‘THE global economy faces a depression-era collapse in demand if Europe doesn't quickly act to dramatically boost the size of its debt crisis firewall, implement pro-growth policies and further integrate the eurozone, the head of the International Monetary Fund warned overnight.
"It is about avoiding a 1930s moment, in which inaction, insularity, and rigid ideology combine to cause a collapse in global demand," IMF managing director Christine Lagarde said in prepared remarks before the German Council of Foreign Affairs in Berlin. "A moment, ultimately, leading to a downward spiral that could engulf the entire world," she said.
The dire warning from the IMF's top executive is designed to spur political action in Europe and within the Group of 20 industrialised and developing economies and avoid the political stagnation she said exacerbated the crisis.
Last year, "policy makers let an old wound fester, and in doing so made the situation worse", she said, speaking ahead of a euro-area finance ministers' meeting in Brussels tonight.
We will confess to a feeling we were becoming repetitive on the subject of the coming Eurozone collapse.
We pointed out way back in early 2010: ‘Government debt in advanced G-20 economies is projected to reach 118 percent of GDP in 2014, even assuming some discretionary tightening next year. Getting debt below 60 percent by 2030 will require raising the average structural primary balance by 8 percentage points of GDP relative to 2010 (10½ percentage points for the headline primary balance). Action will be needed on entitlement spending, on other spending, and on revenues. Japan, the United Kingdom, Ireland and Spain are projected to require the largest fiscal adjustment. Only Denmark, Korea, Norway, Australia and Sweden among advanced economies will require little or no medium-term adjustment to keep debt stocks at safe levels.
Furthermore, if debt ratios were merely stabilised at post-crisis levels interest rates would be higher (perhaps by 2 percentage points). Moreover, 'there are important nonlinearities: the impact on interest rates of each additional percentage point of debt or deficit increases as the initial debt or deficit level rises, pointing to a risk that government debt could snowball without corrective action'.
This is all pretty scary stuff. Bankrupt nations are like bankrupt companies - they do not buy much from other nations.
Henry is feeling depressed himself. There are at least two obstacles to a happy ending for the Eurozone, and thus for the global economy.
It is doubtful that the Eurozone itself has the financial muscle to save the Club Med nations and the Eurozone banks from serious debt default, and even more doubtful that the IMF’s late attempt to assemble a sufficient rescue package will produce the goods.
And it is doubtful that Germany has any strong incentive to provide strong support to sort out the crisis, because German exports are benefitting greatly from the weak Euro. Germany is in fact doing furtively what China is castigated for doing openly.
Even in the miracle economy that is Australia various pundits are finally beginning to realise that we would not be immune following a Eurozone collapse into depression. This would snuff out America’s promising but fragile recovery and slow China’s double digit expansion. Record Australian terms of trade would collapse just as tourism, manufacturing and other non-mining industries find themselves flat on their backs gasping for air.
This unhappy outcome is by no means sure but is now looking a better than even money bet. The RBA can cut interest rates but there is little room for fresh fiscal expansion. Poor fellow my country.
Long weekend Sanity Break, 2 - 5 November 2013
Date: Saturday, November 02, 2013
Author: Henry Thornton
Where are Australia's manufacturing industries going? That is the question of the decade and there is no easy answer. Specialised hi-tech manufacturing, like just-in-time 3D printing of structures to replace bones in serious cancer surgery, is a world-leading example of manufacturing with promise. Manufacturing of cars or processing food when there is a flat global supply (cost) curve, and Australia has high domestic costs but lacks access to vast economies of scale, is a mug's game.
New age protectionism
Saturday was long and lazy but a mining man phoned as Henry was taking exercise to ask if he had read Judith Sloan's column.
I had to confess that I had not. Said mining man told Henry that Sloan was onto something, something that applied to mining.
The source of this shaft of clear white light is here. It is about the lack of competitiveness that is driving Australia's old-fashioned, heavily unionised food processing businesses offshore. Mention is made of excessive wages, and Ms Sloan quotes the story of the lack of (inexpensive) scallop shuckers (in Tasmania, with its horrendous rate of unemployment) that has led Aussie scallops being shucked in Thailand, and then re-exported back to Australia.
In some excitement the mining man said 'It's just like mining. Think of a steeply rising cost curve. If a mine is in the first quartile of efficiency, as many Australian mines are, then good profits can be made. But metal manufacturing, or manufacturing generally, has a flat cost curve, so even an efficient enterprise finds it hard to make good profits. Why do you thing BHP eventually sold its steel mills, and RIO never had any'. (Henry's correspondant is a retired RIO man, who hates to miss a chance to deliver a cruel barb to the old enemy.)
I had to agree that this analysis was as tight as an unopened scallop, and another brick in Henry's so far limited understanding of microeconomics has been cemented in place.
[Later: A very senior mining man emailed as follows: ' Your Saturday Henry Thornton blog is spot on. 'Mining projects in Australia today have to be either high grade or very large scale and export the first saleable product to be economically viable. As an example, at Olympic Dam WMC built a smelter and refinery to produce highly refined metals (copper, gold and silver), as well as uranium oxide. The (now shelved) BHPB plans for Olympic Dam expansion were based on exporting a mixed concentrate for refining in China. 'Under the present conditions no further smelters or refineries can be built in Australia. Existing such plants may well have to close when they need substantial capital replenishment.
Mrs Thornton came out punching on the matter of subsidies for vehicle manufacturing whilst watching Insiders on Sunday morning.
'Who wants to use taxes to subsidise companies to make cars here? If the goverment wants to do that the least they can do is extract shares in return.'
Henry could not fail to agree, as he had previously argued, in discussing the bail-outs of failed American financial enterprises, that all government bail outs should only be made in return for equity that could presumably be sold later at a substantial profit.
Ruminating a bit further, Henry and Mrs T had the amazing insight that another condition of a bailout could be forced merger of failing vehicle manufacturers in Australia. If Australian governments had been accumulating equity in exchange for bailouts, by now they would have enough equity to enforce mergers, thus improving scale of Australian vehicle manufacturing.
