Daily Learning – July 28, 2017
Superinvestors Podcast with Jesse Felder of the Felder Report
Podcast #10: William White on the Undesired Side Effects of Experimental Monetary Policy
Released July 26, 2017
Approximate Length – 1 hour and 11 minutes
Overview; William White is an Adam Smith Prize award winner which is the highest honor of the US National Association of Business Economists. A former Bank of England employee as well as the Bank for International Settlements where he was chief economist. Today he is the chairman of the Economic and Development Review Committee at the OECD in Paris. Gave an important and well received speech, “Ultra-Easy Money: Digging the Hole Deeper?”
He discusses his economic philosophies what he worries about and the possible/probable negative side effects of experimental monitory policy and how it may end during this remarkable cycle in the global economy.
Two important themes emerge from the podcast from Jesse Felder’s perspective;
- That someone in such a prominent place in economics would question the policies being used by central bankers.
- That such a prominent organization would award him for his contrarian viewpoints.
He began in economics through shear serendipity. Was interested in politics as a teenager. Did not grow up with a lot of money. Wanted to go to university on scholarship and they only had a joint course on politics and economics/political science. So, the economics was sort of there in conjunction with the politics. One thing led to another and he became more interested with the economics. He followed the money and took a scholarship to the University of Manchester in economics.
First degree in Windsor Ontario. Did the PhD at University of Manchester in England.
He is a contrarian and not like the common thought process of central bankers. From the earliest days of his graduate work he was skeptical of received theory and was influenced by the book, “Random Walk Down Wall Street.” The basic lesson he took away is that you don’t just read the stuff that people tells you what to do but rather get into the trenches and figure out what people actually do. Because there could be a difference.
Spent a lot of time in London working on his thesis. Debt management, monitory policy, financial stability, etc. He had chapters about portfolio practices at banks and insurance companies. There was always a distinction in his mind between what organizations were saying they were doing and the actual practice of those organizations. That was his starting point to raising questions. Later personal experience cemented his questioning attitudes.
Examples of flawed past policies used by governments were fixed rate currencies or natural rates of unemployment which led to mistakes. He concluded philosophically that just because people say something is true means that it is. He kept up that view of the world and not just in economics.
Science proceeds through empirical analysis and testing. His whole career has been based on putting theories to actual testing and then being skeptical unless the analysis works as intended.
Most economists get too married to theory and not to what is really going on with humans. It’s hard for humans to challenge certain beliefs once those beliefs are rooted across the board. We see this in economics. In economics, there have been in the past a reasonable willingness of people to say, “this isn’t working” but now the rigidity of the belief system is noticeable.
In “Thinking Fast and Slow” when people are shocked with something that conflicts with their belief system, people DON’T in fact go back and challenge their belief system but rather get more committed to their belief system (more stubborn to incorrect theories). They ignore the facts.
It may be possible that after the long period of the “great moderation” we are actually seeing this in action. That people don’t want to believe anything other than their old beliefs. Central bankers have done in unconventional ways two things;
- Whenever you get a slowdown in economic activity it is because of insufficient aggregate demand and monetary policy will correct this and
- Monetary policy will kick that demand back in again without bad side effects. (Monetary policy will always work without side effects.)
So it’s been business as usual without people challenging the old beliefs.
Central bankers live in their own world of reality. They have decided to treat every recession over the past with monetary policy that is based on debt creation. It should be obvious that this can’t be done indefinitely. This extreme monetary policy is not having the intended effects and they haven’t acknowledged this.
It could be because of false beliefs, but it could also be that they did the right thing between 2007 and 2009 and they stepped in to restore stability. But once they were into it, there was a lot of pressure to continue to do it from other sources. You had the initial push to stabilize the economies and financial systems but then in 2010 there was a retrenchment. There was also a push to reform regulations which impacted demand and a tightening. So, they found themselves as the only game in town and continued with their methods even though they were now deviating from their initial goals of providing stability to the system.
In Bernanke’s speech in 2010 it was all on aggregate demand, raising asset prices, trickle down, lifting all boats, but it was a different objective for policy at that point. Are the central bankers really believing that this will work and that the side effects are inconsequential? Or have they got sucked into the situation where they felt they had no choice but to continue?
There is a lot of literature out there (going back 100 years) that if you lower interest rates below the natural rate of interest that you will get inflation and that was a negative side effect (so don’t do it). But subsequently there were others who came along who said, “That’s not the only thing to worry about.” In the 1930’s there were talking about misallocation of resources. Balance sheet recessions, too easy monetary policies build up debt and leverage that lead to recessionary times that take a long time to reverse. Stability breeds instability. When things are ok, they say things will continue to be ok even though things are building under the surface.
