Stagflationary global debt crisis looms – and things will get much worse

 


The global financial and economic outlook for the year ahead has soured rapidly in recent months, with policymakers, investors and households now asking how much they should revise their expectations, and for how long. That depends on the answers to six questions.

First, will the rise in inflation in most advanced economies be temporary or more persistent? This debate has raged for the past year but now it is largely settled: “Team Persistent” won, and “Team Transitory” – which previously included most central banks and fiscal authorities – must admit to having been mistaken.

The second question is whether the increase in inflation was driven more by excessive aggregate demand (loose monetary, credit, and fiscal policies) or by stagflationary negative aggregate supply shocks (including the initial Covid-19 lockdowns, supply-chain bottlenecks, a reduced US labour supply, the impact of Russia’s war in Ukraine on commodity prices, and China’s “zero-Covid” policy). While demand and supply factors were in the mix, it is now widely recognised that supply factors have played an increasingly decisive role. This matters because supply-driven inflation is stagflationary and thus raises the risk of a hard landing (increased unemployment and potentially a recession) when monetary policy is tightened. That leads directly to the third question: will monetary-policy tightening by the US Federal Reserve and other major central banks bring a hard or soft landing? Until recently, most central banks and most of Wall Street occupied “Team Soft Landing”. But the consensus has rapidly shifted, with even the Fed Chair, Jerome Powell, recognising that a recession is possible, and that a soft landing will be “very challenging”.

Moreover, a model used by the Federal Reserve Bank of New York shows a high probability of a hard landing, and the Bank of England has expressed similar views. Several prominent Wall Street institutions have now decided that a recession is their baseline scenario (the most likely outcome if all other variables are held constant). In the US and Europe, forward-looking indicators of economic activity and business and consumer confidence are heading sharply south.

The fourth question is whether a hard landing would weaken central banks’ hawkish resolve on inflation. If they stop their policy-tightening once a hard landing becomes likely, we can expect a persistent rise in inflation and either economic overheating (above-target inflation and above potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant.

Most market analysts seem to think that central banks will remain hawkish but I am not so sure. I have argued that they will eventually wimp out and accept higher inflation – followed by stagflation – once a hard landing becomes imminent because they will be worried about the damage of a recession and a debt trap, owing to an excessive buildup of private and public liabilities after years of low interest rates.

Now that a hard landing is becoming a baseline for more analysts, a new (fifth) question is emerging: Will the coming recession be mild and short-lived, or will it be more severe and characterised by deep financial distress? Most of those who have come late and grudgingly to the hard-landing baseline still contend that any recession will be shallow and brief. They argue that today’s financial imbalances are not as severe as those in the run-up to the 2008 global financial crisis, and that the risk of a recession with a severe debt and financial crisis is therefore low. But this view is dangerously naive.

There is ample reason to believe that the next recession will be marked by a severe stagflationary debt crisis. As a share of global GDP, private and public debt levels are much higher today than in the past, having risen from 200% in 1999 to 350% today (with a particularly sharp increase since the start of the pandemic). Under these conditions, rapid normalisation of monetary policy and rising interest rates will drive highly leveraged zombie households, companies, financial institutions, and governments into bankruptcy and default.

The next crisis will not be like its predecessors. In the 1970s, we had stagflation but no massive debt crises because debt levels were low. After 2008, we had a debt crisis followed by low inflation or deflation because the credit crunch had generated a negative demand shock. Today, we face supply shocks in a context of much higher debt levels, implying that we are heading for a combination of 1970s-style stagflation and 2008-style debt crises – that is, a stagflationary debt crisis.

When confronting stagflationary shocks, a central bank must tighten its policy stance even as the economy heads toward a recession. The situation today is thus fundamentally different from the global financial crisis or the early months of the pandemic, when central banks could ease monetary policy aggressively in response to falling aggregate demand and deflationary pressure. The space for fiscal expansion will also be more limited this time. Most of the fiscal ammunition has been used, and public debts are becoming unsustainable.
 
Moreover, because today’s higher inflation is a global phenomenon, most central banks are tightening at the same time, thereby increasing the probability of a synchronised global recession. This tightening is already having an effect: bubbles are deflating everywhere – including in public and private equity, real estate, housing, meme stocks, crypto, Spacs (special purpose acquisition companies), bonds, and credit instruments. Real and financial wealth is falling, and debts and debt-servicing ratios are rising.

That brings us to the final question: will equity markets rebound from the current bear market (a decline of at least 20% from the last peak), or will they plunge even lower? Most likely, they will plunge lower. After all, in typical plain-vanilla recessions, US and global equities tend to fall by about 35%. But because the next recession will be stagflationary and accompanied by a financial crisis, the crash in equity markets could be closer to 50%.

Regardless of whether the recession is mild or severe, history suggests that the equity market has much more room to fall before it bottoms out. In the current context, any rebound – such as the one in the last two weeks – should be regarded as a dead-cat bounce, rather than the usual buy-the-dip opportunity. Though the current global situation confronts us with many questions, there is no real riddle to solve. Things will get much worse before they get better.

There is ample reason to fear big economies such as the US face recession and financial turmoil writes Nouriel Roubini in The Guardian

Debt levels are not an issue

The Bank of England must be clear about its focus on jobs and growth – and that stimulus needn’t spoil anyone’s sleep writes Phillip Inman in The Guardian

Bank of England governor Andrew Bailey was sure-footed at the start of the pandemic. Photograph: Reuters 



Tearing at the Tory party’s fabric is the thought of spiralling government debt. The subject triggers a cold sweat in some of the most emotionally resilient Conservative backbench MPs, such is the distress it generates.

Much as the German centre-right parties have spent the past 90 years fearing a return of hyperinflation, their UK counterparts worry about paying the national mortgage bill, and the possibility it will one day engulf and sink the ship of state.

Since the budget, there is a sense that the costs of the pandemic, of levelling up, of going green and of social care – to name just four candidates for extra spending – are scarily high.

Plenty of economists say these costs can be managed with higher borrowing. Even the experts who warned against rising debts back in 2009 have changed their minds. The International Monetary Fund and the Organisation for Economic Cooperation and Development say that after 30 years of falling interest rates, this is the moment to stick extra spending on a buy now, pay later tab. 

Yet, gnawing away at the Tory soul is the prospect of an increase in interest rates by a fragile Bank of England, an institution that owns more than a third of UK government debt. This week, Threadneedle Street’s monetary policy committee meets to discuss the state of the economy and whether it needs to adjust its current 0.1% base rate.

Last year the committee was concerned that the economic situation was so bad it might need to lower interest rates even further, pushing them into negative territory. In recent weeks, though, the success of the vaccine programme, some additional spending by Rishi Sunak in his spring budget and Joe Biden’s monster stimulus package – which has made its way unscathed through the US Congress – have turned a few heads.