Of course, as Ms Sloan and the mining men understand only too well, the global cost curve for cars is very flat and Australian wages and conditions (not just sub-optimal scale) puts us at the top of the global cost curve. ]
The political news is, to put it colorfully, as boring as bats**t'. Labor has decided to fight the end of the carbon tax, and will live to regret this ignoring of the will of the people. (Correction, might live.)
Rather than running about like two-headed chooks, the Abbott government is proceeding slowly and purposefully. The second week without boats of paperless would-be immigrants and the extradition from Indonesia of an Iraqi person-smuggler are both signs of an election promise being kept.
Australia has been accused of spying on the nations of Asia, upsetting the Indonesians but apparently not the Chinese, who if anyone there noticed might have said with grudging admiration: 'Didn't think the Aussie's had it in 'em'.
Monetary policy shenanigans
The RBA's confession of its powerlessness to control the excessively strong dollar has been much commented on. Most fulsomely in the Weekend Fin, where John Kehoe says "As the economy muddles through at sub-par growth, the Reserve Bank of Australia may be forced to admit defeat – at least until Ben Bernanke starts the great stimulus unwind". Mr Kehoe quotes everyone except Uncle Tom Cobly and, wait for it, Henry, with his bold plan to tame the dollar by taxing capital inflow. First articulated in January this year with the aid of Friedman's aphorism 'Monetary policy cannot serve two masters'.
She concludes that Woody still has a few problems to sort through!
Image of the week
Courtesy Google images
Managing money for the ages
Date: Friday, November 01, 2013
Author: Henry Thornton
Ever keen to help central bankers, as well as ordinary punters, Henry's research team presents their research on the tricky matter of Asset inflation and Monetary policy. The summary is here, and contain links to other important contributions and to the full paper, including footnotes and references.
Readers familiar with the London underground will recall, perhaps fondly, the recorded message: 'Mind the gap'. We have long suspected that there is a gap in monetary history and analysis, a gap that is far more important than the gap between train and platform in the London underground. The gap in question concerns the role of asset prices in the analysis of the effects of monetary policy.
Milton Friedman famously said: 'Inflation is always and everywhere a monetary phenomenon' (Friedman, 1963, p. 17). Inflation in this context is goods inflation, or goods and services inflation. This was based primarily on the masterful historical analysis of Friedman and Schwartz (1963), but has been confirmed with statistical analysis of different levels of complexity and is now part of the canon of macroeconomics.
There has, however, been a long and we judge inconclusive debate about the interaction of asset prices and monetary policy. There has been resort to complex econometric techniques of different sorts and simulation analysis of simple models. But this work has not resolved the issue. We approach this question by repeating in summary form the analysis of Friedman and Schwartz including (as they did not) asset prices as represented by US share prices, specifically the S&P 500 index, with the advantage of five decades of additional data.
We must stress that this paper is fundamentally empirical, as we believe were Friedman and Schwartz. Our aims are to determine: what are the facts; and what does the data suggest about how to include asset inflation in existing models.
US share prices are more volatile than the monetary, price and real income variables used by Friedman and Schwartz. But all the major episodes, and most of the sub-periods, analysed by Friedman and Schwartz, show trends in both share price inflation and goods and services inflation directionally consistent with changes in monetary policy as represented by growth of the money stock.
But there are also cases when share prices are suppressed, such as in the first world war and the second part of the second world war, when goods and services prices rise much faster than suggested by their normal relationships with money growth. Conversely, when goods and services prices are suppressed, share prices rise especially rapidly, as they did in the second part of World Was II. The Roaring Twenties and the share booms of 1948 to 1960 and 1990 to 2000 are far more important examples in which money growth and wholesale inflation were both low but there were large booms in share prices. Another key example of such an apisode, is the Japanese land and share boom that ended in late 1989. These 'aberrant episodes' (as we call them) are of especial interest and when appropriately allowed for will improve both theory and empirical analysis of how economies work. This is a vital matter as the 'aberrant episodes' have almost always ended badly,
Clearly some plausible theory needs to be brought to bear if these episodes are to be incorporated into macroeconomic theory and policy modelling. We suggest that allowing for the state of confidence, Keynes' 'animal spirits', would be a good way to start. Powerful confidence seems to have been an important part of the story of the USA in the 1920s, the 1950s and the 1990s, in each case associated with powerful innovation and strong growth. Powerful confidence might be expected to boost demands for both money and shares. Increased demand for money would presumably mean lower goods inflation for any given rate of money growth, and contained money growth would itself boost confidence. Powerful confidence would presumably make bankers more inclined to advance credit, and as Schularick and Taylor (2010) show so convincingly, strong credit growth is a vital part of the generation of asset booms.
We are aware of no systematic measure of the confidence of investors that stretches back to post-Civil War America. When questioned about this matter, share brokers usually comment that the best measure of confidence is the behaviour of share prices, which is of course circular if used to explain strong share booms.
Blainey (1988) provides a systematic and persuasive analysis of the effects of the 'Great Seesaw' of swings in confidence in the history of the Western world from 1750. Kindelberger and Aliber (2005) say: 'Asset price bubbles - at least the large ones - are almost always associated with economic euphoria'. (p 115). Galbraith (1955) documents in telling detail the progress of euphoria during the boom of 1922 - 29, and especially in 1928 and 1929.
Daniel Yergin's wonderful 1991 book, The Prize, summarises in just a few pages the dramatic post-WWII development of America. 'The inexorable flow of [cheap] oil transformed everything in its path'. (p 532). Suburbanization gathered pace requiring widespread ownership of cars. Great highways were built, drive in restaurants and movie theatres were built, cars added fins and other symbols of innovation and success. (Pp 530 - 536).
Ben Bernanke (2013), reviewed here, says 'low and stable inflation over a long period supports healthy growth and productivity and economic activity'. (p 40) Then in discussing the so-called Great Moderation, he remarks: 'With twenty years of relatively calm economic and financial conditions, people became more confident, willing to take on more debt'.
These contributions, and others like them, especially Akerlof & Shiller (2009), reviewed here, provide useful hints for modelling investor confidence, and Bernanke's general statement suggests a way to relate low and stable goods inflation with the genesis of asset inflation.
