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.

Currency wars are nothing new – but who will be the casualty of the next?

Satyajit Das in The Independent

Wars frequently take place over years, with shifts in theatres, strategy, and tactics.

The current currency wars began in 2009. Badly affected by the sub-prime crisis, the US cut interest rates dramatically and subsequently launched 3 waves of QE. Between March 2009 and August 2011, the US dollar fell by around 16 per cent on a trade weighted basis against major currencies. With its banks exposed to the 2008 financial crisis, the UK adopted similar policies resulting in a sharp fall in the Pound Sterling.

There were counter-attacks commencing late 2011/early 2012. The European debt crisis forced the European Central Bank (“ECB”) to cut rates and then launch its own version of QE. Between 2011 and 2012, the Euro fell by over 25 per cent against the US dollar. As part of Prime Minister Shinzo Abe’s economic program, the Bank of Japan (“BoJ”) expanded its QE programs, weakening the Yen, which fell by over 30 per cent between 2012 and 2015.

There were side skirmishes. After 2014, falling oil prices and diplomatic conflict with the West over the Ukraine and resulting sanctions caused a sharp fall in the Rouble. Since 2011, the Indian Rupee has lost half its value. Falling commodity prices weakened the Canadian, Australian and New Zealand dollars, Brazilian Real and South African Rand.

The battles themselves have been inconclusive. The US recovery was assisted by the weaker dollar which increased exports. But investment in the shale oil boom, growth in emerging markets, budget deficits and also prompt action to deal with banking problems were crucial. In Europe and Japan, fiscal stimulus, demand from emerging markets and a lower commodity, especially oil, prices were arguably as important as the fall in the Euro and Yen in stabilising economic activity.

The complex impact of devaluations can be seen from the case of the UK. The sharp drop in the pound after 2007 was expected to increase exports. In the early 1990s, it stimulated activity pulling the country out recession. The lower pound, this time, improved the balance of trade but not sufficiently to offset declining domestic demand and the higher cost of imports. The muted effect was driven by the lack of external demand from major trading markets such as the US and Europe, the changed structure of UK industry with its focus on services rather than raw materials, advanced machinery, automobiles and luxury goods demanded by emerging markets, and the decline in North Sea oil and gas production.

The divergence in economic cycles between various major economies caused a change in fortunes. Between August 2011 and July 2014, the US dollar rose by 11 per cent on a trade weighted basis. By January 2016, it had risen a further 25 per cent because of a strengthening US economy, anticipation of higher interest rates and the deliberate weakening of the Euro and Yen.

The rise slowed the US economy. It created pressure on emerging market borrowers with substantial US dollar debt not covered by cash flows or assets in the currency. The stronger dollar placed pressure on already weak commodity prices and resulted in a revaluation of the Yuan which is linked to the American currency.

At the March 2016 G20 Shanghai Summit, the leading economies recognised the stresses. There are suggestions that there was agreement to lower the value of the dollar. Between January and July 2016, the US dollar declined by around 5 per cent. But the accord, if there was one, unravelled quickly. At the G7 Finance Minister’s Meeting in May 2016, Japan clashed with the US on the issue of currency valuation. The dollar’s fall reversed, exposing problems for the US and global economy.

The war is entering a more dangerous phase. Gold, which now functions as a de facto currency, has risen in value anticipating the currency crisis which appears increasingly unavoidable.

Japan and Europe are likely to further ease monetary policy weakening their currencies to address the lack of growth and low inflation. For Europe, the immediate effect of the Brexit decision and the depreciation of the pound is an additional consideration. China needs to devalue to help manage a slowing economy, property bubble, industrial overcapacity, fragile banking system and export-dependent, debt-based economic model.

Policy makers risk losing control. A falling Yen or Euro could force China to retaliate by devaluing the Yuan significantly. Other countries, especially in Asia where currencies are directly or indirectly pegged to the dollar, are likely to be forced to take measures to counter the effects of the stronger US dollar and a loss of competitiveness against the Euro, Yen or Yuan.

The currency wars will spill over into interest rate markets. Central banks globally will be forced into accommodative monetary policies to avoid large capital inflows seeking higher returns pushing up the currency. Sharp falls in interest rates anticipates this trajectory.

Low rates will increase risk in already over-valued asset markets. They will be reinforced by deflationary pressures as countries, such as China, with excess production capacity undercut competitors. Political responses, such as a declaration by the US of Europe, Japan and China as currency manipulators or reporting countries to the WTO for violation of dumping rules, will add a geo-political dimension.

In foreign exchange wars as in military versions, there are no winners. A weaker dollar means that the rest of the world loses. Japan and the Euro zone benefit from a stronger dollar but the US loses. At the same time if the Euro and Yen weaken, then as the dollar rises China loses because the Yuan appreciates. If a country lowers rates to weaken their currency to improve export competitiveness, there is a risk of capital flight, which may weaken the domestic economy. If a country takes no action and their currency appreciates due to aggressive measures from competing nations, then exports suffer as competitors gain market share. It will end, as it does always, in stalemate with major casualties on all sides.

