The solo becomes a duet

The world economy is a bit like my early love life – long periods or inactivity and boredom interspersed with rare flashes of excitement.  Growing up in rural England with no Facebook, mobile phone, nor any natural ability to chat up girls made things pretty dull!  The same is true of the world economy - one minute we are in a world of dull stagnation and deflation and the next we are in mortal danger, thanks to Greece.

The excitement of a good riot

Who is rigging the market now?

In the run up to the credit crunch the market manipulations perpetrated by the world’s largest investment banks are now well known to us.  The banks rigged many of the important markets required for the global economy – proprietary trading held sway, credit and other derivative products were miss-sold, reference interest rates (Libor and others) were fixed and so it goes on.  Fortunately for us governments around the globe and their central bankers have been on a mission to sort out these market abuses.  The Wolves of Wall Street have been tamed by the Gnomes from Zurich, the ECB and the Fed – all very reassuring.  That is until one looks closely at the market manipulation now being pushed through by Central Banks culminating in the completely unexpected decision of the Swiss National Bank (SNB) to remove the 1.20 floor on the Swiss franc against the Euro.

Anything the banks can do .....

As Gavyn Davies tells us this was “one of the biggest currency shocks since the collapse of the Bretton Woods system in 1971. The decision has been heavily criticised, both for its tactical handling of the foreign exchange market, and for the collapse of the centrepiece of its monetary strategy, without (apparently) any overriding cause. The credibility of a central bank that has traditionally been hugely respected by the markets has clearly been dented.”

Crude benefits of falling oil prices

The ending of QE in the US and the fall in the price of oil from over $115 a barrel to under $60 a barrel were the defining economic events of 2014, but their consequences will not be felt until next year.  The ending of QE in the autumn brought to an end the huge expansion of the US Federal Reserve’s balance sheet, since 2008 the Fed has pumped some $2.3tn of “new money” into the world economy which has had a wondrous effect on asset prices in all sorts of weird and wonderful places.  London property prices have boomed, stocks in emerging markets reached new heights and bond prices sky rocketed as yields collapsed – also commodity prices boomed and oil was not left out of the party.  Between 2009 and 2011 oil prices rose from $40 to $125 a barrel, driven by ever increasing demand from emerging markets and $1.9tn of US and UK QE.  Following the boom in commodity prices between 2011 and 2013 prices stabilised at a high level before falling off a cliff in 2014.

The Crude Story

Time up for QE

No one really understands it and because of this opinions are all the more divided and intransigent. Despite this incoherence the market has understood enough to know that it drives asset prices and confidence in future prices.  It is QE – quantitative easing.

Ben Bernanke - the Godfather of QE

QE is where Central Banks print themselves some money to buy bonds and other instruments from the banks, the idea is that this puts cash / liquidity into the economy increasing the money supply and making credit more freely available.  Under “normal” conditions of growth (+2-3% annually)and inflation (around 2% annually) equilibrium this would drive up aggregate demand (growth)  and inflation as the banks push this extra liquidity out into the market in the form of loans.

Emerging market emergency?

The mere thought of the US Federal Reserve tapering their asset purchase programme (QE) in May last year put the world into a spin.  As sellers sold out their positions, currencies were devalued and Central Banks had to step in with higher interest rates.  Nine months on and the Fed has begun to taper by $10 billion a month and the impact on emerging markets is ratcheting-up.  This time last year the Fed started buying $85bn of asset purchases a month they and least we forget they are still pouring $65 billion a month into the world economy?  On the face of it this is a small reduction, $20bn a month after $2tn or more of asset purchases in four years, but it is having a material effect in emerging markets and may well come home to haunt us in the West .