The aberrant experiences deserve emphasis because all three of the relevant episodes analysed in this paper ended badly, in the latter case with continued uncertainty more than five years after the start of the crisis itself. As previously noted, Japan's experience in the 1980s, with a massive asset bubble while monetary policy seemed to be restraining goods and services inflation, (also followed by a massive asset bust), fits this 'aberrant' scenario well, and was followed by two decades of poor economic performance. The build-up to the Global Financial Crisis also involved great confidence, especially the almost manic confidence of the bankers of Wall Street and the City of London.
Apart from further efforts to quantify 'confidence', or 'Animal Spirits', there are several obvious extensions of this work - to include other assets, especially real estate - and to investigate more systematically alternative or subsidiary measures of the impact of monetary policy.
Application to smaller economies is not straight-forward because, even if they have flexible exchange rates, small country share prices are influenced directly by swings in Wall Street, as well as by in-country monetary policy, real growth, goods inflation and other domestic factors.
Despite the difficulties of wars and depression, the regularity of the relationships exhibited in the full paper, linked here, should provide fresh impetus to modelling of interactions between share prices and other key economic variables.
The paper also discusses the implictions for monetary policy. Essentially the results justify policies other than manipulation of cash interest rates if asset booms and busts are to be modified. This is a point that Australia's Reserve Bank seems to be ignoring with great focus. Unless this apparent blind spot is overcome, Australia's economic performance will suffer, perhaps in a big way.
Here is the key point: 'Tightening monetary policy, as in the USA in 1928 and 1929, on top of a general expectation that markets are over-valued, will bring any asset boom to an end. But, as Friedman and Schwartz say, there are 'great difficulties in seeking to make [monetary] policy serve two masters' ... and 'the Board [in the 1920s] should not have made itself an "arbiter of security speculation or values" ' (p. 291). In our view, policy-makers need to have a clear way to modify asset booms when the evidence suggests the strong risk of such a boom getting out of control. Ironically, the evidence suggests that firm monetary policy is likely to promote asset inflation, which is a powerful reason not to rely on monetary policy to control asset inflation. The literature generally has missed this point, which has resulted in many wasted and unproductive articles on the subject of this paper'.
We hasten to assert that the aim should not be to strangle a boom for its own sake, since much that is constructive occurs in the boom times. Rather the aim should be to control the asset boom so that it is not based on 'irrational exuberance', or excessive credit growth, especially not credit based on lending with narrow asset backing or highly risky credit standards.
Managing money in troubled times
Date: Wednesday, October 30, 2013
Author: Henry Thornton
Sometimes an unorthodox approach to a knotty problem is required. Yesterday, Henry's favourite fund manager (FFM) made this point by telling his audience about the unorthodox approach used by Lord Nelson to the battle of Trafalgar.
The starting point, and much of the discussion, was about the dramatic growth of the USA's national debt and what that means for investment markets. As the chart shows, US government debt is currently forecast to rise, as a ratio to GDP, to the height reached following the onset of depression and war in the 1930s and 1940s. This debt ratio fell sharply as vast armies were returned to civilian life and what became one of history's great economic booms began to gather pace. There is no expectation of such a natural debt reduction for the next decade and a half, though one should perhaps be aware that, in economics as in life, good things sometimes turn up unexpected.
While the USA has made progress in reducing its budget deficits and economic recovery seems to be underway, recovery will raise the rate of interest required to service the debt and put an expansionary spoke in the wheel of debt reduction. So far, every time the US Fed discusses reducing the so-called 'taper', ie reduction of super-easy monetary policy, bond yields rise and equity prices fall sharply.
There are only three ways to reduce a debt mountain of the size predicted for the USA: turn budget deficits into surplusses (Plan A); repudiate the debt (Plan B);and inflate the debt away (Plan C). Here is a discussion of the relevant issues.
As this earlier discussion put it: 'By all means enjoy the equity boom that will go on if and when the bandaid is applied to the oozing, toxic fiscal mess in the USA. But consider what you will do to protect your family's wealth and welfare when Plan A fails and some mix of Plans B & C is applied to the US economy'.
Henry's FFM said that he hoped the whole show could go on without drama in asset markets, implying I thought a continuation of asset inflation setting new records for asset prices and with no dramatic fall to be avoided or not as the case may be. No one was rude enough to point out that 'this time it's going to be different' is simply wrong, and Henry's FFM does not believe that either, in my view.
There was much discussion of what, if anything, could be done to take advantage of the situation. Extra exposure to real estate was ruled out as most of the audience were already long real estate. Our FFM had some radical ideas of what might be done by the Abbott government to reduce negative gearing, thus reducing investor demand for houses and flats, and keeping prices down for first home owners. We reminded him of how Paul Keating's efforts in this direction required a backflip after only five weeks, which ended that discussion.
'What about the usual rule that old people, like us, should increase their holdings of bonds?' asked one of the oldish persons present. 'There are two possible futures for bond prices apart from continued steady yields that we might all hope for', replied our FFM, 'inflation or deflation. Either approach will be bad for bond yields - falling yields with deflation and rising yields with inflation. Either outcome will smash returns from bonds'.
Our FFM asked us if we were aware of current levels of long bond yields in Spain, Italy amd Australia. 'All are approximately 4 %' he pointed out. Perhaps, however, Spanish and Italian investors are expecting 2 % annual deflation, while Australians are expecting 2 % inflation - ergo, real yields are far higher in the banana republics of southern Europe. Precisely what this might mean for asset allocation decisions was unclear to Henry, possibly because it was fast approaching the time for his afternoon nap.
Another question concerned the apparently relatively excellent returns from Australia shares relative to overseas shares over long runs of history. Henry was jolted awake to point out that Australia has historically suffered greater inflation than the USA, and our currency has fallen, meaning higher yields here suffer from what economists call 'money illusion'. 'Of course, the Aussie dollar is very high now, and that is a good reason to put money offshore', Henry opined.
As well as avoiding bond markets, our FFM suggested he will shortly be applying a policy of gradually reducing holdings of shares, starting with the most heavily overvalued. When he perceives that real trouble is in the offing, he will try to cut overall equity holdings quickly, although he conceded that many other fundies will also be poised with fingers hovering over the sell button. This approach is unorthodox as fund managers usually stick to the old saw that 'time in the market beats market timing', but this time the boldest among them are planning to avoid the inevitable crunch with the caveat 'to the extent possible'. The quote of the day was 'Being too prescient can appear to be too conservative'.