The side effects of the very nature is growing evidence that you get big misallocations during the boom periods by the easy money. You get misallocations that forced too many resources into retail (especially in the United States) banking, commodities, etc. You get these misallocations and then along comes the bust and in the bust there is more misallocation which makes the banks “evergreen the loans”. Bernanke wrote in the 1980s that if you don’t know your client is insolvent and you don’t know if you are solvent, the idea that you are going to blow the whistle on them is to evergreen the loan rather than taking the hit. Maybe/hopefully things will work out is the thought because if you are the banker, you can’t take the hit. You don’t have enough capital. So you just roll it over. But you have so much competition that should be dead that is still alive. So it’s the zombies that are dragging the good companies down into the grave with them.
On the financial instability side, if you have a world where market prices are determined by the central bank, and the price discovery has disappeared and the correlation is long gone by the asset classes, where is the value in value investing and the reasons for diversification. And those things are good for credit growth and the economy going forward. So, you worry about the negative effects of potential growth going forward.
You have all the financial sector problems in the narrowing of the spreads and term spreads. So, insurance companies and pension companies are struggling. Now the banks margins are getting squeezed. So, you will have more instability down the road not less instability with all of this central bank policy. I think there is a good case to be made that if the prices are set falsely and too high and with too much credit that everything gets driven up. Trillions of dollars of riskless bond yields in negative territory. High yield spreads that have been squeezed. VIX at record low levels.
All of these things are reversible and what will be they fallout? But it most likely is going to be very unpleasant. There are all these negative side effects that I believe are terribly important.
Some things that are not directly related to the economics but wealth distribution has been skewed. We already have a big problem in almost every country with rising inequality. And I think monetary policy has made it worse.
We have issues with central banks independence. I think the ways central banking has been conducted have left central banks exposed with respect to their own internal capital. What happens if the rates go up and with the assets that the central bankers have brought in? I think there are a lot of unintended side effects.
If it was only a year or two you could argue that maybe the benefits outweigh the costs but what I am concerned is that after 9 years of this stuff, and it has been almost 10 years, that’s a long time and the way that I’ve expressed it is, “if you think the efficiency of monetary policy is declining over time, the bang for the buck is getting less and less, and aggregate demand is decreasing and the costs are associated with the policy are going up over time, then we have a point where these two paths are going to cross.” If we are doing more harm than good, then we should stop doing it.
I guess reasonable men and women can disagree when that crossover point occurs but after 10 years you at least should be thinking that we are past the due date.
Should central banks have to show the intended benefits of these policies? Not all attempts to increase demand will work. Use extraordinary instruments can work (back in the 1930’s) but other things must also be used like fiscal policy and infrastructure.
With monetary policy whether it is conventional or unconventional, it is trying to induce people to move their spending forward in time because the discount rate is lower. So whatever people want to spend later, they are spending sooner. This is supposed to be a good thing. While central bankers always talk about more spending today as a good thing, they never talk about what you spend today means what you can’t spend tomorrow. So, it is spending today at the expense of spending tomorrow.
But that is precisely what happens. If you encourage people to build up debts that must be repaid, and the debt is what is causing spending, then the stimulus today is a de-stimulus tomorrow. There is a lot of that going on now at the global level.
Since 2007 to 2017 the overall level of global debt (government, corporate and household) is up over $70 trillion. A very large chunk is in emerging market. It’s these debt levels are eventually headwinds and it will stop monetary policy from working and demand will diminish.
So after 10 years of all this stimulus, not only has there been a weak response to the policy but now we are left with all of the debt that makes many people fear where we go from here.
What the central banks have done has been so unusual. They are making this stuff up as they go along. This is so unusual and scary that it implies that there is something bad happening. Therefore, just hunker down. So there is also a risk that more and more people just hunker down to see how all of this evolves because we are in unchartered territories.
Given Janet Yellon’s background as a labor analyst, it’s possible that she is taking a conventional view that since we are coming so close to full employment with momentum that even though we don’t see the inflationary pressures, we should move because they probably will be on the way.
There is a growing sense of concern of the side effects but it may be that people are saying to themselves that they need to have some concerns to head some negative things off.
We have seen inflation in the asset prices but we haven’t seen it in traditional ways. I wrote a couple of papers back in 2008 for the BIS on why global inflation is so low. The answer I came up with is with China and others constituted a supply side shock along with baby boomers doing through the market, it led to this supply side shock. Demand was weak. Labor and wages were weak (oversupply of labor). Wage growth was severely constrained. So, the workers didn’t have The wherewithal for consumption.
So even though corporate profits were high it didn’t lead to more investment spending. Everybody was making money so why invest more? There were shocks. Prices were weak so monetary policy to make up for the lack of demand.
What I’m worried about is that we may have a similar thing going on right now. The increases in capacity in China and value-added chains may be disinflation to the global economy. If that is the case, leaning in with more credit growth isn’t going to help and isn’t the answer.