Now there are warnings of a rebound in growth so strong that it will force central banks to calm things down with the much-dreaded increase in interest rates.

At Thursday’s meeting, Andrew Bailey will mark a year as governor, and will be forgiven for wanting to draw breath. Within weeks of the handover from Mark Carney, he was plunged into the pandemic and – like his counterpart in the Treasury, Sunak – forced to plot a way through the crisis.

Bailey should set aside his in-tray and do the nation a favour by making explicit what, in a post-pandemic world, the Bank’s mandate means. And what he should say is neither outlandish nor controversial.

It should not differ wildly from what Jerome Powell, the head of the US central bank, said last week. Bailey should explain that the Bank’s focus is on generating a path for growth that has momentum and is sustainable. Only when the Bank can verify that jobs are being created – and, more importantly, that pay rises of at least 4% a year are being awarded – will it begin to consider tightening monetary policy.

This means interest rates cannot increase until the government has two things working in its favour. First, that there are enough jobs and pay increases to generate the level of tax receipts that can pay for higher debt bills. Second, that there is a level of growth which means the debt-to-GDP ratio, expected to hit about 110% during this parliament, starts coming down, even as the government spends more.

If Bailey says this like he means it, those who worry about rising interest rates can switch to worrying about something else, such as the climate emergency, Britain’s spectacular loss of biodiversity and rising levels of child poverty.

Bailey’s record over his first year in charge does not augur well. While he was sure-footed at the outset of the pandemic, dusting off the 2008 crisis playbook and printing a huge sum of money to restore confidence, things soon started to go awry.

He has flip-flopped from optimist to pessimist on the economy while throwing incendiary devices on the fears of those who worry about debt. In an interview last June, for example, he claimed the bond markets brought Britain close to insolvency when the bank launched its first pandemic rescue operation. It was an exaggeration that matched the hyperbole of his recent support for the idea that consumers are ready to “binge” once lockdown eases.

If the past 10 years has taught us anything, it is that the Bank has consistently done too little to help the economy and not too much. Bailey could ask Sunak to overhaul the MPC remit, increasing the inflation target from the current 2% to 3% or 4%, or bolting on a growth target that would force the Bank to keep rates where they are until growth reaches 3% or 3.5% a year.

That could be Bailey’s legacy, for which the nation would thank him.

Most ingredients are in place for a property crash later this year

Rising unemployment is toxic for the property market and low interest rates may not be enough writes Larry Elliott in The Guardian 

 

Spring is usually the time when the property market comes out of hibernation. Photograph: lucemac/GuardianWitness


This weekend marks the start of a truncated summer house buying season, the moment the residential property market comes out of hibernation.

Normally this happens at Easter but, for obvious reasons, that has not been possible in 2020. Estate agents have been shuttered along with almost every other business, waiting impatiently for the lifting of the lockdown. This bank holiday weekend, with fine weather forecast, provides a chance to make up for lost time.

Well, perhaps. Britain’s love affair with rising house prices borders on the pathological so a mini boom can’t entirely be ruled out. The government did its best last week to give the market a boost by extending its mortgage holiday for the financially distressed for a further three months. That means those having trouble keeping up with their home loans won’t have to make a repayment until at least September.

That said, the notion that this is going to be a year of high turnover and rising house prices is wide of the mark. All the ingredients, bar one, is in place for a crash later in the year.  

Let’s start with the obvious: the economy has been poleaxed by the Covid-19 pandemic. The official jobless figures – showing a rise to 2.1 million in claimant count unemployment – provide only a hint of the damage that has been caused to the labour market by the lockdown. A truer picture comes from the number of jobs furloughed under the Treasury’s wage subsidy scheme, which stands at 8m and counting.

Not every one of those furloughed workers is going to end up jobless, but some of them will. The number will depend, crucially, on how long it takes for the economy to return to something like normal. The slower the process the more businesses will close permanently.

Rishi Sunak announced earlier this month that the furloughing scheme will be kept going until the end of October, but from the start of August employers will be asked to foot part of the wage bill themselves. At present, the government is paying 80% of wages up to a monthly maximum of £2,500, an expensive commitment that helps explain why the state borrowed almost as much in April (£62bn) as in the whole of the last financial year.

The chancellor will announce in the next few days how big a contribution employers will need to make, but at a minimum they can expect to pay 20% of an employee’s wages. This will be the moment of truth for many businesses.

Rising unemployment is toxic for the property market. If people struggle to find another job quickly after losing their job they fall into mortgage arrears and eventually have their homes repossessed. That happened in the early 1990s and is one reason why a mortgage holiday has been introduced this time.

Hansen Lu, property economist at Capital Economics, has shown how a moratorium on home loan payments saves someone paying 2.5% on a £200,000 mortgage £5,400 over a six-month period. That’s quite a financial cushion because although the lender eventually has to be paid back, it means subsequent mortgage payments go up by about £30 a month.

Again, everything depends on the state of the labour market this autumn. The mortgage holiday will end at the same time as the furlough scheme, and already there will be many households who will be wondering how they will manage at that point.

Buying a house is the single biggest financial commitment most of us ever make. When people are deciding whether to buy or not, they think hard about whether they are going to be able to keep up the monthly payments. It is not just being unemployed that matters; it is the threat of unemployment. Surveys suggest, hardly surprisingly, that consumers are extremely wary of committing to big-ticket items.

Only one thing is missing from a perfect storm: sharply rising interest rates. A doubling of official interest rates was the trigger for recession and record home repossessions in the early 1990s, but there is not the slightest prospect of that happening this time. The Bank of England has cut interest rates to 0.1% and is debating whether to take them negative.

There are economists – the monetarist Tim Congdon, for example – who believe that the vast quantities of money the Bank is chucking at the economy will eventually lead to much higher inflation. In those circumstances Threadneedle Street would have a choice: raise interest rates aggressively to hit the government’s 2% inflation target and guarantee deep recession in the process; or go easy. If it chooses the first option the housing market will collapse because many owner occupiers can only service the debts they have had to to incur to afford expensive real estate if interest rates remain at historically low levels.

So here’s how things stack up. On the one hand, the economy has collapsed and is recovering only falteringly; unemployment, whether real or hidden by the furlough, is rocketing; incomes are being squeezed; consumer confidence is at a low ebb; and the ratio of house prices to earnings is high. On the other hand, interest rates are low and will stay low for some time. In the jargon of the economics profession, there are more downside than upside risks.

But let me personalise things a bit. A relative for whom I hold power of attorney is about to have his house put on the market to fund his care home fees. My intention is to take the first halfway decent offer that’s received, because my sense is that prices are heading lower. In the past I haven’t heeded my own advice and lived to regret it. Not this time, though.