Why the rupee can keep falling

S A Aiyer in Times of India

People ask me, will the exchange rate go to Rs 70 to the dollar? I reply, why not Rs 80?

Indian analysts are in denial. They don’t dare face up to the full consequences of the global financial hurricane originating in the US. This will keep blowing for 12-18 months.

To revive the US economy, the Federal Reserve has been pumping out $85 billion of cash per month (called quantitative easing). With the US economy recovering, the Fed plans to reduce this cash bonanza in stages to zero. Emerging markets like India have long enjoyed a slice of this $85 b/month. Not only will fresh flows stop, older flows will reverse to the US, a net turnaround of hundreds of billions.

This storm has knocked the rupee down almost 25% in two months. It is the first of many storms that will hit not just India but the whole developing world, with every tightening of the money tap by the Fed.

Expect a second Asian Financial Crisis. This will cause much less damage than the earlier one in 1997-99. Then, Asian countries had low forex reserves, excessively high debt, and semi-fixed exchange rates. Learning from 1997, Asian countries (including India) now have large forex reserves, less debt, and floating exchange rates. This makes them far more resilient, so they will not collapse as in 1997. But they will suffer substantial damage. Countries with large current account deficits like India will suffer the most. But even Malaysia, which runs a surplus, has seen its currency crash 10%.

A crashing currency raises the prices of all items that can be imported or exported. This erodes people’s purchasing power — by maybe 2.5 to 3% of GDP in India’s case. That is hugely recessionary, as is already evident in the latest data showing falling production of services as well as manufactures.

Such a recession can, in theory, be combated by monetary and fiscal stimuli, as in 2008. But today money must be kept tight to check inflation, so no monetary stimulus is possible. Finance Minister P Chidambaram has sworn to limit the fiscal deficit to 4.8% of GDP, so no fiscal stimulus is possible either. With GDP growth and revenues falling far below budgeted numbers, and oil and fertiliser subsidies rising, he will have to slash Plan investment to meet his fiscal target.

The breach will not be filled by private investment — few businessmen will invest when domestic demand is collapsing. So, the economy will spiral downwards.

One theoretical solution is use a depreciated currency to stimulate export-led growth. If exports grow 20% per year for two years, that will help weather the storm. However, as we found in 1997, when all developing countries are hit, all cannot suddenly increase exports at the same time: the West lacks enough absorption capacity. Besides, India’s investment climate is terrible — files just don’t move, with or without bribes. Many Indian companies would rather invest abroad. Politicians are more focused on distributing goodies before the election than on slashing red tape.

Finance ministry analysts say the equilibrium exchange rate is Rs 58-60 per dollar. They say irrational panic has caused overshooting, and economic fundamentals will soon force the dollar’s value back to Rs 60.

Warning: similar things were said when Asian currencies began to slide in 1997. Far from recovering, they crashed further. The Indonesian rupiah went from 2,500 per dollar all the way to 18,000.

Why so? Because when a currency crashes, that itself changes the economy’s fundamentals. Domestic purchasing power falls, causing a recession. Prices shoot up, negating the positive effects on exports. Corporations that have borrowed abroad heavily go bust. Banks that have lent to such borrowers (and others hit by recession) cannot recover their loans. International rating agencies downgrade such economies, inducing further capital flight.

India’s fundamentals have already changed. GDP growth in the first quarter is down to 4.4%. It could fall to 3.5-4% over the full fiscal year. A slowing economy will help reduce the current account deficit, but hit the fiscal deficit. Wholesale prices had been falling but are accelerating again, dampening purchasing power. All industries face slowing revenues and rising costs, eroding profits. Tax revenue may grow by hardly half the budgeted estimate of 19%.

Disinvestment can happen only at throwaway prices. Chidambaram is a determined disciplinarian, but may be powerless to stop global hurricanes. The threat of a credit downgrade has become very real.

Right now, there is a lull in the financial storm, and the rupee has regained some ground. But this storm will blow, off and on, for 12-18 months. Gird your loins.

Schumpeter's long revenge

By Chan Akya in Asia Times Online

News about major retail chains such as HMV and Blockbuster closing shop inevitably attract greater than usual attention because they sell media content and therefore operate on the edge of the world of entertainment. That said, the demise was fairly obvious to anyone who had read their balance sheets, which have been decimated by technological changes led essentially by Apple but more generically by the broader applications of the Internet and improved hardware. 

Selling and renting films respectively, HMV and Blockbuster were a key part of all retail malls and "high" streets in the UK with similar brands in other countries including in Hong Kong and Singapore. The advent of amazon.com was the first shot across their bows; one that both chains failed to heed. As the business of selling books through bookstores evaporated in the late '90s, the retail chains selling and renting movies and music failed to make the connection between the physical world and the augmented reality shopping of the Internet. 