The meeting broke up quickly about then, all of us agreeing that Glenn Stevens was not going to accept advice to put a tax on capital inflow any time soon. And a cheeky comment on fees was allowed to go through to the keeper.
Who'd be a fund manager? It would not be so bad if the job did not involve pesky clients, but at least Henry's FFM is prepared to meet and brief his customers.
Reflections on issues for the gnomes of Martin Place.
Exactly a month ago we started our regular article on the issues for the RBA board as follows:
'The RBA meets tomorrow facing three objectives. Its single instrument of 'vary cash rate' will not be able to help fix the three economic problems except by accident for short periods.
'The RBA has said it is watching the hot property market and some (killjoys) say higher interest rates would help to prevent a boom turning into the next bubble.
'The RBA has also shed some crocodile tears about the exchange rate, and sort of let it be known that it welcomed the fall in rates that followed its rate cuts. Lately, however, the currency has rebounded with better global economic news and the lack of the US Fed's foreshadowed 'taper'.
'In its real job of containing inflation and maintaining economic activity many advisors (owners of shopping centres, real estate agents) wrongly say more rate cuts may be helpful, even necessary'.
Similar messages were conveyed, although less prominantly, by other news outlets.
All this excitement was generated by the latest example of the RBA's 'open mouth' policy, which can be accessed here.
Orthodoxy is a virtue for central banking gnomes, but we are all going to pay for their failure to see that current problems require unorthodox solutions.
Saturday Sanity Break, 26 October 2013
Date: Saturday, October 26, 2013
Author: Henry Thornton
'William White, chairman of the OECD's economic review committee in Paris, says there's growing recognition in central banking circles that the risk that asset bubbles will burst and wreak havoc might outweigh the short-term benefits of money printing.
"Ultra-loose monetary policy seeps into every crack in the economy, corrupting asset prices and encouraging bad lending," he tells Inquirer. "Everything gets touched."
'While Europe's debt crises have faded into the background for now, its banks and governments remains fragile, each beset by massive debts. European banks are very highly leveraged, with capital ratios typically lower than 5 per cent, implying they are leveraged more than 20 times.
'For similar reasons, US banks are "probably not" equipped to withstand another financial shock, says Poole, a former head of the Federal Reserve Bank of St Louis.
"The European Central Bank's current stress tests on the region's banks have little credibility," says White, also former chief economist of the Bank for International Settlements in Switzerland. "But they will have to give them the tick of approval; so far there's no plan B to recapitalise them."
'How the end of quantitative easing will affect global markets, and in particular the strung-out financial system, is the biggest "known unknown" hanging over the world economy today. But nor should the Rumsfeldian "unknown unknowns" be forgotten. White says financial conditions are eerily similar to early 2007, when the world's experts were cooing about the safety of the financial system. "House prices are rising, equity prices are veering far from what earnings would suggest reasonable and so-called volatility indices that measure risk are tracking near record lows," he says. (Continue here.)
The OECD has famously been lacking in monetary expertise. now, by hiring former BIS expert, William White, they are beginning to have credibility in this area.
Australia is facing many economic challenges. Treasurer Joe Hockey is fighting manfully with these problems, and to a large extent we are facing the global monetary conditions bewailed by William White.
When the USA finally bites the bullet and begins to end its 'ultra-loose monetary policy' the Aussie dollar is likely to climb, possibly as high as $US1.20.
Yet the RBA Chief says he is 'powerless' to cope, except perhaps to use the now $10 billion contingency fund in what will be a vain attempt to stem the rise of the $A. (Plan B outlined here.)
Adam Creighton's long article, from which we quote above, includes the following summary: Australia is 'an economy beset by excessive regulation, public spending and federal dysfunction.
'Resource revenues are tipped to recede, leaving Australian governments' growing structural deficits starkly exposed. The RBA is anticipating a slump in mining investment and early signs other sectors will take up the slack aren't promising.
'Unemployment continues to edge towards 6 per cent and investment levels outside mining, as Reserve Bank deputy governor Phil Lowe pointed out this week, are at 50-year lows, despite rock-bottom official interest rates'.
Hence the replenishment of the RBA's war chest, the Commission of Audit and other initiatives yet to be announced.
Paul Kelly spells out the 'triple threat' facing the Treasurer and all Australians: 'Hockey, busy in waking hours, is beset by three nightmares: a US financial "event" that sends the Australian dollar into the stratosphere with lethal consequences across a range of industries; a cliff-like decline in mining investments that cannot be replaced, leading to lower growth, weaker revenues and rising unemployment; and the need for a Keatingesque pre-budget shock that prepares the public for the Commission of Audit reforms. (Click here for more.)
Enough of this gloom! Government is a risky business, but crisis provides opportunity and, by honestly and steadfastly facing the looming crisis, the Abbott government can place itself in the pantheon of Australia's best governments.
Not much footy news except the churn of end-of-season transfers. Caaaarlton! has not done much, or so it seems. Effectively swapping our best forward (Eddie Betts) for mid-fielder Daisey Thomas (formerly with Collingwood) is a bit of a punt, and sending Shane Hampson somewhere else may not make sense. The last fringe ruckman who got sent on his way has become one of the competition's best under new management, so clearly the Blues' management is not all that sharp in the ruckman area.
The Poms have arrived with the aim of sqishing the Aussie cricketers again. Davy Warner has hit three centuries (one a near-double) and Mitch Johnston has been scaring the s**t out of the Indians in the one day series in India. Bert has secured tickets for Henry and himself for day one of the test that begins at the 'G on boxing Day. Imagine Mitch and one of the young quicks bowling to the Poms on a pitch with a green tinge. Delicious. Groundsmen, do the same job the pestiferous Poms do at home, and all will be well.
Henry modestly accepts praise for his review of the book about the origins of asset boom and bust by George Akerlof and Bob Shiller, reviewed here.
The choice is not between free markets and regulated markets, but rather between poorly-regulated markets and sensibly regulated markets.