If you take a Phillips Curve the coefficient in the gap has been going down and down in all countries but the global has been going up. So global forces are having a more impact. This may call for a broader discussion on how countries cooperate on a global level on problems that deal on the global level. But things are all being done on the national level. We are making the same mistakes that we made before the last crisis. We are responding to a supply side issue with credit creation and that will make the problems worse and not better.
The most likely end game – There are alternative scenarios and how monetary policies lead to other uncertainties but where we go from here – two broad stories. The happy story is that monetary policy has now got us to a point where we are self-sustaining and with the growth rates going faster than the interest rates, we have a world in which the economies are recovering and debt ratios will go down because GDP is growing faster than the debt service. It could happen.
Global GDP should be around 3.5%. This is the first time in 9 years where the forecast for the middle of the year is not significantly lower when the forecast was made a year ago. Usually it gets revised downward. This is the first year we haven’t had that. We may get sustained good news. If we continued with good growth and debt levels go down, then asset prices even though they are quite rich the fundamentals get better over time.
The problem with that story has to deal with possible inflation. In most developed places, they are close to full employment so inflation may erupt. Monetary policy may be too easy for too long. Central bankers know they may get the blame they deserve and they are aware of that.
Debt levels are too high and demographic growth is too low. So we may not get a sustained rise in inflation. It’s possible that the demographic trends themselves cause inflation. It’s all uncertain. Maybe we get productivity gains of a sort that will offset that. Nobody really knows how this all plays out. I think we should see these two forces of inflation and disinflation fighting it out with productivity in the middle of the fight. We won’t know until we see it happen.
While we don’t see the inflation rise, central banks will keep gunning the monetary stimulus and eventually that will create imbalances and probably inflation. We could get into other problems.
So, inflation can go wrong. But even without inflation we still have so many imbalances out there. Once central bankers start to tighten, how financial markets respond could be quite disorderly. That is why I think the Fed has this in the back of their mind. Things are so far away from normal and with so much leverage, there is a lot of worry on the vulnerabilities there. If we get rates that really start to rise, then people will start to respond. We also have markets now where everybody thinks they are smarter than then next guy and believes that they could get out first. That could lead to more interesting and dangerous times. Markets may even just over-react.
We may not only end in recession but a recession with all of that debt overhang.
The bad news story is that the forecast for 2017 is first revised up but then it gets revised back down again and it turns out to be a false signal and the global economy is as sluggish as ever. Then all the wishful thinking on equity prices and high yield spreads being justified by the circumstances will make people go back and think again. Then extend and pretend will come to a halt. Then you are back to the big risks that materialize. So, it could end happy. But there are a lot of risks out there. It is a pretty narrow doorway to the happy ending. They are trying to thread a needle.
If what we see with asset prices is all due to QE, and then we undo QE, then I would expect to find a reversal which would not be good for aggregate demand.
The book, “Lords of Finance” talks about the concept of good intentions and how a lot of good intentions end up just being nothing in the end. It all ends up fictional.
History is an important teacher. Once you start thinking about the Japanese experience it makes you think about the 1930’s. With economic cycles, it’s all “seen it, done it.” There are always new financial products but all crisis’ have new instruments involved. Central bankers always cite the new financial instruments and use it as an excuse. But they usually all add to the leverage and credit and speculation. It’s not the instruments themselves it’s the repeat of the leverage and credit and speculation that leads to the problems in the cycles.
If you are looking for a common denominator on what causes harm it is the speculation on property and the use of property as collateral. It all comes back to credit being extended for the purchase of even old properties and driving up the prices.
A new book by two young guys from Zurich (Jonathan McMillan) The End of Banking is good. It is about the end of the system where banks can create credit by running up both sides of the balance sheets. It’s old Chicago School thoughts. But people can create money in a lot of different ways like shadow banking. This book makes a good case using FinTech and put FinTech together with narrow banking to create a better financial system.
I’m against any narrow use of a rules based system like the Taylor Rule because the world is too complex. These rules end up being wrong over time and mistakes are made because of bad beliefs. But there should be a lot more emphasis on the unintended consequences of what central banks do. So, it is putting constraints on the system in different ways. The policies have been so radical and the radical implications are large. There should have been some significant proofs that the side effects aren’t there.
Think about the FDA. If you want to bring in a new drug, you not only have to prove that it works, but that it doesn’t cause harm with significant negative side effects. But that’s not the way central bankers have been operating. It’s like they aren’t even considering the negative side effects. I think that is wrong. But that also might be my basic conservative nature.
Institutions and the basic ways people do things with a purpose and evolve over time to suit a purpose and to sweep them away without consideration isn’t very sensible to me. There must be some good reason that central bankers are straying from conservative fundamentals. They should take steps to make sure unintended consequences aren’t ignored.
Perhaps the central bankers should use the rule, “First, do no harm…”. They should be like doctors working with patients. First do no harm.
www.williamwhite.ca is the website for his personal website.
More notes at the podcast notes on the Felderreport.com