The end of an era of cheap money?

Nicole Bullock, Eric Platt and Alexandra Scaggs in The Financial Time


For more than a decade, Mike Schmanske made a living trading “volatility” — betting on the size and speed of moves in the US stock market. After 2014, the market was calm for so long that he spent much of his time sailing a Swan yacht. He got his adrenalin flowing in a different way: on his first trip from Bermuda to Newport, Rhode Island, he raced a hurricane back to port and made it with 12 hours to spare. 

Now, a new bout of turbulence is pulling him back to Wall Street. A sharp outbreak of volatility has written more than $5tn off the value of global stocks in less than two weeks and Mr Schmanske is talking to his old trading buddies about getting back into the market. 

“This is the most calls I’ve taken in years,” says Mr Schmanske*, a pioneer of some of the first volatility trading products while at Barclays and now a consultant. “Things were slow. I was literally on a boat a few weeks back.” 

The catalyst for the volatility surge came at 8:30am last Friday when the US government employment report showed a surprisingly strong rise in wages, prompting bond yields to shoot upwards and the price of those bonds to fall. Within hours, the losses in the $14tn Treasury market had spread to stocks, setting the stage for Wall Street’s worst week in two years.** By Thursday, US equities had entered what is known as a correction — a fall of at least 10 per cent. Many investors who had piled into esoteric instruments that enable them to bet on continued calm in the market had been wiped out. 

The ructions over the past week have attracted so much attention because they strike at the question that has haunted markets for the past two years — what happens when the economy returns to normal? Since the financial crisis, markets have been boosted by an unprecedented mixture of ultra-low interest rates and asset-buying by central banks in a bid to fend off the threat of deflation. But with global growth robust and inflation beginning to re-appear, central banks are pulling back. 

The question investors are trying to answer is how much of the sharp drop in share prices is due to a technical reaction driven by a much-hyped niche in the market that bets on volatility, versus part of a broader adjustment to a different economic reality. 

“The system has changed,” says Jean Ergas, head strategist at Tigress Partners, who said the market had made more of a “rethink” than a correction. “This is the unwinding of a massive carry trade, in which people borrowed at zero per cent and put money into stocks for a yield of 2 per cent.” 

The year began on a euphoric note as a large cut in US corporate tax prompted investors to mark up their expectations for earnings growth. The economy was already humming around the world for the first time since the financial crisis. 

At its peak on January 26, the market values of S&P 500 companies had surged by $5tn from a year earlier, while global stocks were up by nearly $14tn. The gains lured small investors into the market, with more than $350bn pumped into equity funds in the year, according to fund tracker EPFR Global. 

But cracks had already appeared in the bond market. Investors were starting to make noise and demand higher yields. Bill Gross and Jeffrey Gundlach — two well-known money managers in fixed-income markets — both declared last month a new era after a 36-year “bull market” in bonds, which had seen yields driven steadily lower. 

It was against that backdrop that markets reacted to last Friday’s news of a 2.9 per cent rise in US wages — not dramatic in a different era but still the largest year-on-year rise since the financial crisis. Inflation fears rose. Investors began marking up the odds that the Federal Reserve could tighten policy by a full percentage point this year, more aggressively than previously thought. Robust growth in Europe and Japan also raised the question of when the European Central Bank and Bank of Japan would begin to remove crisis-era stimulus. 

“Inflation fears running back into the market and hitting basically all assets in a market that had run up significantly is a pretty plausible, simple story,” says Clifford Asness, co-founder of AQR Capital Management. “You do not have to go looking for Alger Hiss in this pumpkin.” 

By the end of last Friday, yields on benchmark 10-year US Treasuries had hurdled above 2.8 per cent for the first time in nearly four years. For the year, yields had risen more than 40 basis points, increasing the appeal of bonds relative to stocks. The Dow Jones Industrial Average lost 666 points — an unsettling omen for religiously minded traders. 

“Optimism over synchronised global growth and supportive macro conditions led to outsized gains in equity markets to start the year,” says Craig Burelle, macro strategies research analyst at Loomis Sayles. “But more recently, some investors worried the economic momentum was too much of a good thing, and optimism gave way to concerns about the future path of inflation and interest rates.” 

Before long, the anxiety had gone global. On Sunday evening, many Americans were watching the Philadelphia Eagles upset the New England Patriots in the Super Bowl: at the same time, Asian markets were opening on Monday with a spike in bond yields. 

“On any other Sunday night you might have been more anxious about what you were seeing,” says Matt Cheslock, a trader at Virtu and a 25-year veteran of the New York Stock Exchange. “The game provided a nice distraction.” 

Monday morning in the US added a new source of uncertainty with the swearing in of Jay Powell as the chairman of the Federal Reserve, bringing a relatively little-known face to lead the central bank. For much of the day, Wall Street avoided serious losses. Then, a big drop seemed to come out of nowhere. About an hour before the closing bell, the Dow slumped more than 800 points in 10 minutes. 

“The adrenalin kicks in,” says Mr Cheslock. “Everyone gets sharper. The complacency is long gone.” 

Customers rushed to log into their accounts at Vanguard, TD Ameritrade, T Rowe Price and Charles Schwab, straining websites. Some were unable to place orders. 

“As the volatility picks up and the indices plummet the rumours start to swell,” says Michael Arone, chief investment strategist at State Street Global Advisors. “Folks are wondering the classic Warren Buffett line about when the tide goes out, you see who is not wearing swimming trunks.” 

Over the past week, the investors who have been left most exposed are those who had made bets on subdued volatility. As share prices slumped, Wall Street’s “fear gauge” — the widely watched Cboe Vix volatility index — spiked. 

Trading strategies that profited from the calm in markets during 2017 quickly unravelled. Two exchange-traded products that enabled investors to bet on low volatility lost nearly all their value on Monday. 

After the bell on Monday, the Vix continued to rise and shares in vehicles related to Vix also fell. 

On Tuesday morning, Nomura, the Japanese bank, said in Tokyo that it would pull a product that was pegged to S&P 500 volatility. Within half an hour, the Nikkei 225 had fallen 2.5 per cent, which, in turn, prompted a bout of selling in bitcoin. The digital currency — worth more than $19,000 as recently as December — dropped below $6,000 just after 2:45am in New York, as traders in London and Frankfurt were getting to their desks. Stock markets in both countries would open 3.5 per cent lower. 

As US investors slept, the turbulence continued. At 4am in New York, a number of exchange traded products related to volatility were halted. By 7:11am, more than two hours before the US open, the Vix volatility index shot above 50 — only the second time it has done so since 2010. The turbulence forced bankers to postpone a number of bond sales planned for the day. Then Credit Suisse said it would close an exchange traded note, known by the ticker XIV — which is designed to move in the exact opposite direction to the Vix each day, and had thus collapsed as volatility rose. 