The process was to accelerate with improved software - Apple's iTunes comes to mind - even as hardware continued to provide an underwhelming experience. The inability to bridge the quality gaps in films and music (or else apply them to an environment where more people were using crummy mobile devices for enjoying the same) simply meant that all competition ended up being about price. This was the wrong battleground and, much like Napoleon's forces marooned in the harsh Russian winter 200 years ago, the retail chains were destroyed. 

Oddly enough, HMV also played a small part in the global financial crisis; one of the largest lawsuits from that era pertained to Guy Hands' private equity firm Terra Firm filing suit for misrepresentations against its banker, Citibank, over its purchase of EMI from which HMV had been spun off to a separate listing in 1998. 

Although the suit was pretty quickly dismissed, opportunities for mirth abounded from the materials provided as part of the proceedings. Such large leveraged buyouts generated billions in loans that were purchased by collateralized loan obligation vehicles, which in turn were partly funded by the shadow banking system that helped to fell the global economy in 2007-08. 

In any event, the various reorganization plans filed by HMV management provided fodder for private equity firms on its own; in parallel, Blockbuster went through its own interaction with the forces of competition. While the global business of Blockbuster went into administration in 2010, the company continued to operate in many parts of the world. Last week's closure of the UK business is a continuation of the global process. 

The circle of stupidity

On the other end of the scale from market forces is the circle of stupidity that underpins global monetary policy today. 

An industrial version of the HMV/ Blockbuster process of creative destruction is Japan, an article about which I wrote late last year, touching upon the effects of competitive landscape changes ushered in by the pincer grip of South Korea and China at the branded and generic ends of manufacturing respectively; even as sclerotic politics and inane monetary policies end up accelerating the decline. (See The end of Japan as we know it, Asia Times Online, November 27, 2012). 

Following the elections, Japan's monetary policy impetus has moved into aggressive easing as the government and the Bank of Japan attempt to push the yen sharply lower by easing quantitative policy and accelerating the purchase of bonds issued by the US and European governments (the Italians and the Spanish sent a couple of "thank you" notes to the new government, presumably). 

Meanwhile, other Asian countries - primarily Korea and China - are increasing their own purchase of Japanese government bonds to offset the effect of a falling yen on their own currencies. And all along, Federal Reserve chairman Ben Bernanke and European Central Bank president Mario Draghi are cheerfully printing money by the trillions to support yawning fiscal deficits and to keep their currencies from rising. 

Think of the average pensioner anywhere in the Group of Eight leading industrialized nations and the picture is downright depressing. With regular income from bonds and bank accounts whittled down to barely nothing, they are being forced to take on financial risks by purchasing "high dividend" stocks or worse, corporate bonds. These are not folks who are equipped to analyze such risks, let alone manage them. 

Businesses go bust when they run out of liquidity, not when they run out of "capital" or any such esoteric concept. Granted that HMV and Blockbuster were so bad that not even all the money sloshing around the global financial system could save them, but that also raises the question of how many companies and governments survive today because of the excess money sloshing around. 

At the very least, we know that interest rates and risk premia are severely depressed in G-8 countries and, as a result, across much of the financial world. There are countries that would be considered borderline default where government bond spreads are trading well under 5%, an anomaly that makes no sense irrespective of the "base" funding rate. Similarly, equity markets are getting record inflows at a time when valuations aren't exactly cheap anywhere in the world. 

Such conditions are usually spelt b-u-b-b-l-e; and I entirely hold Bernanke, Draghi and their kin responsible for this state of affairs. There will be time of reckoning later, but for now we will have to live with all the Keynesian rationalization. 

Why is Schumpeter important

One of the key defenses used by those seeking to broaden the ambit of monetary policy whilst emptying government coffers is that corporate closures are bad form and cause disruptions for employees and other stakeholders alike. This is indeed true over the short term, but over the longer term the truth is perhaps in the opposite direction and in line with the views of Austrian economist Joseph Schumpeter on "creative destruction". 

Systems that weed out inefficient capital users end up deploying funds to more deserving users thereby reducing the overall risk of the system and increasing the gap between risky and less risky ventures; this extra compensation therefore ends up attracting more robust capital - and perhaps more appropriate capital for risky ventures. 

In contrast to this, folk who lend money to French companies - typically only other French folk - see their risk analysis dulled by constant government intervention and corporate subsidies (internally) to their worst divisions. When the car firm Peugeot decided to shutter some plants and fire workers recently, the howls of protest were loudest from the country's socialist government, which may however not have quite realized that by denying the company such internal efficiencies they inevitably put the firm at a longer-term disadvantage that increases the chances of a comprehensive collapse at a later date. 

Investors in such countries will also be confused as to the correct risk premium for a loss-making company compared to that for a profitable company; because debt is about getting one's funds back, the question becomes academic if loss-makers are routinely bailed out. This dulls the calculation of risk, inevitably driving inappropriate funds - pension funds and the like - towards risky assets. 