Sadly, global financial markets are not currently sensibly regulated, which is why the issue raised first in this blog is some pressing.
Here is a set of modest suggestions for consideration by the Treasurer's financial system review to be announced soon.
Image of the week
Economy - more asset inflation, unemployment to come
Date: Friday, October 25, 2013
Author: Henry Thornton
Recent uncertainty about the sustainability of the global asset boom retreated with a surge of share prices overnight. Ironically, the 'story' seems to be that slowing global economic recovery means super-easy monetary policies in most (all?) countries mean 'Central banks drop talk of tightening'.
The world of central bankers remains deeply uncertain and divided on what to do about asset inflation. Ignore it and clean up after the crash was the Greenspan approach but that grizzled veteran of the interest rate wars seems, if recent reports are correct, to be reviewing this position. 'About time Al' would be heard from a cheeky young bloke at the RBA, but alas they are no longer allowed to be cheeky.
Luci Ellis of the RBA's Financial Stability Department spoke recently about happy liason with other regulators, but was not around to hear later speakers assert that 'monetary policy cannot serve two masters'. Big Al was right to say 'monetary policy', meaning interest rate manipulation, cannot effectively deal with an asset boom, but he was wrong to say nothing could be done about asset booms.
Proper 'Macro-prudential policy' will do the trick, Mr Greenspan, though from recent reports this is a new idea, and you are (ahem) getting on a bit. 'A real old geezer' as Henry's youngest puts it.
Anyway, the joint statement by Treasurer Joe Hockey and RBA Chief Glenn Stevens agrees with Luci Ellis since the otherwise exemplary statement contains nothing about policies to tame asset booms so they don't turn into bubbles that pop to cause much angst and real hardship. (Henry's comment on the statement available here.)
The point about the need to address asset inflation (when it becomes threatening) with some sort of 'macro-prudential' policy is being seized upon by increasing numbers of commentators, most of whom point out that the time when the US Fed begins to withdraw stimulus will be a dangerous time for us all.
Meanwhile, in the former 'miracle economy' that is Australia, record low non-mining investment seems likely, though the optimistic Mr Lowe from the RBA thinks and hopes this is not the case. Like his boss, Mr Lowe would like to see a lower exchange rate, as his predecessor Ric Battellino apparently hoped the note printing bribery scandal would quietly go away. But his boss, Glenn Stevens, says the RBA is 'powerless' in this matter of currency manipulation, as big Al used say about asset inflation. These men are meant to be our best brains, perhaps dimmed by the low lighting and soothing talk in the RBA boardroom, and a generally syncophantic press.
Treasurer Joe Hockey has chosen a fine group to review fiscal policy, and he needs to do the same thing with his committee to review financial policy. Not too many old snoozers, Joe, is Henry's plea. It is vital you get on top of the 'hockey stick' method of forecasting taken to such new heights by Wayne 'Things will be better tomorrow' Swan.
However, ... the fiscal outlook keeps getting worse, and a prolonged investment drought will make matters even more dire. The post-election confidence surge has 'stalled' screams the AFR front page, and Australian business needs help. Not necessarily by spending more money - though with respect to infrastructure that is vital (though where is the money coming from?). Rather by cutting regulations, red tape and green tape as the election prospectus said. Especially in the labor market, as business leaders keep saying. Dropping the carbon tax, and the mining tax will represent a good start, as well as ending the various mad spending schemes devised by Rudd'n'Gillard'n'Rudd and their enthusiastic band of helpers.
There is indeed a budget emergency, but fixing it will take time and fixing it too fast will raise the unempoyment rate further than the nasty rise already in the pipeline.
Asset inflation, helping the rich. Unemployment, hitting the poor. This combination is a recipe for social conflict, as the world's best thinkers have always recognised.
Economic policy dilemmas
Date: Thursday, October 24, 2013
Author: Henry Thornton
It's all happening in economic policy, gentle readers.
Treasurer Joe Hockey is loading both barrels of his sawn-off shot gun in case of problems due to the American Tea Party zealots.
He has given the RBA almost $9 billion so it can handle any crisis in the money markets. Could the old lady of Martin Place be preparing to (gasp!) intervene in the currency markets (open vault policy), having failed to bring the Aussie dollar down by (a) talking ('open mouth policy') and (b) cutting interest rates (open wallet policy). Shooting with the wrong weapons, comrades.
Australia's inflation rate is up by a bit or a lot, depending on whose favoured measure one looks at. Reminds one of the cartoon in which Treasurer Paul Keating in pyjamas was showing Prime minister Bob Hawke (also in pyjamas, standing at the door of the Lodge in the middle of the night) a graph. The Treasurer was saying something like 'If you look at it in the right way it is turing up'. I forget what was meant to be turning up, but the contect suggested it was not unambiuous good news.
Housing has been recovering in Perth, Melbourne and Sydney. Much too soon to call it a bubble, but interest rate cuts are working, and the next move in rates should be up. Not helpful for the Aussie dollar, but that is just one problem of trying to do three things - bolster the economy, cut the dollar, encourage (or curb) housing.
The current Treasurer, Joe Hockey, has appointed a worthy Committee to audit the fiscal machinery and to search for savings. The major problem for the Treasurer, and therefore all of us taxpayers (and even welfare recipient who are responsible for most of the unsustainable budget spending) is that the economy is weak, and the Prime minister is keen to boost much needed spending on infrastructure. So even the boldest plan to produce a sustainable budget position will need to be tempered.
Cheery Josh Friedenberg is grappling with regulatory reform, and one can predict he will be older (and looking even older) and wiser in three years time. As we have said previously, start with the Labor market, Josh, its the place where the immediate gains will be greatest.
The gloomsters are saying the Treasurer's boosting of the RBA's balance sheet as a precautionary matter risks short-circuiting the nascent recovery. The truth is that the Australian economy is in deep trouble. Young people are signing on for more higher ed since they cannot find jobs, older people are leaving the work-force in droves and the newly recovering dollar is putting fresh pressure on exporters, tourist operators and small businesses throughout the nation.
Economic policy needs to fix long-term problems and but not to lurch around too violently. Economic dilemmas abound. Our fingers are crossed.