“People had forgotten that stocks don’t just go up,” says Adam Sender, head of Sender Company and Partners, a hedge fund. “Corrections are a normal process. This was inevitable. Interest rates rising was the trigger, but short-volatility was the fuel.” 

The volatility subsided amid a Tuesday afternoon rally in New York, and world stock markets survived much of the next day without incident. But then at 1pm on Wednesday in New York, signs of nervousness re-emerged. Demand at the auction of US Treasury bonds was weak, a signal that investors were worried about inflation and a rising budget deficit, and would therefore only buy at higher yields. Stocks ended the day in the red, and when investors in Tokyo returned on Thursday, prices dropped quickly. Heavier selling ensued on Wall Street. By Friday morning, the main indices in the US, Germany and Japan were all down more than 10 per cent from their January highs. When trading finally closed for the week after another rollercoaster day, US losses were shaved to about 9 per cent. 

For some, the shock created by the collapse of the volatility products has been salutary. “It’s always good to be reminded of these things with accidents that aren’t of systemic importance to the entire economy,” says Victor Haghani, founder of London’s Elm Partners and an alumnus of Long-Term Capital Management. “It’s a gentle reminder from the market.” 

However, many investors believe the questions raised over the past week go well beyond the products connected to the Vix index. “We’ve gone from a market used to playing checkers — rising earnings, low rates equals higher prices — to being forced to compete in grandmaster three-dimensional chess: worries over growth versus rates, equity valuations, and the strength of the dollar, and now market structure concerns,” says Nicholas Colas, cofounder of DataTrek, a New York research group. 

While some investors talked of a buying opportunity, believing that faster economic growth and a modest uptick in inflation represent a positive backdrop for equities, many headed for the exits. Investors pulled more than $30bn from stock funds in the week to Wednesday, the largest week of withdrawals since EPFR began tracking the data at the turn of the century. 

The slump in share prices put the White House on the defensive, given that President Donald Trump has taken pride in the stock gains under his administration. “In the ‘old days,’ when good news was reported, the Stock Market would go up. Today, when good news is reported, the Stock Market goes down,” he tweeted on Wednesday. “Big mistake, and we have so much good (great) news about the economy!” 

Others were less confident. “This is not yet a major earthquake,” said Lawrence Summers, US Treasury secretary under President Bill Clinton. “Whether it’s an early tremor or a random fluctuation remains to be seen. I’m nervous and will stay nervous. [It is] far from clear that good growth and stable finance are compatible.” 

Some strategists expect the recent declines to lead to further selling, as computer-driven funds that target volatility are forced to shed more equities. Analysts put the amount of automatic selling from the recent turmoil at about $200bn, and more could be on the way unless markets simmer down. 

Jonathan Lavine, co-managing partner of Bain Capital, says a drop in share prices was not a surprise in itself. “It was the ferocity of the move, not triggered by any material news and propelled by a small corner of financial markets,” he says. “You have to ask yourself what would happen in the event of real bad news.”

Move over central bankers, your models are part of the problem

The new masters of the universe are struggling to understand what makes a modern economy tick and their actions could prove harmful.

Chris Giles in The Financial Times

Central bankers usurped the titans of Wall Street as the masters of the universe almost a decade ago. They rescued the global economy from the financial crisis, flooding the world with cheap money. They used their powers effectively to get banks lending again. Their actions raised asset prices, keeping business and consumer confidence up. Financial markets and populations hang on their words. But never have they been so vulnerable. 

As they gather in Washington for the annual meetings of the International Monetary Fund, there is a crisis of confidence in central banking. Their economic models are failing and there are doubts whether they understand the effects of interest rates and other monetary policies on the economy. 

In short, the new masters of the universe might not understand what makes a modern economy tick and their well-intentioned actions could prove harmful. 

While there have long been critics of the power of central bankers on the left and the right, such profound doubts have never been so present within their narrow world. In the words of billionaire investor Warren Buffett, they risk being the next ones to be found swimming naked when the tide goes out. 

The ability of central banks to resolve these questions does not just affect growth rates, but is fundamental to the health of the democracies of advanced economies, many of which have been assailed by populist uprisings. 

“If we can’t get inflation back up [trouble lies ahead]. We can’t have political stability without wage growth,” says Adam Posen, head of the Peterson Institute and formerly a central banker at the Bank of England. 

The root of the current insecurity around monetary policy is that in advanced economies — from Japan to the US — inflation is not behaving in the way economic models predicted. 

Deflation failed to materialise in the depths of the great recession of 2008-09 and now that the global economy is enjoying its broadest and strongest upswing since 2010, inflationary pressures are largely absent. Even as the unemployment rate across advanced economies has fallen from almost 9 per cent in 2009 to less than 6 per cent today, IMF figures this week show wage growth has been stuck hovering around annual increases of 2 per cent. The normal relationships in the labour market have broken down. 

Amid this forecasting nightmare, some frank talk is breaking out. Janet Yellen, chair of the US Federal Reserve and the world’s most important central banker, has been the most direct. “Our framework for understanding inflation dynamics could be mis-specified in some fundamental way,” she said last month. Her sentiments are spreading. 

For Mark Carney, governor of the BoE, global considerations “have made it more difficult for central banks to set policy in order to achieve their objectives”. Mario Draghi, president of the European Central Bank, is keeping the faith for now, but observes, “the ongoing economic expansion . . . has yet to translate sufficiently into stronger inflation dynamics”. 

Claudio Borio, chief economist of the Bank for International Settlements, which provides banking services to the world’s central banks, says: “If one is completely honest, it is hard to avoid the question: how much do we really know about the inflation process?” 

The details of macroeconomic models are fiendishly complicated, but at their heart is a relationship — called the Phillips curve — between the economic cycle and inflation. The cycle can be measured by unemployment, the rate of growth or other variables, and the model predicts that if the economy is running hot — if unemployment falls below a long-run sustainable level or if growth is persistently faster than its speed limit — inflation will rise. 

The models are augmented by a concept of inflation expectations, which keep inflation closer to a central bank’s target — usually 2 per cent — if the public trusts that central bankers will do whatever it takes to return inflation to that level after any temporary deviation. The holy grail for central bankers is to claim credibly that they have “anchored inflation expectations” at the target level. 

In the model, the most important factors that explain price movements are therefore the degree to which the economy has room to grow without inflation, termed “slack” or “the output gap”, and the public’s inflation expectations. 

The role of central banks in the model is to set the short-term interest rate. If a central bank sets its official interest rates low, people and companies will be encouraged to borrow more to spend and invest and discouraged from saving, boosting the economy in the short term. Higher interest rates cool demand. 