That is the reason why the HMV and Blockbuster stories are important. By providing a timely reminder that bad businesses will not survive even the easiest of monetary conditions, they have served to remind all of us of events likely to unfold when the price of money starts adjusting towards more appropriate levels.

No one really understands what’s going on in our economy

Does anyone properly understand what’s happening in the UK economy anymore? (Editor's comment: If you don't understand then why are you still in your job?)

Can it really be true that an economy which has created more than a million private sector jobs over the past two and a half years is showing no growth at all?  Photo: Reuters

By Jeremy Warner in The Telegraph

7:44PM GMT 11 Feb 2013

I’m sure I don’t, though I spend longer than most attempting to read the tea leaves, and I’m ever more convinced the policy makers don’t either.

There are two related problems here. One is with the data, which are ever more contradictory. Some of them point to a flatlining, or even still declining, economy, with badly impaired levels of productivity, but there are also quite a lot of alternative data to suggest something better – most notably in near record levels of private sector job creation. The other problem is with what fiscal and monetary policy are trying to achieve, which seems to grow more confused by the day.

Both intellectually and practically, monetary policy has become something of a mess. Before the crisis, the Bank of England was guided by a simple and absolute inflation target, which it was relatively successful at meeting and was easy to understand. But since the credit crunch, it has taken on another purpose – that of bringing about a return to sustainable growth. This has brought the Bank into conflict with its primary objective. Since the crisis began, inflation has consistently been well above target, but for a brief dip in 2009, and it has twice been above 5pc.

This week’s quarterly inflation report will bring further discomfort, with the Bank forced to concede both that growth is failing to respond as hoped and that inflation is now likely to remain elevated for the next two years.

Unfortunately, there appears to have been no trade-off between inflation and growth. Inflation has stayed high but growth has been non-existent. The Bank excuses its evident failure on inflation by stressing the apparently higher purpose of preventing a collapse in output, and with justification, it further insists that domestically generated wage inflation has remained tame. This is all very well but, with wages lagging prices by some distance, disposable incomes have been quite severely squeezed and this is plainly bad for domestic demand and growth.

With the Bank’s admission that inflation may remain above target for the next two years, the squeeze on disposable incomes is likely to persist. So, in this regard, the Bank’s policy of tolerating elevated inflation in pursuit of higher growth has been quite harmful to both objectives.

Sticking to the inflation remit has become something of a charade but, ridiculously, the Bank still pretends that this is what it is trying to do. It is to be hoped that the new Governor, Mark Carney, can bring more clarity and openness to the Bank’s endeavours. Don’t expect miracles.

Fiscal policy has been equally badly wrong-footed. Lack of growth has derailed the Government’s deficit reduction plan, threatening certain fiscal crisis down the line in the absence of evasive action.
What’s more, the unwritten compact between Government and Bank of England, under which the Bank is supposed to compensate for tight fiscal policy with monetary activism, seems to be breaking down. At last week’s meeting, the Monetary Policy Committee decided to do nothing even though it judges risks still to be on the downside. To the chagrin of George Osborne, the Chancellor, Sir Mervyn seems to be saying there is little more that monetary policy can throw at the problem.
Mind you, the data as they stand would be enough to paralyse even the most sure-footed of policymakers into inaction. Can it really be true that an economy which has created more than a million private sector jobs over the past two and a half years is showing no growth at all?

Equally hard to understand is why the UK’s export performance continues to look so lamentable. The eurozone crisis provides only part of the explanation, since even Spain and Greece have done better on exports than Britain, and that’s without the “benefit” of a sharp devaluation in the currency.
Britain’s exceptionally large services sector, and its fast-growing digital economy, may provide partial answers to all these puzzles. Once you strip out disruptions to, and structural decline in, North Sea oil revenues, then there has been some underlying GDP growth.

Moreover, if you think of much of the growth that took place in the pre-crisis bubble years as essentially just the “candyfloss” of an out of control financial and property sector, then today’s stagnation looks much easier to understand. Service industries in general, and financial services in particular, are notoriously difficult to measure, both in terms of their output and contribution to exports.

Part of Britain’s problem with the European Union is that there is still no properly functioning internal market across key service sectors. The EU exploits the UK’s weaknesses in traded goods while denying it the opportunity to play to its strengths in services. Until these deficiencies are rectified, the EU will struggle to be a net positive to the UK economy.

But that’s by the by. Looking at business investment, it was on a declining trend from long before the crisis and, to the extent that it was happening at all, there was a disproportionate emphasis on commercial property, great swathes of which now lie empty. Bulldozing this unwanted surplus would perhaps be the best solution, or at least converting it into housing.

So there’s another big chunk of past growth that has turned out to be of little or no long-term value. Strip these things out and it is by no means clear that the rest of the economy is suffering the crippling decline in productivity widely assumed. To the contrary, much of the anecdotal evidence points to significant advances, especially in the digital economy, which is growing faster in Britain than almost anywhere else.