The QE 1 - just a good excuse to remember this grand ship

The morning after the night before

Like a terrible hangover that takes an age to clear the developed world has been limping along, since the aftermath of the financial crisis.  There is lack of vigour, a kind of listlessness that Larry Summers has characterised as “secular stagnation”.   Economies, unable to return to the optimistic per-party state they enjoyed from 1995 to 2007, are now settling for survival rather than growth – the pounding headache makes future endeavours unthinkable – we are definitely in the bunker. There are four connected things going on here: dehydration, nausea, a sense of injustice and finally despair – sounds familiar? Secular stagnation is not inevitable we can find a cure. But as Larry tells us “ without a clear diagnosis of our problem and a commitment to structural increases in demand, we will be condemned to oscillating between inadequate growth and unsustainable finance”. And he goes on to say that " A strategy that relies on interest rates significantly below growth rates for long periods of time virtually guarantees the emergence of substantial bubbles and dangerous build-ups in leverage"  - which is exactly where we are low growth, poor levels of employment, low levels of investment - but the very high risk of bubbles and other financial risks.

The Morning after the night before

Debts Still Matter

The mind of George Osborne works in a strange and Machiavellian way.  His announcement today that austerity will continue unabated into 2016 - 17 was greeted with howls of protest from all sides, could it be that the British Chancellor knows something that we don't?  

which one is George?

Five years after the default of Lehman Brothers and three year since taking office the world is still a dangerous place even after years of pain.  What is now clear is the history of this crisis; and most developed countries have faced a number of distinct phases in this recession.

1. The credit crunch caused by a lack of liquidity in the banks 2008

2. Falling growth and a deep recession, caused by the banking failure and the subsequent free fall in asset prices in 2009

3. A false recovery 2009 – 2010 temporarily fuelled by growth in the Commodities, BRIC economies and emerging markets

4. The sovereign debt crisis triggered the very high public spending required to off-set recession (centred on the EuroZone) that rumbled on over 2011 -12

5. (Secular) Stagnation – weak growth in demand and GDP and deflationary pressure on prices in 2012-14?

As I have discussed in a recent blog there have been a number of strategies that have been deployed since 2008 with varying degrees of success.  These strategies (Abenomics, austerity, QE, etc.) have been blurred and muddled by the realpolitik of the day and no country has been able to pursue a fundamentalist approach, not even the UK under Osborne's guidance.  The main policy argument has been around the need for and the pace of debt reduction.  In a nutshell, can advance economies grow whilst carrying substantial levels of public (or private) debt?  There are good reasons for thinking that high levels of debt will be a drag on growth and these are pretty obvious:

Economists playing with fire

I have a sixteen year old daughter who is working hard on her final secondary school exams (UK ‘A’ levels) the results of which will determine the type of degree and which university she will attend – these are important times!  Being a more focused individual than her father she is already weighing her options and it’s straight fight between Economics and History.  Over the Christmas holiday we had a number of discussions around the relative merits of these options; initially I supported the view that Economics would be a more relevant and “useful” degree but now I am not so sure.
Having missed the vital signs of the credit crunch and the ensuing recession in 2008/09 economists around the world are red faced again and having to play catch up on the startling and unexpected rebound that the US and UK economies kicked off in 2013.  Not a single note-worthy economist was able to forecast up-tick in GDP growth or the stellar year stock markets enjoyed in 2013!   Famously, Olivier Blanchard (the International Monetary Fund's chief economist)  warned George Osborne that his austerity programme was "playing with fire" just as the UK emerged into recovery!

Economists playing with fire  

So if they can't tell us what is going to happen what are economists for?  It's a legitimate question to ask - if economist can’t forecast what is going to happen do they have any practical use? Being increasingly unsure of the future, they spend their days trying to piece together the past and polishing their excuses.  But why should economists worry about the past - as James Buchan told us “Economists, like royal children, are not punished for their errors”.

The world's economy is off-balance

Economists around the world are dusting themselves off after a bruising few years of terrible forecasts, messed up assumptions and missed diagnosis.Whether you have been on the Rogoff / Reinhart or Krugman side of the argument there are red faces all around. The simple problem is that economies are not meant to behave in the way they are.  We have got to a point where old models (classical, Keynesian or monetarist) don’t work and excuses just don’t wash.  The problem is that after five years of negative realinterest rates the world’s economy has been unable to return to “historic trend” levels of growth – we are still bumping along the bottom.  Most economists believe that interest rates can be set to create a sustainable equilibrium in the economy where growth, employment and inflation can be held in a positive balance.  The absence of the interest rate equilibrium after years of interest rates set near or at the lower bound of zero raises the question as to what the alternatives are to negative real interest rates might be?  Larry Summers the former Secretary of the Treasury of the United States made  an important speech on this subject a couple of weeks ago.