The first fundamental problem with the model is, as Mr Borio says, “the link between measures of domestic slack and inflation has proved rather weak and elusive for at least a couple of decades”. 

While Japan’s unemployment rate is now back down to the levels of the 1970s and 1980s boom, leaving little slack, inflation is barely above zero. In Britain, unemployment has almost halved since 2010, but wage growth has stuck resolutely at 2 per cent a year. 

But many economists and central bankers are wedded to the underlying theory, which is about 30 years old, and seek to tweak it to explain recent events rather than ditch it in favour of less orthodox ideas. Such nips and tucks are occurring all over the world, although the explanations differ. 

Ms Yellen has highlighted measurement issues in inflation and “idiosyncratic shifts in the prices of some items, such as the large decline in telecommunication service prices seen earlier in the year”. Similarly, the ECB is fond of a new definition — “super core inflation”, which strips out more items from the index and shows the bank performing better against its target than the headline measure. But few central bankers are happy with meeting targets only once they have moved the goalposts. 

A second explanation is that the level of unemployment that is consistent with stable inflation has fallen. In 2013, the BoE thought the UK economy could not withstand unemployment falling below 7 per cent before wages and inflation would pick up. It now thinks that rate is 4.5 per cent. On this reasoning, inflation has been low because there was more slack in the economy than they had thought. 

The problem with such explanations, as Daniel Tarullo, a Fed governor for eight years until April, notes, is that if central bankers keep changing their notion of sustainable unemployment levels “sound estimation and judgment are sometimes hard to differentiate from guesswork in attempting to see through transitory developments”. 

A third explanation is that central bankers have been so successful in anchoring inflation expectations, companies do not seek to raise prices any faster and workers do not ask for wage rises even when jobs are plentiful. 

Mr Draghi recently urged union pay bargainers to stop looking backward at inflation rates of the past when they negotiate wages, in a move that used to be unthinkable for a central banker. The problem with this explanation is both the self-serving reasoning and the fact that inflation expectations cannot be measured. 

“Over my time at the Fed, I came to worry that inflation expectations are bearing an awful lot of weight in monetary policy these days, considering the range and depth of unanswered questions about them,” says Mr Tarullo. 

The Bank of Japan, meanwhile, frets that companies are cutting employees’ hours and raising productivity rather than paying more, which is hampering its ability to push up inflation despite extremely low unemployment. 

If it was not bad enough that the link between the economic cycle and inflation has broken down, the second fundamental problem in central banking is that estimates of the neutral rate of interest — seen as the long-term rate of interest that balances people’s desire to save and invest with their desire to borrow and spend — appear to have fallen persistently across the world. 

The Fed’s central estimates of the real neutral interest rate has declined by nearly two-thirds in five years, from 2 per cent to 0.75 per cent. But the figures are again little more than guesswork. As Ms Yellen said, “[the neutral rate’s] value at any point in time cannot be estimated or projected with much precision”. 

Whether it is because ageing populations want to save more or because of a global “savings glut”, as former Fed chair Ben Bernanke said, low rates no longer have the same impact, limiting the effectiveness of the medicine central banks want to administer. 

Regardless of the terminology, the two problems combined suggest central bankers cannot easily determine whether their economies need stimulus or cooling and do not know whether their monetary tools are helping them do their job. And there is increasing concern, even expressed by Ms Yellen, that the underlying theoretical model might simply be rotten to the core and attempts to tweak it are futile. 

“Essentially you are setting policy on things you don’t know and can’t measure and then reasoning after the fact,” says Mr Tarullo. His core argument is that central banks maintain an absolute faith in the model with absolutely no evidence to support it. 

At a conference last month to celebrate the BoE’s 20 years of independence, Christina Romer, professor of economics at the University of California, Berkeley, urged central bankers to have a more open mind. 

New research is needed to question whether current thinking is deficient, she said, “and if such research suggests our ideas explaining how the economy works are wrong or need to change, then central bankers need to embrace those ideas”. 

The most aggressive critic of the consensus is Mr Borio of the BIS. He accuses central bankers of misunderstanding the drivers of inflation and their effects on the economy. His argument is that global forces of trade integration and technology are more convincing than concepts of domestic slack in explaining the absence of pricing power among companies and employees. 

He asks: “Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening up of other emerging market economies?” 

His concern is that by keeping interest rates low, central bankers have no effect on inflation or the economy other than to increase the level of debt. The result is that it will be harder “to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates”. 

It is not a popular view, but it is no longer dismissed out of hand. Ms Yellen justified her stance on continuing to raise interest rates gradually in the face of persistently low inflation by appealing to concerns about debt. 

“Persistently easy monetary policy might also eventually lead to increased leverage and other developments, with adverse implications for financial stability,” she said. 

With central bankers credited for keeping the economic show on the road over the past decade, it will come as a shock to many to hear how little confidence they have in their models, their policies and their tools. 

One question posed by Richard Barwell, a senior economist at BNP Paribas, is whether they should let on about how little they know. “It’s rather like Daddy is driving the car down a hill, turning round to the family and saying, ‘I’m not sure the brakes work, but trust me anyway’,” he says. 

For now, the public still trust the women and men who work in the marbled halls of central banks around the world. But that confidence is fragile. Central bankers might have been the masters of the universe of the past decade, but they know well what happened to the previous holders of that title.

Low interest rates revived the economy, but now we're all suffering for it

A 35-year-old needs to invest £125,000 to earn a pension of £35,000 when the interest rate is 5 per cent. If it's 2 per cent, they'll need to save £400,000.

Andreas Whittam Smith in The Independent

I could hardly believe that a politician would blame low interest rates for the success of a far right political party. Least of all that it would be the eminently sensible Wolfgang Schäuble, Germany’s minister of finance, who has held office since 2009. Yet earlier this month he publically blamed the cheap money policy of the European Central Bank (ECB) for contributing to the rise of the country's right-wing anti-immigration party, Alternative for Germany (AfD).

“I told Mario Draghi (president of the ECB),” said Mr. Schäuble, “be very proud: you can attribute 50 per cent of the results of a party that seems to be new and successful in Germany to the design of this policy.”

Founded only in 2013, the AfD has recently gained representation in eight German state parliaments.

In explanation, the transport minister, Alexander Dobrindt, toldDie Welt newspaper: “The ECB is following a very risky course. The disappearance of interest rates creates a gaping hole in citizens’ old age preparations.”

There is the connection. The older generations, who often dislike immigration, have also found that a lifetime of careful saving has brought them little reward. No wonder they make their protest by voting for an anti-immigration party.

Note that Mr. Dobrindt referred to “the disappearance of interest rates”. That hasn’t yet happened here. But it is still a shock, however, to discover how meagre they are. Go into Barclays, for example, and you will find that the bank will give you 0.25 per cent per annum on sums of less than £25,000. So you place £20,000 for a year and you earn – £50 in interest.