According to a report by the Boston Consulting Group, the UK is now home to the largest per capita ecommerce market and the second largest online advertising market anywhere in the world.

Much of the growth in these markets, the productivity gains they drive, and the intangible benefits they deliver, are not caught by official GDP figures, which only attempt to measure the market value of the economy. In a paper just published, Jonathan Haskel of Imperial College Business School and others find that measured real value added has been understated by 1.1pc since the end of 2010 because of failure to capture intangible investment. Take this into account and there has in fact been no fall in productivity since then.

These musings lead to three conclusions. First and foremost, the Chancellor needs to act swiftly to recalibrate fiscal consolidation so as to give growth a supply-side, tax-cutting shot in the arm. Second, he should answer calls from both Sir Mervyn King and Mark Carney for a review of the Bank’s monetary remit. Finally, something has to be done about the GDP data, which beyond their capacity for political knock-about, have become about as useful as a chocolate teapot. (Editor's comments - The analysis is fine but the problem is with the conclusions - This maybe a ruse to cut taxes for the rich! Secondly the author now admits the problems with using GDP data as an apt indicator of economic performance - wheras all this while the UK and the USA have been telling the whole world that GDP performance is the best measure of economic performance. Alas! - the naysayers were saying it all along!)

The US and UK remain wedded to Quantitative Easing to stifle a debate on fiscal policy

Has quantitative easing had its day?

QE's failure to power recovery is clear, but the US and UK remain wedded to the policy to stifle debate about fiscal policy

• 
• Radhika Desai
• guardian.co.uk, Friday 11 January 2013 16.00 GMT

Mark Carney, governor-elect of the Bank of England, wants to retain QE as the chief policy instrument for engineering recovery. Photograph: Mark Blinch/Reuters

 

Last autumn the chairman of the US Federal Reserve, Ben Bernanke, ended months of speculation about whether there would be another round of quantitative easing – the policy of buying up securities from banks so that more money is injected into the financial system. The idea has been that this will get them lending more and powering a recovery. Since the first two rounds had patently failed to generate recovery, he now announced a QE3 with a difference: not only did he announce QE3, its sheer scale and boundlessness made it a veritable QE infinity. The Fed would continue buying up mortgage-backed securities to the tune of $40bn a month until the labour market improved and would keep interest rates to their current near-zero levels until unemployment fell below 6.5%.

Having targeted inflation to please the holders of capital for almost two decades, even when the resulting high interest rates stifled investment and kept unemployment high, the Fed's concern about employment was certainly novel. To be sure, it is mandated to keep both inflation and unemployment low, but until now it had succeeded in finessing this mandate and concentrating more or less exclusively on keeping the former alone in check.

Meanwhile, the UK's new central banker in waiting, Mark Carney, proposed his own innovation in monetary policy: the Bank of England's two-decade-old policy of targeting inflation should be dropped in favour of targeting nominal GDP growth. This would keep up liquidity injections into the financial system until targeted nominal growth materialised. He did not say what he would do if the nominal growth target yielded more inflation than growth. Discussion centred on whether the Bank of England's mandate would be revised. Both David Cameron and Vince Cable appeared open to the concept.

Bernanke and Carey's new and improved monetary policies are designed to retain QE as the chief policy instrument for engineering recovery despite its failure so far. Given that its most vocal opponents are the economic neanderthals of the US Tea Party right, it is usually assumed that QE is progressive, if not, so far at least, very effective.

In reality, QE has served, first and foremost, to socialise the losses of the financial systems of the two countries at the centre of the financial crisis, the US and the UK. In contrast to the publicly fought over Troubled Asset Relief Program (TARP), QE contributed far more to achieving that objective and did so without the fuss and melodrama of Treasury secretaries going on bended knee before House speakers to beg its passage.

Some find consolation in the thought that at the very least QE prevented the economies of these two countries from falling into outright depression. In reality, two other things accomplished this. First, unlike in the 1930s, the "automatic stabilisers" – government spending and transfers – formed a floor beneath which the economy could not fall. Second, there were mild fiscal stimuli. But their end now threatens to send economic activity south again in both economies.

Indeed, insofar as QE was part of a wider set of policy choices that focused on relieving financial institutions of their irresponsibly extended loans but not the households and firms, QE ensured that a highly leveraged private sector would be unable to borrow, whether to invest or consume. It would also ensure that the resulting demand conditions would deter even the comparatively unleveraged from borrowing to invest.

So we shouldn't assume that QE will power a recovery. It probably won't. As Keynes pointed out, under certain conditions (such as those today: rock-bottom interest rates, poor demand outlook, heavily leveraged firms and households) credit easing would amount to little more than "pushing on a string". So why are Bernanke and Carney seeking to tie recovery even tighter to monetary policy with their innovations in QE precisely when its failure to power recovery is clearer than ever?

