that the US Federal Reserve had decided not to raise the countercyclical capital buffer required of banks above its current level of zero, even though the US economy is at a cyclical peak. It also removed “qualitative” grades from its stress tests for American banks, though not for foreign ones. Finally, the Financial Stability Oversight Council, led by Steven Mnuchin, US Treasury secretary, removed the last insurer from its list of “too big to fail” institutions. [Link]

It is a good piece. Worth reading.

This is the actual news-story that Martin Wolf refers to, here.

STCMA – 22nd March 2019

Buying Gold and being bearish stocks is the ‘Trade of the Century’ according to a hedge fund. Personally, I hope they are right.

John Authers defends Jerome Powell for shutting the door on any further rate hike in 2019. I beg to differ. Even if he did not mean to raise rates, there was no harm in keeping markets uncertain. If the Federal Reserve Chairman was worried about a recession, he should also be worried about a stock market that betrays no sign of it. This divergence will make the ultimate pain for the economy all the more longer and greater.

As always, established and prominent figures are dovish in their criticisms of a dovish Fed. Here is Mohamed-El-Erian.

The headline of this article says it all: “Over 80% engineers unemployable for any job in knowledge economy”. If one wished to download the underlying report featured in the article, you can find it here. Have not read the full report yet.

While Martin Feldstein is worried about the looming federal debt crisis, John Authers has a good story in Bloomberg on the 12th March about the corporate debt bloat in the ‘here and now’. The story has many good charts and good arguments (ht Rajeev Mantri). But, John Authers fails to evidently connect this story to his latest missive on the Fed signalling no rate hike. A central bank pre-emptively foregoing its rate increase options does nothing to bring down corporate leverage.

Thanks to my IIM batchmates K.N. Vaidyanathan and Subramanian Sharma, I came across this ‘tweet storm’ or ‘tweet thread’ by Jawad Mian. It is equal to a full credit course on market valuations. It is a salutary lesson in investing at today’s prices.

HFT is FTT levy!

On the 3rd of March, I had written a blog post ‘Towers of Meaninglessness’. See here. I was happy to find my old ‘colleague’ (we were not exactly colleagues but we were in different businesses of Credit Suisse) Douglas Cliggott making an insighful observation that High-Frequency/Algorithmic Trading is a form of transaction tax levied by those with faster machines and servers on those who have slower equipment. Thus, he makes the case for claiming and levying this ‘tax’, rather than it being appropriated by private market participants. A very fair case.

Douglas Cliggott is currently a lecturer at the University of Massachusetts in Amherst – my alma mater!

Towers of meaninglessness

I could not have read a more contrasting article to the one that I had just blogged about on the science of poverty. This is far, far removed from the world that Charles Cooper is concerned about and rightly so.

I scoured the online comments on the article to see if anyone commented on the health implications to people of so many towers coming up to pass the data on from one tower to the other a teeny-weeny bit faster, not to mention the ugliness of it all – spoiling the landscape: “English coastal cliffs”. Together with cellular phone towers, are there radiation implications for people?

Further, as someone has commented below, what benefit is it of to the society – does it improve capital allocation which is the alleged benefit of capital markets (as per textbooks)?

In other words, what is the purpose and meaning of it all?

Read this comment from a reader:

My firm used to make $1bn a year doing it. They are stealing from legitimate order flow from institutional and retail investors. They “ping” the market tens of thousands of times a minute making and cancelling orders. Why the major institutions don’t demand changes is just another sign of the full institutional corruption in the capital markets. The exchanges don’t want to fix it because they want the phony volume. It’s a complete scam.

Wonder if, in the end, these folks pursuing the speed of light for their stock trades will end up like Charles Duhigg’s ‘1.2mn dollar’ friend?

Thank you, Saurabh, for sharing these articles.

[Postscript: Matt Levine has a contrarian piece. He says that there is no morality involved in HFT. I do not agree because the issue is not just about me hitting the keyboard few milli/nano seconds faster than someone else. The algorithms also confuse or ping the market. See the online FT comment pasted above.]