At least this is a positive rate. But if you are a citizen of the Eurozone, or of Japan, or of Sweden, or of Switzerland or Denmark, a group of countries that account for one quarter of the world economy, the situation is even worse. There the banks are actually charging customers for the privilege of depositing money with them. In other words, interest rates are negative. You don’t get your £20,000 back, but a mere £19,950.

It isn’t only German politicians who are concerned about low or negative interest rates. This week Larry Fink, the chief executive of the investment managers Blackrock, which looks after more funds than any other firm, revealed his disquiet in an annual letter to shareholders.

Fink said that the adoption of negative interest rates was “particularly worrying”. He commented that investors were being forced to take on more risk in order to obtain higher returns. And this often meant that they had to sacrifice the certainty that they could find buyers when they wanted to sell their assets. Fink rightly calls this ‘a potentially dangerous combination for retirement savers’.

But what about people, for instance, in their thirties and saving up for retirement. Fink gives this chilling calculation. A 35-year-old looking to generate an income of £35,000 per year for a retirement beginning at age 65 would need to invest £125,000 today in a 5 per cent interest rate environment. In a 2 per cent interest rate environment, however, that individual would need to invest £400,000 (3.2 times as much) to achieve the same outcome when he or she stops working.


If the disadvantages of low interest rates are so daunting, what then are the supposed advantages? That is matter that will be debated at the IMF’s annual spring meetings this week in Washington.

Three officials have written a blog that seeks to balance the pros and cons. They “tentatively” conclude that, overall, negative interest rates help deliver additional monetary stimulus and easier financial conditions, which support demand and price stability. But, they add, “there are limits on how far and for how long negative policy rates can go.” I call that lukewarm support.

In fact, taking together the reservations expressed above and the analysis presented by the IMF paper, the drawbacks of low or negative interest rates fall into three groups.

First, savers may prefer physical cash to bank deposits, which is bad for economic activity. The IMF paper discusses using bank vaults or non-bank vaults for holding cash safely. Second, the policy may encourage excessive risk taking both by banks and by individuals. And third, as the IMF comments, if low or negative rates persist they could undermine the viability of life insurance, pensions and other savings vehicles.

The truth is that governments no longer have the means to revive economic activity. Gimmicks such as negative interest rates could easily do as much harm as good.

Crime, terrorism and tax evasion: why banks are waging war on cash

Paul Mason in The Guardian

Governments would love to see the end of banknotes. But what would a cashless society mean for freedom?

 

Will contactless payment help usher out cash? Photograph: Bloomberg/Bloomberg via Getty Images



I can remember the moment I realised the era of cash could soon be over.

It was Australia Day on Bondi Beach in 2014. In a busy liquor store, a man wearing only swimming shorts, carrying only a mobile phone and a plastic card, was delaying other people’s transactions while he moved 50 Australian dollars into his current account on his phone so that he could buy beer. The 30-odd youngsters in the queue behind him barely murmured; they’d all been in the same predicament. I doubt there was a banknote or coin between them.

The possibility of a cashless society has come at us with a rush: contactless payment is so new that the little ping the machine makes can still feel magical. But in some shops, especially those that cater for the young, a customer reaching for a banknote already produces an automatic frown.

Among central bankers, that frown has become a scowl. There is a “war on cash” in the offing – but it has nothing to do with boosting our ease of payment or saving trees.

Consider the central banks’ anti-crisis measures so far. The first was to slash interest rates close to zero. Then, since you can’t slash them below zero, the banks turned to printing money to stimulate demand. But with global growth depressed, and a massive overhanging debt, quantitative easing (QE) is running out of steam.

Enter the era of negative interest rates: thanks to the effect of QE, tens of billions held in government bonds already yield interest rates that are effectively below zero. Now, central banks such as Japan and Sweden have begun to impose negative official interest rates.

The effect, for banks or long-term savers, is that by putting your money in a safe place – such as the central bank or a government bond – you automatically lose some of it.

Not surprisingly, these measures have led to the growing popularity of cash for people with any substantial savings. Bank of England research shows demand for cash has grown faster than GDP in many countries. So the central banks face a further challenge: how to impose negative interest rates on cash itself.

Technologically, you can’t. If people hold their savings as physical currency, it keeps its value – and in a period of deflation the spending power of hoarded cash increases, even as share prices and the value of bank deposits fall. Cash, in a situation like this, is king.

But the banks are ahead of us. Last September, the Bank of England’s chief economist, Andy Haldane, openly pondered ways of imposing negative interest rates on cash – ie shrinking its value automatically. You could invalidate random banknotes, using their serial numbers. There are £63bn worth of notes in circulation in the UK: if you wanted to lop 1% off that, you could simply cancel half of all fivers without warning. A second solution would be to establish an exchange rate between paper money and the digital money in our bank accounts. A fiver deposited at the bank might buy you a £4.95 credit in your account.

More radical still would be to outlaw cash. In Norway, two major banks no longer issue cash from branch offices. Last month, the biggest bank, DNB, publicly called for the government to outlaw cash.

Why would a central bank want to eliminate cash? For the same reason as you want to flatten interest rates to zero: to force people to spend or invest their money in the risky activities that revive growth, rather than hoarding it in the safest place.

Calls for the eradication of cash have been bolstered by evidence that high-value notes play a major role in crime, terrorism and tax evasion.

In a study for the Harvard Business School last week, former bank boss Peter Sands called for global elimination of the high-value note. Britain’s “monkey” – the £50 – is low-value compared with its foreign-currency equivalents, and constitutes a small proportion of the cash in circulation. By contrast, Japan’s 10,000-yen note (worth roughly £60) makes up a startling 92% of all cash in circulation; the Swiss 1,000-franc note (worth around £700) likewise. Sands wants an end to these notes plus the $100 bill, and the €500 note – known in underworld circles as the “Bin Laden”.

The advantages of a digital-only payment system to the user are clear: you can emerge from the surf in only your bathing shorts and proceed to buy beer, food, or even a small car, providing your balance is positive. The advantages to banks are also clear. Not only can all transactions be charged a fee, but bank runs are eliminated. There can be no repeat of the queues outside Northern Rock, nor of the Greek fiasco last summer, because there will be no ATMs, only a computer spreadsheet moving digital money around. The advantages to governments are also clear: all transactions can be taxed. Capital controls are implicit within the system.

But there are drawbacks, even for governments that would like to take absolute control of money transactions. First, resilience. If a cyber-attack or computer malfunction took down a digital-only payment system, there would be no cash reserves in households and businesses to fall back on. The second is more fundamental and concerns freedom. In most countries, the ability to take your cash out of the bank and to spend it anonymously is associated with many pleasurable activities – not all of which are illegal but which exist on the margins of society. How tens of thousands of club-goers would pay for their drugs each Saturday night is a non-trivial issue.