It's because without some action on their part, public discussion is bound to turn towards the alternative: a vigorously expansionary fiscal policy, with massively increased state investment in the economy. This option lies just below the surface of public discourse: the neoliberal triumph of recent decades was never able to entirely eradicate it from public discourse and memory. But as long as the public can be kept believing that monetary policy will achieve some semblance of growth, later if not sooner, that the economy's managers are busy refining monetary policy tools to accomplish that, fiscal policy can be that much more effectively kept out of the picture.

In effect the public in both these countries is being told that they cannot get recovery unless the banks give it to them. And keeping recovery hostage to the financial system is tied up with something very fundamental. Announcing the failure of monetary policy is to displace that holy of holies – the private sector – from its current centrality in our understanding of the economy and admitting that government action and expenditure, probably on a large and unprecedented scale, is necessary for recovery.

Britain can’t afford to fall for the charms of the false economics Messiah Paul Krugman Superstar economist Paul Krugman wants us to change course, but his solutions are simplistic.

Jeremy Warner in the Telegraph

What does the future hold as Europe slides, ever more hopelessly, towards the abyss? As David Cameron has pointed out, there have been 18 EU summits since he became Prime Minister little more than two years ago, and none of them has produced anything remotely resembling a solution.

The stand-off got a whole lot worse this week. France and Germany are now in open conflict over the way forward, if indeed there is one. For the UK, already bleeding badly from the after-effects of the financial crisis, the situation could scarcely look more threatening.

The fiscal consolidation chosen by the Coalition was always likely to have a negative impact on output, at least in the short term. To make it work, the Government needed the following wind of decent growth elsewhere in the world economy. Instead, it’s facing a hurricane. We look set to be broken by the storm.

But fear not – salvation is at hand. Next week, there comes to these shores a Messiah, a prophet of great wisdom and understanding whose teachings promise to vanquish despair and “end this depression”. He is Prof Paul Krugman, a superstar polemicist who has been described by The Economist as “the most celebrated economist of his generation”. Actually, “celebrated” is not exactly the right word, for Krugman divides opinion like no other. To his followers, he’s a saint; to his detractors, he’s a false prophet with satanic intent.

I’ve been a little misleading here. He’s not really coming to Britain to save us, but rather to promote his latest book, End This Depression Now! Krugman is an economist with attitude, and he thinks Britain is in the midst of a “massive blunder” in economic policy. The UK is the very worst example of austerity economics, he believes, for unlike the poor beleaguered nations of the eurozone periphery, we’ve not had this misery forced on us by the ghastly euro, but have opted for it as an unnecessary penance for the sins of the boom. If only we could be persuaded to forsake “Osbornomics” and tread the path originally set out by our dearly beloved former leader, Gordon Brown – that of spending our way back to growth – then all would be well again.

Put like that, of course, it sounds ridiculous, but the fact that Krugman is a Nobel prize-winning economist gives Labour’s calls for a U-turn on the economy an intellectual credibility they would otherwise struggle to attain.

All the great economists – from Adam Smith to John Maynard Keynes – were as much moral philosophers as dispassionate analysts of events, and Krugman is no exception, preaching his message with all the passion of the religious zealot. He feels our pain and begs us to let him help. “The road out of depression and back to full employment is still wide open,” he insists. “We don’t have to suffer like this.”

Krugman may appear loud and radical, but he follows a fairly standard Keynesian text. By his own admission, the social cost of the present downturn doesn’t come anywhere close to the Great Depression of the interwar years, or not yet. None the less, there are parallels, and we already meet Keynes’s classic definition of a depression as a “chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse”.

In such circumstances, monetary policy can help, but only up to a point. In a depression, even those with the balance sheet strength to spend and invest won’t do so, whatever the encouragement offered through ultra-low interest rates. It follows that governments should step into the breach and do the job instead, as a kind of spender of last resort. They can worry about the accumulated debt later, once output has picked up again.

To Krugman, it’s understandable that policymakers screwed up so monumentally in the Great Depression; they didn’t understand what was going on and there was no template for the circumstances they found themselves in. To his mind, there is no excuse this time around; it’s textbook stuff, which is being wilfully ignored.

But haven’t we already tried borrowing to stimulate? And what did it deliver other than fiscal ruin, which in the eurozone periphery is so serious that markets have stopped lending altogether? Krugman has an answer for these questions, too. It’s not the policy that was wrong, merely that the stimulus wasn’t big and sustained enough. As for the eurozone, again, it wasn’t the policy, but the euro. Countries with their own currencies and central banks won’t run into this kind of problem. In extremis, they can always print the money.

Easy peasy, then. What’s not to like? Well, I’m sorry, but I just don’t buy it. It may or may not be possible for a vast, largely internalised economy such as the US, with its reserve currency status, to run double-digit deficits into the indefinite future without adverse consequences, but for the UK it is a much more questionable policy.

True, Britain has lived with much higher debts relative to GDP in the past, but this has nearly always coincided with major wars. With demilitarisation, much of this borrowing to spend falls away and domestic consumption comes roaring back. No such get-out-of-jail-free card exists this time around. Further, the demographic is completely different from that of the post-war baby boom generation, where growth and therefore debt erosion were more or less guaranteed. Today, the unfunded liabilities of an ageing population stretch menacingly into the long-term future.