Larry Summers - tired of waiting for the recovery

The Great British Bail-in

There is an old boy in our local community who has, over the last 15 years, restored a scruffy over-grown wood into a beautiful heathland with heathers, gorse and wonderful roan trees.  This labour of love has been completed with some support from the village but without the time, leadership and effort of one man we wouldn’t be able to enjoy the great amenity he has created.  He has done this because he can afford time but he has given this time so lovingly.





Not out of the woods

 As with this wood so with the national economy;  in 2008 the British economy and our way of life was hanging in the balance.  The financial bust created a structural deficit that amounted to 6% of the national economy (caused by the banking collapse) and on top of that we had the recession the rest of the developed world suffered adding some 4% to the downturn.  There is no precedent for a the UK economy taking a 10% hit to its national income in two years.  Following the bust we have been through a very painful process of rebalancing the economy so we can start again.  The rebuilding process has been achieved by a section of society is the same stoic and silent approach that the man in wood has brought to his restoration.

We're Mad As Hell

Many of us will be experts in the dark arts of sequestration, whereby we create an ultimatum that will have future consequences.  At a personal level it might be “Give up smoking or I will leave you” or it might have a geopolitical significance “declare war on Serbia and we will declare war on you”.  Some of the most dangerous events in history have been triggered by intransigence enshrined in law.  The problem with sequestration is that is hardens attitudes and creates false deadlines and makes sensible negotiation all but impossible.

It may be that comparing one of the causes of the First World War with the current debt crisis in the US is somewhat melodramatic; but the important point is that a possible default by the US government has been conjured from a law that was meant to protect the US economy. 

Tea Party Slogan - reads badly in English!

A Northern Tiger the UK economy roars back!

No one else will say it, so I will!  The UK is in the grip of a full economic recovery, this recovery does not look fragile, nor unbalanced, nor debt driven and it’s probably unstoppable.  So how has it been possible for the sick man of Europe, as we were described barely six months ago, transform himself into the “northern tiger” that we have become.  After years of miserable economic data, there was unanimity that the UK was permanently stuck in a liquidity trap where the shortfall in demand was looking like a problem without solution.  Having thrown monetary policy (£375bn of QE), fiscal policy and a much weaker currency at the problem,  the economy was still flat-lining and all the talk was of a triple dip, much to the amusement of the Labour opposition.

The Full Monty on Osborne's economic policy

In the five years that have elapsed since the global financial crisis  erupted in the summer of 2008 living standards in the UK have dropped sharply (in 2008 a single person earning £13,000 would have reached the minimum they needed to get by. if their wage had risen in line with average increases, they would now be earning £14,000 – which is roughly three thousand short of the £16,850 salary needed to cover the same basic standard of living today).  During this period we have had two governments who have been  attempting to nurse our broken economy back to health.  In  the first two years of the crisis we had the 'fag end' of a long running Labour government, who had little stomach for the fight.  The only Labour minister who came out of this period with any credit was Alistair Darling the who, despite constant interference from Gordon Brown (self styled saviour of the world), did an excellent job of first aid on a patient that was dead on its feet.  His sensible approach to encouraging consumption through sales tax reductions and the motor car recycling scheme combined with a massive blood transfusion of QE made sure that Britain survived the trauma of an imploding financial services industry and the cataclysmic effect this had on credit markets and the tax take.  The rest of the Labour government were in shock as they watched 13 years of neo-socialism unwind before their eyes. 