Nevertheless, the arrival of negative interest rates for banks, together with new rules allowing governments to bail-in – ie confiscate – deposits above a protected minimum, are certain to increase savers’ awareness of the value of cash, and will prompt calls in earnest for its abolition.

If it happens, it would be the ultimate demonstration of the power of finance over people. As for resistance? Go ahead and try. It may be the Queen’s head on a £50 note but the “promise to pay” is made above the signature of a Bank of England bureaucrat.

The world can't afford another financial crash – it could destroy capitalism as we know it

A new economic crisis would trigger a political backlash in Britain, Europe and the United States which could drag us all down into poverty



Call this a protest? You ain't seen nothing yet Photo: PAWEL KOPCZYNSKI / REUTERS


By Allister Heath in The Telegraph


They bounce back after terrorist attacks, pick themselves up after earthquakes and cope with pandemics such as Zika. They can even handle years of economic uncertainty, stagnant wages and sky-high unemployment. But no developed nation today could possibly tolerate another wholesale banking crisis and proper, blood and guts recession.

We are too fragile, fiscally as well as psychologically. Our economies, cultures and polities are still paying a heavy price for the Great Recession; another collapse, especially were it to be accompanied by a fresh banking bailout by the taxpayer, would trigger a cataclysmic, uncontrollable backlash.

The public, whose faith in elites and the private sector was rattled after 2007-09, would simply not wear it. Its anger would be so explosive, so-all encompassing that it would threaten the very survival of free trade, of globalisation and of the market-based economy. There would be calls for wage and price controls, punitive, ultra-progressive taxes, a war on the City and arbitrary jail sentences.





Two men walk along the road to Los Angeles in 1937, during the Great Depression





For fear of allowing extremist or populist parties through the door, mainstream politicians would end up adopting much of this agenda, with devastating implications for our long-term prosperity. Central banks, in desperation, would embrace the purest form of money-printing: they would start giving consumers actual cash to spend, temporarily turbo-charging demand while destroying any remaining respect for the idea that money needs to be earned.

History never repeats itself exactly, but the last time a recession was met by pure, unadulterated populism was in the Thirties, when the Americans turned a stock market crash and a series of monetary policy blunders into a depression. President Herbert Hoover signed into law the Smoot-Hawley Tariff Act, dreamt up by two economically illiterate Republican senators, slapping massive taxes on the imports of 20,000 goods and triggering a global trade war. It was perhaps the most economically destructive piece of legislation ever devised, and it took until the Nineties before the damage was finally erased.

That is why we must all hope that the turmoil of recent days in the financial markets, and the increasingly worrying economic news, will turn out to be a false alarm. It would certainly be ridiculously premature, at this stage, to call a recession, let alone a financial crisis. But at the very least we are seeing a major dose of the “dangerous cocktail of new threats” rightly identified at the turn of the year by George Osborne, a development which will have political repercussions even if the economy eventually muddles through.

Investors in equities, including millions of people with private pensions and Isas, have already lost a fortune; they won’t be too happy when they begin to realise the extent of the damage. Growth is slowing everywhere, and the monetary pump-priming of the past few years is looking increasingly ineffective. Traders believe that interest rates won’t go up in Britain until 2019, and there is increasing talk that negative interest rates could become necessary across the developed world, further crippling savers.

No positive spin can be put on any of the latest developments. Banking shares have taken a beating; China’s slowdown continues; Maersk, the shipping giant, believes that conditions for world trade are worse than in 2008-09; industrial production slumped in December, not just in Britain but more so in France and Germany; energy prices are devastating Middle Eastern and Russian economies; and sterling has tumbled.

It is always a sure sign that panic has broken out when financial markets respond badly to all possible scenarios. The prospect of higher interest rates? Sell, sell, sell. A chance of lower rates? Sell, sell and sell again. A rise in the price of oil is met with as much angst as a decline. The financial markets remain addicted to help from central banks: they are desperate for yet more interventions, regardless of the consequences on the pricing of risk, the allocation of resources or the creation of unsustainable bubbles that only enrich the owners of assets.

This is exactly the tonic that the populists have been waiting for. Despite their dramatic emergence, they have so far failed to make a real breakthrough. The SNP was unable to win the Scottish referendum and the National Front didn’t gain a single region in France. Mariano Rajoy remains Spain’s prime minister, and anti-establishment parties have been thwarted in Germany. Even lighter forms of populism, such as Ed Miliband’s, were rejected. Syriza’s victory in Greece was one of the few genuine populist triumphs; but it was soon crushed by the combined might of Brussels and Frankfurt.






The Republican presidential nominee often proclaims that his presidency will make America a "great" country again

This could be about to change. The fact that Donald Trump and Bernie Sanders both won their respective New Hampshire primaries is certainly one remarkable indication of the state of mind of many US political activists. Any economic relapse would help Marine Le Pen’s chances in next year’s French presidential election, and further undermine Angela Merkel’s sinking popularity in Germany.

But it is in Britain that the immediate impact could be the greatest. The Brexit debate is already being overshadowed by the migration crisis, undermining the Government’s attempts at portraying a Remain vote as a safe, low-risk option; a sustained bout of economic volatility would further ruin the pro-EU case, especially given that the eurozone, rather than the City, is likely to emerge as one of the epicentres of any fresh crisis. It would be hard for bosses of large financial giants to credibly tell the electorate to vote Remain when their own businesses are in crisis.

Britain will noticeably outperform the EU this year: our labour market remains strong and our banks far better capitalised than many of their eurozone competitors, too many of which are still sitting on massive amounts of bad debt. The Chinese slowdown is worse for Germany than for us. But while the Eurosceptic cause to which some of us are partial is likely to benefit from the turmoil, it would be madness for anybody who cares about this country’s future to feel anything but dread towards the economic threats facing the world. The sorry truth is that there is very little that governments can do at this stage, apart from battening down the hatches and hoping that central banks succeed in kicking our problems even further down the road.

'We knew we were going to be hit by a tsunami’: John McDonnell Interview

Source The Guardian

John McDonnell arrives with his shirt open at the neck. As the photographer sets up, he says: “I must put a tie on. I want to look respectable.” He rummages in his rucksack and draws out a tie of a very conservative deep blue. As he puts it on, the man who once declared his mission to be “generally fermenting the overthrow of capitalism” jokes: “I’m trying to look more like a central banker.”

This fellow veteran of the Bennite left is Jeremy Corbyn’s closest ally in a shadow cabinet that contains very few true friends of the new Labour leader.

The cartoonish version of his shadow chancellor is a belligerent, divisive, leftwing firebrand. He certainly has a history of incendiary rhetoric and he is unquestionably leftwing. He is not humourless and, if he can be abrasive, today he is doing his best to turn his most emollient face to the world.