As it is, government spending in the UK is already approaching 50 per cent of GDP. Just how high does Prof Krugman propose it should go? It’s all very well to say “jobs first” and worry about the deficit later, but once government spending becomes entrenched, it’s very difficult to get rid of it. Even Reagan and Thatcher struggled to make significant inroads.

In any case, the picture Krugman presents of wrong-headed British austerity is a caricature of the reality, though one admittedly encouraged by the Coalition’s rhetoric. Yesterday’s revised GDP figures, showing that the country is even deeper in recession than we thought, would appear to support the mocking tone in which Krugman condemns the idea of “expansionary austerity”. But where is this austerity? In fact, one of the few positive contributors to output in the last quarter was government spending, which grew by 1.6 per cent. Krugman seems to have forgotten the automatic stabilisers, which because of our welfare state are considerably bigger than in the US. In America, much current UK spending would count as a discretionary fiscal stimulus of the sort End This Depression Now! advocates.

As Raghuram Rajan, a former IMF chief economist, has argued, today’s troubles are not simply the result of inadequate demand, but of major changes in the world economy brought about by globalisation. The old monopoly of knowledge and expertise once enjoyed by advanced economies has been swept away. For decades, we compensated for the jobs and income lost to technology and cheaper foreign competition with unaffordable government spending and easy credit. Much of the growth enjoyed in these pre-crisis years was simply unsustainable.

Paul Krugman’s message is seductive, but it’s also unrealistic. If only the solutions to our plight were as simple as he thinks.

The true costs of Keynes

By Martin Hutchinson

Adolf Hitler, Joseph Stalin and Mao Zedong each killed tens of millions of people, and John Maynard Keynes was a pacifist who never fired a shot in anger. However, economically, when the billions come to be totted up, it may well be the case that Keynes was the most destructive of the four.

He cannot entirely be blamed for mistakes in monetary policy, which he never understood, and even his "stimulus" ideas owed much to those who came before him - for example Arthur Pigou - and after him - for example Joan Robinson. Yet the other value destroyers had their henchmen too, in Heinrich Himmler, Lavrenti Beria and Jiang Qing. Overall, when henchmen are added in, Keynes runs the other value destroyers close, and may in the future surpass them as his value-destructions continue. Truly, persuasive but misguided economic theories can be much more damaging than they appear.

This is not to claim that big government per se is value-destructive (it is, but that's a separate issue.) The right size of government is a matter for legitimate debate, and successful societies such as Sweden and Singapore can be built with very different sizes of government. Personally, I would rather live in Singapore than Sweden, and I would expect Singapore to exhibit markedly faster long-term economic growth than Sweden, but both societies run their finances in a responsible manner and are models of governmental integrity.

Since both Sweden and Singapore currently have modest budget surpluses and have kept control of their currencies and avoided excessive monetary stimulus, they are in the modern debased sense of the term non-Keynesian, even if the managers of Sweden's economy might well describe themselves as Keynesians for the sake of harmony at international gatherings.

The Keynesian fallacy is in essence one of getting something for nothing. By Keynesian fiscal stimulus, normally involving spending more money though occasionally through tax cuts, providing they avoid the annoyingly savings-prone rich, we are supposed to produce additional economic output whenever there is an "output gap" from full employment, that is, in all conditions save those of a raging boom, when resources are scarce.

Keynes himself recommended such stimulus only at the bottom of deep recessions, and suggested that it should be balanced by running budget surpluses in times of boom. Needless to say, his disciples have neglected the disciplines he recommended.

Similarly, the analogous monetary policy (which Keynes personally did not advocate, since he believed that interest rates had no effect on output) pushes down interest rates and indulges in ever-more lavish bouts of monetary "stimulus" in the belief that by doing so the economy can be persuaded to expand more rapidly.

It's fair to claim that monetary stimulus does not derive directly from Keynes (though it is not new - it was a policy advocated by Keynesians in the 1960s Lyndon B Johnson administration, for example.) However fiscal stimulus is a direct product of Keynes' 1936 General Theory and both forms of stimulus derive from Keynes' overall approach of flouting economic orthodoxy and using ingenious paradox to propound unorthodox policies.

Keynes was the origin of the "stimulus" approach; its central idea that by manipulating monetary or fiscal policy we can get a bigger government than we pay for is his. It is thus fair to blame the costs of that approach on him.

Those costs are considerable. In the 1930s, US president Herbert Hoover's reckless expansion of government spending, including loans to cronies through the Reconstruction Finance Corporation, caused further slowdown in the economy, which was exacerbated by his dreadful early 1932 increase in the top marginal rate of tax from 25% to 63%.