Carney's Conundrum declining productivity

Understanding the mystery of our terrible productivity performance since 2007 in the UK is at the heart of Mark Carney’s concerns (this is a topic of great interest  to Mr Carney).   His analysis of this productivity fall is important to get right as it will determine whether the Bank of England decides to pursue a looser monetary policy or not.  Many economists believe that, after a brief period of decline at the start of a recession, productivity should pick up pretty quickly as a slimmed down labour force is raises production per head.  Before examining why our productivity has declined so much we should look at some numbers.

Bernanke Vernacular

Ben Bernanke the Chairman of the Federal Reserve Bank has been on quite a journey since 2007, having saved the world after the Lehman's default he has nursed the US economy back to health quicker than anyone would have dared to hope.  The soon to be retiring Chairman of the Fed  warned us this week that over the next year he would start tapering off the amount of money the Fed pours into quantitative easing, which is currently running at $85bn a month.  This effectively signals the end of ‘near zero’ interest rates in the US and around the world. 

I'm forever blowing bubbles

The soccer fans of West Ham United have sung the song ‘I’m forever blowing bubbles’ since God was a boy (or least since the mid 1920s) and whatever relevance it may have to inspiring sportsman has been lost in the mists of time.  The chorus of this American ballad goes;

I'm forever blowing bubbles,

Pretty bubbles in the air,

They fly so high,

Nearly reach the sky,

Then like my dreams,

They fade and die.

Fortune's always hiding,

I've looked everywhere,

I'm forever blowing bubbles,

Pretty bubbles in the air.

As with sports so with finance, the economic cycle is an endless treadmill of  precarious bubbles that ‘fade and die’.  The simple truth is that markets (people) are lazy, we are programmed to take the easy option, that’s evolution for you.  And this rubs off in the world of finance, we almost always lurch from one soft option to the next; in the last 15 years we have had the dotcom boom, the alchemy of algorithmic trading, the credit bubble and the addictive pleasures of QE.   In the good old days we had central bankers who would from time to time burst the bubble and insist that we get back to the serious business of controlling inflation and nurturing sustainable growth.  With deflationary pressure all around the Fed have been busy blowing bubbles not bursting them, but this is about to change.  

 In the last week the markets for both bonds and equities have been in full scale retreat, frightened by the smoke signals coming out of the Fed, which is pouring $85bn of new money into the US economy every month.  QE has had the effect of lowering interest rates and presumably nurturing some growth and new jobs.  All this has been achieved without stoking the fires of inflation but this can’t go on forever; in the short run negative real interest rates have a positive impact in the longer run (just ask the Japanese) worthless money kills ambition and productivity. It is therefore somewhat worrying that our Central bankers are now so cautious on the need to wind back QE and return to real money.  Probably more worrying is the fact that these self-same central bankers now believe that they should have a remit for ensuring high levels of employment and positive rates of growth rather than just managing the money supply and inflation.  News that the Fed will use QE until employment rates rise to 92.5% and to be in a world where employment should be the sole arbiter of interest rates and money supply is a madness of schizophrenic proportions.  Have we have forgotten all the important lessons of the of the 80s and 90s when we had raging inflation, high interest rates and low employment?  The world’s central bankers need to get back to their day jobs of managing inflation, otherwise more pretty bubbles will fade and die!

Abenomics on the ragged edge

Economist around the world watch Japan with baited breath, there is much at stake for the both sides of the argument, The Keynesian wing have their fingers tightly crossed hoping that Abenomics will finally  be the solution to kick starting the world third largest economy, that has been moribund for years. Others on the monetarist wing believe that it will end in tears, and it looks like the markets are voting in favour of the monetarist.