Treasurer-RBA governor statement on monetary policy
Date: Thursday, October 24, 2013
Author: Henry Thornton
The Treasurer and the governor of the Reserve Bank today released a joint statement on this important matter.
This statement is stronger than previous similar statements, chiefly by recognising the requirements of the RBa under the relevant act of parliament and relating these to the focus on a target for goods and services inflation.
The lack of comment on asset inflation is a serious omission that will eventually be rectified when the RBa works our its position on this crucial matter.
Under the heading of 'financial Stability' the statement says: 'Financial stability, which is critical to a stable macroeconomic environment, is a longstanding responsibility of the Reserve Bank and its Board'.
The statement goes on to discuss the RBA's cooperation with government and other agencies, hardly 'responsibility'.
Achieving financial stability is undoubtedly important and could not be guarenteed by any agency, but then the objectives of the Reserve Bank act are only required to be achieved to the extent possible.
In this writer's view, explicit policies to control excessive general asset inflation, especially those very powerful upward moves sometimes called bubbles, are currently missing, but are necessary if 'financial stability' is to be maximised.
This will be recognised in due course, most likely when the next coalition Treasurer signs a new agreement in due course.
It`s official - central bankers can be (gasp!) wrong
Date: Tuesday, October 22, 2013
Author: Henry Thornton
Confessing to such matters is especially likely when they are selling a new book, as is the case with the grizzled veteran of the interest rate wars, Alan Greenspan.
'In his new book, The Map and the Territory, to be released today', writes Alexandra Wolfe, 'Greenspan, 87, goes on a hunt for what has gone wrong in US politics and in the economy. He doesn't blame the Obama administration for today's partisan divide. The culprit?
"It's the benefits," he says, pointing to the disagreements between Republicans and Democrats over how to deal with the growth of entitlements.
'In the book, he also ponders why the Fed failed to predict the financial crisis, where he himself went wrong and how that discovery has completely changed his worldview'.
Mr Greenspan discovered the adverse effects of 'entitlements' when playing with GDP statistics, the way other 87-year-old play with lego (correction, their DIY pension plans). Rising entitlements and reduced savings are correlated. Joe Hockey, take a bow.
There's more. "I've always considered myself more of a mathematician than a psychologist," says Greenspan. But after the Fed's [massive, econometric] model failed to predict the financial crisis, he realised that there was more to forecasting than numbers. "It all fell apart, in the sense that not a single major forecaster of note or institution caught it," he says. "The Federal Reserve has got the most elaborate econometric model, which incorporates all the newfangled models of how the world works - and it missed it completely." ...
Mr Greenspan 'concluded that fear has at least three times the effect of euphoria in producing market gyrations'.
"I wouldn't have dared write anything like that before," he says.
Ms Wolfe continues: 'Greenspan set out to find his blind spot step by step. First he drew the conclusion that the non-financial sector of the economy had been healthy. The problem lay in finance, because of its vulnerability to spells of euphoria and irrational fear. Studying the results of herd behaviour provided him with some surprises. "I was actually flabbergasted," he says. "It upended my view of how the world works."
Curious, perhaps, that Mr Greenspan had not heard, or did not value, the frequently rehashed views of regular stock price watchers who say the markets show persistent phases in which greed and then fear predominate among 'the herd'. All of which reminds us of 'Animal Spirits'.
The other big mistake of Alan Greenspan is not mentioned by Ms Wolfe. This is Greenspan's belief that it is not possible to recognise or to act against an asset bubble while it is happening, but mopping up (with massive monetary policy stimulus) after the crash.
To be fair ('Why?', I hear you cry), his belated recognition of the forces of euphoria and fear perhaps amount to a half-confession.
Sadly, there is no tradition of Australia's former central bankers writing biographies, and thus gaining the benefit of cleansing their souls before shuffling off to meet whatever awaits them in the great hereafter. I suspect Ian Macfarlane were he sufficiently honest would confess to moving too little, too late to tighten monetary policy, and being saved by the global financial crisis. Also he could boast about banning serious model building at the RBA, meaning there doing away with the best articulation yet devised of how the economy works. The RBII model certainly worked well in predicting the rise of Australia's international debt in the 1980s and the powerful drop in the value of the Australian dollar. By the time the boom of the late eighties was underway, the model had been mothballed so we will never know if, used with appropriate expertise, it would have predicted 'the recession we had to have'.
It is far too soon to write the confessions of Glenn Stevens. But delivering really boring speeches might well be among the issues to be considered, at least if Tiresias of Canberra was involved in the process. Read on here, folks. I gotta zip.
Animal spirits - creating economic booms and busts
Date: Monday, October 21, 2013
Author: Henry Thornton
John Maynard Keynes believed 'the economy was not just governed by rational actors, who "as by an invisible hand" will engage in any transaction that is to their mutual economic benefit, as the classicists believed. Keynes appreciated that most economic activity results from rational economic motivations - but also that much economic activity is governed by animal spirits. People have non-economic motives. And they are not always rational in pursuit of their economic interests. In Keynes' view these animal spirits are the main cause for why the economy fluctuates as it does. They are also the main cause of involuntary unemployment'.
This arresting paragraph is from the preface to the first edition of Animal Spirits, written in early 2009 by George Akerlof and Robert Schiller. I purchased the second paperback edition, whose preface was written in late 2009 when tentative green shoots of recovery were beginning to be noticed. I regret not reading this book before writing Great Crises of Capitalism as it would have helped me strengthen some of its conclusions, but I will confess with appropriate humility I have found nothing to contradict my analysis.
I have acquired and read Animal Spirits now as with others I am about to test some hypotheses about the systematic causes of the asset booms and busts that are such a large part of the financial crises of capitalism. Akerlof and Shiller also acknowledge the strong positive animal spirits that produced the share boom in the 1920s USA, and the subsequent share bust, which they attribute to a dramatic shift of mood. They apply the same logic to Japan's asset boom in the 1980s and subsequent asset bust and again in the USA in the 1990s and beyond. These are three of the four dramatic 'aberrant episodes' identified in this author's article (with Elizabeth Prior Jonson and Ka Mun Ho) 'Monetary Policy and Asset inflation', still being reviewed in the USA.