Then, as I discussed a few weeks ago, Franklin Roosevelt's New Deal deficit spending, combined with his reckless "set the gold price in my pyjamas" monetary policy prolonged the Great Depression far longer than would naturally have occurred, delaying full recovery from 1934-35 to 1939-40.

In the recent unpleasantness, fiscal stimulus worldwide initially appeared merely ineffective. By diverting resources from the productive private sector to unproductive public sector boondoggles it reduced long-term output. In the US case, the Barack Obama stimulus converted a vigorous recovery into an anemic one; only in the third quarter of 2011, after the effects of stimulus had begun to wear off, did output begin to accelerate and unemployment trend down (in this case we should celebrate public sector job losses and declines in public sector output, since they free up resources for healthy private sector growth!).

However, with the euro crisis it has become clear that fiscal stimulus, if excessive, has an exponentially adverse effect. By increasing deficits to unsustainable levels, it precipitates bond market fears about the state's credit risk. Naturally, that strangles credit availability to almost all entities domiciled in the country concerned.

Thus while a mild fiscal stimulus in a country that before recession was running a surplus might be mildly beneficial (because the differential between private sector savings rates and the 100% stimulus spending rate outweighed the inefficiency effect of diverting resources to the public sector), a large fiscal stimulus, or one incurred in a country like Greece or the 2009 US that was already dangerously in deficit, will cause economic damage rising to many times the value of the stimulus itself, persisting for years or even decades to come.

Monetary stimulus is similarly damaging. As Walter Bagehot remarked over a century ago, the correct response to financial crisis is to lend on top quality security at very high interest rates. This was notably not done in 2008; instead the injection of liquidity to favored companies was accompanied by pushing interest rates far below inflation. Repeating the monetary stimulus in 2010 and again in 2011, when in the United States at least the financial crisis was over, was inexcusable.

Monetary stimulus causes structural damage to the economy in the following ways:

Normally, as was the case in 1965-79, it causes accelerating inflation. Since 1995, this has not been the case, because the West has benefited from an enormous deflationary force from the Internet and modern telecommunications, which has enabled massive outsourcing of goods and services to locations with much cheaper wage rates. That effect is now ending, while in some countries, notably Britain, the monetary stimulus has been increased to Weimar Republic-like proportions of 40% of public spending. We can expect the inflationary effect to strike with massively multiplied force compared with the gentle zephyr of 1965-79 when it finally arrives. As discussed in this column a few months back, by making capital artificially cheap, monetary stimulus encourages employers to substitute capital for labor to an artificial extent, thus raising the equilibrium level of unemployment. In current circumstances, this substitution takes the form of outsourcing production to emerging markets, thus depressing US and European labor markets further. By allowing banks to make artificial profits from "gapping" - borrowing short-term and investing in fixed rate long term bonds and mortgages - it suppresses lending to small business, thus further increasing unemployment. It must be noted that the true level of U.S. unemployment is far higher than the officially admitted 8.6%, as many workers have become discouraged and left the workforce. Ultra-low interest rates suppress savings (which receive negative real returns on their money), thereby de-capitalizing the economy. Finally if, as happened in 2008, monetary stimulus is directed only at favored banks and finance houses, it destroys the integrity of the market. Beneficiary banks have been shown by the recent Fed audit to have benefited to the tune of $13 billion by profits made on emergency Federal Reserve loans. Had that money been lent at appropriate penalty rates, this profit would have been captured for taxpayers. It was in essence a gigantic subsidy to Wall Street bonus recipients by the corrupt Federal Reserve. Needless to say, damaging cronyism has thereby been encouraged. As recent events have overwhelmingly demonstrated, both fiscal and monetary stimulus are highly addictive, since they appear to provide something for nothing and the cost of reversing them appears unpleasant to the Keynesians who control the levers of policy. As to their cost, the current Congressional Budget Office projections suggest that there is at present a 5% output gap below full employment, and that the output gap will disappear only in 2016. The cost of current Keynesian policies over 2009-16 can thus be conservatively estimated at about 15% of GDP, or $2.2 trillion in today's dollars. To that we can add very roughly 50% of one year's 1929 GDP, for the output lost through Keynesian policies in 1932-40, or another $500 billion, for a very conservative total of $2.7 trillion all-told in the United States alone. That may not sound sufficient to counterbalance the tyrants' depredations, but consider: 1930s Germany, 1940s Russia and 1950s China were all much poorer countries than the modern United States. Very roughly, Germany's 1936 GDP and the Soviet Union's 1940 GDP were both about $500 billion modern dollars, while China's 1955 GDP was about $1,500 billion. Thus Hitler and Stalin could have destroyed their entire output for more than five years, and Mao for almost two years, before doing as much economic damage as Maynard Keynes has wreaked in one country. It's a rough calculation, but illuminating - and while Hitler, Stalin and Mao are long gone, Keynes' depredations continue. Martin Hutchinson is the author of Great Conservatives (Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). Both are now available on Amazon.com, Great Conservatives only in a Kindle edition, Alchemists of Loss in both Kindle and print editions.