Abenomics is in fact a sort of con-trick, the Bank of Japan (BoJ) is trying to break a deflationary cycle but massive doses of Quantitative Easing (QE) alongside a huge increase in government spending on capital projects.  It is hoped that these two levers will prize economic growth out of an economy that has been going sideways for 20 years.   What everyone knows, is that the moment inflation resurfaces and growth returns, the BoJ will return to a more prudent approach.  This highly transparent strategy has now turned into a game of cat and mouse between the BoJ and the markets.  This week bond yields rose (higher interest rates expected), stock prices fell and the yen rose a little against the dollar last week.  Paul Krugman argues that higher bond yields, a weaker stock market and a stronger exchange rate are all in response to a tighter monetary policy than the one now promised (a broken promise).  The markets don’t believe the Haruhiko Kuroda the new governor at the BoJ is going to be as mad as he says he will be!  The big questions are:

1. Will the markets believe that the policy to risk all for 2% inflation is real or just a short term con-trick 

2. Will interest rates remain lower enough to see this policy through
3. Will the fourth arrow of increase sales taxes to fund the capital spend programme actually be delivered

It’s difficult to believe that the BoJ will be utterly reckless for much longer, everyone knows that Mr Kuroda is trying a form of blind man’s bluff.  The markets will take a medium term view so this promise ‘to be reckless for a little while’ doesn’t cut much ice.  

A further difficulty is that the whole plan depends on low interest rates, to force down the value of the Yen (supporting export growth) and to drive up consumer spending in Japan.  But low interest rates are going to be dependent on the level and expectation of government debt, which already unsustainably high.  If interest rates rise then the need slash capital spending would create a very swift about turn in policy and this is what the markets believe will happen – this could become one-way bet.  

In addition to the interest rate time bomb another problem is that Abenomics has weaken the Japanese banking sector, which is now sitting on Y821tn ($8tn) of government bonds (the result of government debt and QE) and the bottom is falling out of this market.  This is making it very difficult for the Banks to lend money to new and growing businesses.   

The net result of all of this is that Shinzo Abe is on a tightrope above a shark infested river.  He needs to tread a fine line between a credible reflationary policy and need for low interest rates to manage the crippling public debt.  He might just totter across the ravine and receive a hero’s welcome but my money is on him ending up in the torrent with the short sellers enjoying a tasty lunch. 

Should central bankers be concerned with unemployment

In a recent speech Ben Bernanke, head of the US Federal Reserve told us that the stagnation of the labour market is a “grave concern” because of “the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years”. This is pretty strong language for a banker?  On our side of the pond Mark Carney arrives to take the reins at the Bank of England in a couple of months and he has hinted that the Central Banks should have wider concerns than interest rates and inflation.

There are two question that are prompted by this loose banker talk, firstly what monetary policies might they have up their sleeves to save the world from high unemployment and secondly,  should they have these wider concerns anyway. 

George Osborne and the IMF - the blind leading the blind

Stock markets are generally a much better forward economic indicator than ‘independent’ forecasters, and the indices around the world are climbing, this is in part driven by the need for investors to find better yields but it’s also a sign that the money men think the worst is over or that the balance of risk has moved in favour of the real economy and away from sovereign bonds.   

Against this back drop of soaring stock markets the UK economy is having its annual health check from the IMF and like a sickly patient waiting in the surgery waiting room there is some nervousness.  Much of this nervousness comes from the fact that we are surrounded by a large number of ailing economies with high contagious problems, most of who hail from southern Europe.  Unfortunately one of the examining ‘doctors’, has already pronounced on our untimely demise without any examination.  In an ill-informed outburst, the IMF's chief economist, Olivier Blanchard, recently accused the UK of "playing with fire" by persisting with growth-destroying austerity.

Since 2008 the UK has performed worse than most other ‘developed’ economies, this is due to our reliance on the banking and financial services sector and the structural deficit that emerged due to a lower tax take from these businesses.  Making a correction to resolve this structural problem, equivalent to 6% of the economy, is proving to be very painful, but there are early signs that we are well into our convalescence.  Banking profits are rising, even RBS made a substantial profit in the first quarter, and these profits will eventually flow through to the exchequer and the wider economy.  Linked to the banking sector is the housing market and again there are some reasonably solid signs that recovery is under way.

The evidence supporting the IMF’s view is pretty weak and points again to the generally poor service this organisation provides the world economy.  The IMF ‘missed’ warning signs in the run up to the financial melt-down and then became invisible during the Lehman crisis and they are still playing catch up.  The IMF is also a very European centric organisation (Blanchard is French as is the current MD Christine Lagarde) and they never pass-up the opportunity to bash the Brits.  It’s likely that, following their detailed examination over the next three days, they will recommend a less austere approach. 