The episodes are aberrant because boom and bust seem not to be related in any obvious or consistent way to changes in the stance of monetary policy. Akerlof and Shiller, if they noticed this statement, might reply that it strengthens (certainly does not refute) their hypothesis that it is changes in animal spirits that changes the trend of asset prices. Crucially, of course, their hypothesis needs testing, which ideally requires a measure of animal spirits, or an hypothesis about what causes animal spirits to vary.
The best attempt I have seen is Geoffrey Blainey's The Great Seesaw, A New View of the Western World 1750 - 2000, first published in 1988, curiously not referenced by Akerlof and Shiller. Blainey writes toward the end of his stimulating book: 'The factors which are capable of promoting oscillations in mood are more powerful and varied than ever before. The seesaw itself is more sensitive to slight pressures. These extreme swings of the seesaw come not only from war and peace, economic depressions and prosperity, the finding or depleting of new natural resources, inventions and pollution, but also from less tangible and more subjective factors operating in free societies'. (p 304). This passage goes on to list among more subjective factors the decline of Christianity, an 'increasing narrowing of human experience', 'the cobwebbed complexity of western civilisation', and what Blainey calls 'the cycle of expectations'.
Akerlof and Shiller, in the 'Preface to the Paperback Edition', writing in late 2009, say: 'Animal spirits are more than just confidence as measured by confidence indicators. We argue that declining animal spirits are the principal reason for the recent severe economic crisis'. (P vii). News media do not speculate about the roots of behaviour, but largely report changes in measurable economic facts such as share prices and retail sales. 'The reasons the leading indicators have improved remain mysterous'.
'There seems ... to be an unseen force propelling the economy, driving it to periodic booms and busts'. This view is not new. The Nobel laureates quote Baghot, in his 1873 book Lombard Street.
'Most people who begin to think of the subject are puzzled: Why should there be any great tides of industry, with large diffused profit by way of flow, and large diffused want of profit by way of ebb? The main answer is hardly given in our common books of political economy'. (Quoted by Akerlof and Shiller, Pp vii and viii).
The tentative recovery beginning in late 2009 'defies the analysis' of the many economists who build and use econometric models. Is also 'defies the analysis of those economists of the "real business cycle" persuasion, who are in the habit of thinking that all economic fluctuations are ultimately driven by exogenous changes in "technology" and "productivity", but cannot point to a descriptopn of the cause of such a change right now'. It also defies the work of people who seek to extract patterns from time series of data. (P viii). Clearly forming hypotheses to embed in minimal but largely complete econometric models - which is our plan - will be quite a challenge.
'The basic theme of this book', say Akerlof and Shiller, 'is that animal spirits are the force that drives all of this, and that to understand animal spirits we have to use methodologies outside of traditional economics, leading us to other social sciences'. (P ix).
They identify 'five psychological factors' ... that they think are of particular importance. They are confidence, fairness, corruption and bad faith, money illusion, and stories. 'Changes related to all these factors are the ultimate reason for the boom that preceded the world economic crisis, for the crisis and recessions in which we have been immersed, and for the apparent beginnings of recovery. These phenomena cannot be understood in terms of traditional economic theory alone'. (P ix)
Of course, the success of any such analysis will require it to be successfully applied to previous episodes of boom and bust and (of course) to be successful in predicting future episodes of a similar nature.
We say, again with appropriate humility, that our hypothesis about the 'aberrant episodes' previously mentioned is as follows: 'Clearly some plausible theory needs to be brought to bear if these episodes are to be incorporated into macroeconomic theory and policy modelling. We suggest that allowing for the state of confidence, Keynes’ ‘animal spirits’, would be a good way to start. Powerful confidence seems to have been an important part of the story of the USA in the 1920s, the 1950s and the 1990s, in each case associated with powerful innovation and strong growth. Powerful confidence might be expected to boost demands for both money and shares. Increased demand for money would presumably mean lower goods inflation for any given rate of money growth, and contained money growth would itself boost confidence. Powerful confidence would presumably make bankers more inclined to advance credit, and as Schularick and Taylor (2010) show so convincingly, strong credit growth is a vital part of the generation of asset booms'.
Establishing plausible ways to measure animal spirits, whether following Akerlof and Shiller, Blainey or Keynes himself (or all four such towering figures) is likely to be difficult and time consuming. Akerlof and Shiller's emphasis on 'stories' provides a possible form of linkage, and we plan to focus on this point.
To return to the Nobel laureates: 'We argue in Chapter 5 that human-interest stories that give vitality and emotional resonance to economic views drive animal spirits. Since economic expansions and contractions in the modern world tend often to be worldwide phenomena, these are not stories confined to any one country. The stories spread amidst a growing world culture, from country to country, since the same salience that works for a certain sort of story in one country in one country will generally work in another country as well'. (P ix)
The example used is a series called The Apprentice, which in the USA featured Donald Trump, and in its rapid global spread featured local tycoons. 'The tycoon is a tough man who shouts belligerently "You're fired" at the losers, but who, in his own harsh but distant ethical way, serves as a mentor to them all'. This series was shown in 2004, as the American asset booms began to really hot up, partly one assumes as a result of the Fed's sharp monetary expansion after the crash of the early 2000s. Sadly, this writer never saw the American Apprentice and is not aware of any Australian remake. Perhaps the lack of such a local product helped shield Australia from the worst of the global boom and bust, like the families in the American Appalachian mountians, lacking television and thus immune (according to the 'stories' hypothesis) from the general American madness. (Just joking, dear American friends.)
The remainder of the late 2009 preface goes on to argue for an activist approach to economic management, as opposed to those this writer calls the Tea Party economists, (with reference to the Mad Hatters' tea party, incidentally, not the law-breaking tipping of tea into Boston harbour in 1773). I liked particularly the following passage, which relates to the absence of effective financial system regulation in the USA during the boom of the 2000s: 'The public, and the regulators who were supposed to act on their behalf, had failed to understand a fact of life that is totally obvious to everyone who has played a serious team sport: there have to be rules and there has to be a referee who enforces them - and a good and contientious referee at that. Otherwise there will be random cheating that destroys the sense of the game, and dangerous and aggressive play, so that many people will get hurt and the game will cease to reward good play'. (p xiii).