He acknowledges that many senior Labour MPs were appalled by his appointment and influential trade union figures urged the Labour leader to make a less contentious choice. The rightwing press have raged against him even more than they have about the election of Corbyn himself. “It was a difficult decision for both him and me” and “we knew we were going to get a tsunami hit us.”

He is a man many love to hate. Why is that? He puts it partly down to “swimming against the tide” for all those decades when his brand of leftwing politics was despised and ignored by successive leaders of the Labour party. He reveals that his wife and family had their doubts about whether he should take it on: he had a mild heart attack two years ago. “I had warnings from them: ‘Come on, look, are you sure?’ But it had to be done.”

After many conversations with Corbyn, they concluded that they had to “ride the controversy” because it was essential that leader and shadow chancellor were as one on economic policy. “We didn’t want to go through a Blair–Brown era again where leader and chancellor are falling out all the time or what went on with Ed [Miliband] and Ed Balls. I think Jeremy’s point of view is ‘I’ve got to have someone who I one hundred percent trust.’ ”

The composition of the rest of the shadow cabinet, he argues, shows that they are not being militantly factional and are genuinely interested in having “a really broad-based team” representing all strands of Labour opinion. “As big a tent as we possibly can.” They started making overtures to people before it was announced that Corbyn had won and he is still appealing to some who quit the shadow cabinet for internal exile on the backbenches. He hopes that they will think again and cooperate on the development of policy. “I’m still having that conversation now with people to see if we can get them back into some role. I think we might be able to.”

Like who? “I would like Chuka [Umunna] to come back, desperately.” He mentions some more of those who have refused to serve. “Shabana Mahmood is a brilliant talent for the future. People like that I’d really like to get back. If we could get them back on board it will send a message that we really are a big tent.”

His friend’s debut week as leader has not been a smooth ride. Even sympathisers have been tearing out their hair over an often shambolic first seven days of unforced errors and forced U-turns which gifted a lot of ammunition to their many enemies in both the press and the Labour parliamentary party. McDonnell acknowledges that it has been “a bit rough” and puts the mistakes down to naivety. Whatever mutinous colleagues say to the contrary, he claims to be completely confident that his friend will lead Labour into the 2020 election.

His own appearance on Question Time involved two apologies. Once for saying that he wished he could have assassinated Margaret Thatcher – “an appalling joke”. And again for a notorious speech in which he commended the bravery and sacrifice of the IRA for using their bombs and bullets to bring “Britain to the negotiating table”. Some of the audience applauded his expression of regret. Others have found his explanation for the IRA speech – that he was praising them to try to sustain the peace process – utterly unconvincing. “I set up the all-party group on conflict prevention and conflict resolution. I chaired it,” he says, but acknowledges: “There’ll be some I’ll never convince.” Part of his problem with presenting himself as one of nature’s peacemakers is that he has a lot of form when it comes to suggesting political opponents should meet violent ends, talking about “lynching the bastard” in reference to the Tory Esther McVey and having “a recurring dream about garrotting Danny Alexander”.

He smiles: “I know.”

Where is that coming from? Liverpool, is his answer. “I’m from the north. You can take the boy out of the north but you can’t take the north out of the boy. I’m a plain speaker.”

Does the mellow version of McDonnell extend to having anything pleasant to say about the man he now shadows, George Osborne? “I’ve tried to get to a situation where you mature, where you don’t personalise your politics. But I go back to my constituency and you should come to my surgery some time, you’d sit down and weep. I have people begging me for a house. I’ve got families living in beds in sheds. Shanty places. So I think Osborne is cut off from the real world. I’m going to challenge him to come down to see them. What angers me is that they don’t have any understanding of the consequences of what they’re doing.”

This promises lively fireworks ahead when he clashes with a Tory chancellor he calls “immoral”. But to opponents within his own party, the message is relentless conciliation. A manifesto he wrote three years ago called for a tax raid on the wealthiest 10%, banning companies from paying their chief executives any more than 20 times the lowest wage, and a new top rate of tax set at 60%. But he says he is not going to dogmatically impose his ideas. What he will instead announce is policy commissions to investigate various areas and he hopes for participation from a wide range of opinion not just confined to the Labour party.

He wants to change the Bank of England’s target so that it considers not just inflation when setting interest rates, but also the effect on jobs, investment and inequality. One of his biggest and most hotly contested ideas is forcing the bank to print money to fund infrastructure projects: so-called “people’s quantitative easing”. The governor of the bank, Mark Carney, has suggested that this would so compromise its independence that he could not remain as its governor. Rather than upbraid Carney for straying into political partisanship, McDonnell mildly responds that he is “going to try to meet him as soon as possible”.

For the first time in many decades, Labour has a shadow chancellor committed to the nationalisation of some strategic industries. Polls suggest that taking the railways back into state control is popular with a majority. He is likely also to strike a chord when he describes the recent sales of shares in chunks of the Royal Mail and Royal Bank of Scotland as “complete rip-offs” that have left the taxpayer seriously short-changed.

What is perhaps most interesting in terms of his personal ideological development and the way in which debate has shifted over the decades is that he no longer advocates, as the left did back in the 1980s, a return to nationalisation across the board. BT was once a state company. Would he seek to bring it back into public ownership again? “Too late,” he says. “Love to but too late.”

Lack of voter faith in Labour’s economic competence lay at the heart of the party’s defeat back in May as it also did when they were thrown out of office in 2010. If the public did not trust Gordon Brown and Alistair Darling with the economy, nor Ed Miliband and Ed Balls, why are they going to trust Jeremy Corbyn and John McDonnell?

“They’re not going to have to trust me or Jeremy Corbyn or whatever. They’re going to have to trust the Labour party.”

He says he wants the membership, which grew during the leadership contest and has drawn in more Corbyn enthusiasts since the result, to get involved in policy making. This also hints at how he and Corbyn think they can mobilise support in the party as a counterweight to the hostility of the great majority of Labour MPs.

“We’ll go on the stump immediately after the party conference, get as many members out there as possible, in the same way that Jeremy went on the stump before. But the difference now will be not urging people to vote for us, it’ll be about urging people to get involved in the discussion. I think Labour MPs will be shocked at the way in which they will be engaged in a democratic process of determining our policies.”

His admirers say McDonnell is a serious thinker about a radically different way of approaching the economy. Asked which writers have most influenced him, he rattles off several names of contemporary, leftwing economists, but at the top of his list he places Karl Marx. ‘You can’t understand the capitalist system without reading Das Kapital. Full stop.’

He says this with a knowing twinkle. That is not an answer you would have got from any previous Labour shadow chancellor in living memory. Nor from any central banker.