A marriage made in heaven - Osborne and Lagarde

This is missing the point completely.  George Osborne has presided over one the greatest con tricks in political history, claiming to be the Iron Chancellor whilst actually being soft on reducing the public deficit, the result of which is the deficit has hardly been dented but employment rates have been protected.  This cautious approach to dealing with our public finances has infuriated many of us but is can hardly be described as austerity.

So what is the IMF up to?  Their main priority is saving the Eurozone and if they can convince the UK to pump up our economy this will have benefits for the exporters in the Eurozone and as one of the largest importers of European goods the UK is a vital component in the wider European economy (we are the second largest economy in the EU).  Obviously George Osborne should resist their advances robustly and we should focus on solving our problems and rebalance away from banking dependency and EU dependency.  Despite his best efforts our economy is mending and we are probably well in advance of Europe whose major economies; France, Italy and to some extent Germany are in denial of the structural changes required.  This reconstruction of the UK’s economy has been achieved by stealth through the effects of quantitative easing (QE), which has the effect enforcing haircuts on all creditors by the introduction of a negative real interest rates, this obliges saintly savers to pay for the bad debts of the boom and provides banks with the time and liquidity that they need to rebuild their balance sheets.

The issue for the IMF and Britain specifically will be how we can now kick the drug of QE without slipping back into recession.  Perhaps Mr Blanchard should confine his thinking and remarks to this problem rather than promoting the policies of the Jurassic period – see my post http://getwd50.blogspot.co.uk/2013/05/walking-with-dinosaurs.html.

Go Abe Go - Proving Paul Krugman Correct

We watch with bated breath for the results Abenomics (the economics strategy of Shinzo Abe the Japanese premier), which is a lethal cocktail of Keynesian supply-side expenditure reckoned to be worth $75bn in this quarter alone and a massive dose of quantitative easing.  Some like Paul Krugman (the liberal conscience of economics) believe it’s the perfect cocktail of goodies to resolve the liquidity trap that the Japanese economy has been in for 15 years or more.  A liquidity trap is where private demand is too weak, so that even at a zero short-term interest rate private consumption (spending by people and private companies) falls well short of what’s required for full employment and positive growth. In these circumstances, monetary stimulus, quantitative easing (QE) is unlikely to have any effect.

Which on is Abe, Angela?

Japan is a very important economy to study and understand as they have been in this liquidity trap for 15 years and these are now the conditions that apply in the US and much of Europe, so if Abenomics works we all need to know how and why.  Krugman argues that people will continue saving even at low interest rates if they believe that central banker are genetically modified to maintain low inflation and interest rates. Krugman is pining his hopes to the idea that Bank of Japan can this time “credibly promise to be irresponsible”.

Read his blog at 

http://krugman.blogs.nytimes.com/2013/04/11/monetary-policy-in-a-liquidity-trap/

I think things are a little bit more mom and apple pie than Krugman.  Private consumption is flat and saving are increasing for two reason, firstly we have an aging population in the west and Japan that are under-funded in their pensions and they are having to stash whatever they can away to cover their endless retirement (same is true with company schemes).  This squeeze on 35-40% of the population is intensified by the terrible savings rates due to all that QE, you need double the pension pot if interest rates are half of what you expected.  Secondly working households are carrying the entire burden of austerity and have no room for manoeuvre, although mortgage rates are down real wage deflation and unemployment have hit them hard. 

So what to do, in the short term I would ignore the saving issue as monetary policy doesn’t seem to have much effect and the medium term expectation is for continued low rates of interest.  I would focus is providing relief to  the working middle class (cutting sales taxe is the most direct route) this would give them money in their pockets, which is likely to flow back into the economy quickly.  This should help prices to rise and eventually force interest rates up.  However unpopular a demand side stimulus is, it's probable to only way to escape the liquidity trap!