Amen to all that.
Saturday Sanity Break, 19 October 2013
Date: Saturday, October 19, 2013
Author: Henry Thornton
Exhibiting superb just in time management, US legislators caved in to President Obama's wishes that the mighty USA not default.
The partial shutdown of the USA government cost the economy a few points of GDP in the forth quarter, and cost unpaid government employees a rather larger share of their income.
It is important ro recognise that global monetary Armegeddon has been postponed, not eliminated, and we shall in all liklihood come back to more useless grandstanding by Tea Party zealots early in 2014.
Treasurer Joe Hockey boasted that he had a plan 'in his back pocket' in case of Armegeddon, but Gov'nor Glenn Stevens on ABC radio as Henry drove home from the airport last night said while his team 'had a few notions' about what might be done if the real crisis had erupted, the truth was the world would be in uncharted territory, with no clear guidance from anywhere.
This is the headline summary of RBA chief Glenn Stevens' speech to a worthy group in Sydney yesterday.
The report itself continues as follows: 'The dollar rose to a four-month high of US96.46¢ on Friday after markets bet the US government shutdown would delay the Federal Reserve’s plans to withdraw the cheap financing that has driven global investors into higher-yielding currencies like Australia’s.
'Mr Stevens, who has repeatedly lowered interest rates in part to try to drive the dollar down, acknowledged the Reserve Bank’s ability to stem the currency’s latest rise was limited.
“I personally think a lower currency than this will be helpful in rebalancing the growth sources of the economy. Whether it’s in my gifts to make that happen is another question,” Mr Stevens said at a lunch for the Australian British Chamber of Commerce.
“Fundamentally, I don’t think you could really credibly say that the level of cost and productivity in Australia, on those metrics, would point you to present or higher levels being really sustainable.”
Read on here. Or, if you prefer your tonic without the gin provided by feisty newspaper reporters, the real thing is available here.
As it happens, Henry was also speaking to a group in Sydney yesterday.
The notes for his part in a debate on the wisdom of capital markets, conducted by the Paul Wooley Centre for the study of Capital Market Disfunctionality, are available here.
On the subject of the RBA's 'powerlessness', key points were as follows: 'The floating exchange rate has meant that resources are allocated more efficiently than they were when the currency was fixed.
'However, resource allocation is far from optimal when a floating dollar becomes stubbornly high, as it has in the past few years. (The RBA governor's statement today that he is 'powerless' in this matter is surely a joke, or an admission that he is overdue for retirement. A tax on capital inflow would fix this problem, but the bureaucrats lack the courage to implement such a tax, fearful that it will cause capital inflow to dry up.)
Also, in conclusion: 'I would be happy to discuss how the world might move to a wiser system of capital allocation if time permits, but for the present debate it is sufficient to demonstrate that current policies and our present policy framework, fail to allocate capital wisely. But let me pass on an iron law to the RBA people present here today. Milton Friedman said 'Monetary policy cannot serve two masters'. Manipulating interest rates cannot both contain inflation and overall economic stability (two tightly linked objectives) and also contain a housing bubble or restrain an overly buoyant currency'.
I might mention that the dominant member of the opposing team, Professor Tom Valentine, admitted that the current system for allocating capital was far from ideal. But he won the debate, and the biggest laugh of the day, by asking if the audience would prefer 'The Obeid method: management by corrupt politicians', or 'The bureaucratic method: management by incompetent bureaucrats'.
It was notheworthy that Valentine agreed that Henry was right about Friedman, and Friedman was right about the limits of monetary policy. 'If you want to control a housing bubble', he thundered, 'you need a seperate way to do it'. From what Luci Ellis, head of the RBA's financial stability department said in her paper (linked here), I doubt she would agree. But since her boss has not yet opined on this matter, she wisely faffed about.
Sources of Australia's prosperity.
Gov'nor Glenn did, however, opine on the bigger question of Australia's long-term prosperity. He discussed the value of overseas investment, of cash and human capital, and the mineral wealth that was not obvious at the first glance of Dutch and other mariners.
'But it wasn't just money, land and minerals. There are other countries with resources and land that do not enjoy the same incomes. And there are nations with very little in the way of resources or land that are wealthy. It was other things about the British heritage that were of higher value. ...
'It turns out that the English language is just about everyone's second language, which means even with our broad accent, we can communicate with educated people virtually everywhere and engage in commerce in most places. The common law and parliamentary democracy provide a foundation for the sorts of property rights and governance processes that are widely and rightly regarded as fundamental to building a prosperous modern economy. That property rights could become so well established in a society in which the ‘immigrants’ of 1788 had no such rights is, perhaps, an ironical outcome. And we are still coming to terms with the property rights of those descended from the inhabitants who were here before 1788.
'But the point is that this heritage, so important for enterprise, is something we have in common with the UK. One has to observe as well that Britain traded with and invested in her former colonies, however imperfectly, rather than simply extracting the rents. The fact that so many prominent English-speaking former colonies are counted among the rich of the advanced world today is perhaps not entirely a coincidence'.
I thought Gov'nor Glenn's exposition owed a lot to Ian McLean's recent book, The Historical and Global Roots of Australian Prosperity, reviewed here, but it was curiously not in the list of references. Accidental omission or parallel discovery, but who cares, comrades. The conclusions are what matter, right?
Not much footy stuff this week, so we must pass on to Rugby, where Australia searches for redemption tonight. The Kiwi's fearsome captain is out with an injury, so the game may be worth watching, provided one's expectations are low.
Cricket is creeping into the news. Davey Warner belted a quick century on a small ground, seen as a step to his redemption. The one day side got belted in India, and are at one-one, with presumably more very hot curry to come.
The 'futball' (soccer) team beat even less competent Canadians and the local futball community celebrated. The powers are said to be trying to decide between three Aussies for their new coach, but things are looking very grim for the world cup. Bring back Davey Warner is Henry's advice ['Dad, you just don't get it' says one of the junior Thorntons.].
The image of Australian sport has beem greatly shaken by allegations of widespread drug use in AFL and Rugby League, says retiring global anti-drug crusader John Fahey. Best let the courts decide that matter, Mr Fahey. No convictions yet mate.