January, 27 2017 by lsr team

Major changes are afoot

LSR Blog - Major changes are afoot

The hangover from the fiscal and monetary excesses of the last 40 years is adding to the depressing effects of deglobalisation.

 

Oxford Dictionaries has declared post-truth to be its word of the year. It’s an adjective “relating to or denoting circumstances in which objective facts are less influential in shaping public opinion than appeals to emotion and personal belief”. In 2016, its use increased by about 2,000% over 2015 because it perfectly describes the perceptual changes that are seeping into the global political economy. The first change is the growing realisation that central banks have feet of clay.

 

The natural (neutral in Fedspeak) rate of interest is the real policy interest rate that would equate savings with the real rate of return on capital investments. Real interest rates below that level should lower unemployment and raise inflation via the Phillips Curve, whereas rates above that level should do the reverse. The Fed employs the neutral interest rate as an input for its deliberations on setting the fed funds rate. It claims that the neutral rate has fallen sharply recently, so ultra-low interest rates don’t signify an easy monetary policy, giving little urgency to raise rates.

 

The neutral rate isn’t observable, so the Fed uses models to compute it – based on their formulas and assumptions about output gaps and what interest rates would close those gaps. However, double counting has caused and still is causing big model errors. The inputs to the neutral rate model are data that embody the Fed’s past interventions. For example, regular readers know that the Fed’s excess money printing and ultra-low interest rates have greatly distorted credit allocation, thereby reducing productivity. Therefore, using the current low productivity growth as a factor to show that the neutral rate has fallen is an obvious case of double counting.

 

We can’t know what the neutral rate is in real time; we can’t even know what it was after the fact because the neutral rate doesn’t leave markers behind. Convertible currencies succeeded for a long time because they enabled market participants to freely negotiate interest rates for lending and borrowing. Continuous free negotiations among countless lenders and borrowers kept risk-adjusted interest rates near the neutral rate for centuries. After convertible currencies ended in 1914, central bank policy rates began misrepresenting the risk-free interest rate, the base from which all other interest rates are calculated. This misrepresentation distorted financial markets enough to cause the Great Depression – the worst depression so far.

 

Capitalist systems depend on money having a positive time value, i.e. positive real interest rates. Economies with consistently negative real interest rates, which are inflationary, perform poorly because inadequate inflation adjustments erode real capital and the real incomes of many people. Negative nominal policy rates are even worse. They levy a direct charge on capital in every lending transaction, assuming risk adjustments are relatively accurate. So they’re deflationary, with the savings industry their first victim.

 

Central bank complicity in eroding national capital is compelling evidence that they’re not fit for purpose. For example, the ECB announcement of negative nominal interest rates initiated a massive flow of long-term institutional money out of Europe and into America, according to BNY/Mellon. Triggering an exodus of private capital is a strange way of trying to increase lending and investment.

 

The price of money is the most important price in a capitalist economy. If Fed economists could accurately estimate the neutral interest rate, we wouldn’t need bargaining to set wages. Instead, Fed economists could estimate the neutral wage rates for various types of labour, neutral commodity prices for various inputs, etc. and then issue comprehensive economic plans. Many governments have tried to do this. Not one has ever improved conditions because, as von Mises and Hayek stressed, central planners can never effectively calculate prices.

 

Instead, a continuous and competitive price discovery process in bond and credit markets is necessary to keep risk-adjusted interest rates near the neutral rate. However, competitive has become a meaningless word in this world of cartels, monopolies and oligopolies, nearly all of which can easily impose their desired prices. Breaking up those monolithic institutions and reintroducing competition would be required to reinstate the competitive discovery of prices.

 

Unfortunately, the many ex-Goldman Sachs employees in Washington and New York rule out the reinstatement of Glass-Steagall, the best move Trump could make, as it would greatly reduce systemic risk. Messing with Dodd-Frank is unlikely to fix anything, but Trump’s proposal to end interest rate deductibility would make the tax treatment of debt and equity capital equal for the first time since the early 1980s. This could halt the erosion of American corporate balance sheets over the past three decades and more, a small step in the right direction.

 

Global trade growing faster than GDP is the defining feature of globalisation. The second perceptual change is the incipient realisation that the post-WWII period of globalisation ended in 2010. Global trade is now growing slower than GDP for the same reasons that prevailed in the interwar period – currency manipulation and increasing national barriers to trade. Various countries entered into currency wars between 2009 and 2011 while the average freedom of trade score (scroll down to see the chart) rose continuously up to 2011, but has since moved sideways.

 

Protectionism against China is already rising, especially in the US and EU, which, with Trump’s anti-trade stance, should cause the freedom of trade to turn down. This would confirm that a long-term retreat from globalisation has begun and could remain a major headwind to the world economy for decades, as it did after WWI. Moreover, it could take a generation or more to remove the hindrances of low productivity, rising dependency ratios and trashed balance sheets in many DMs. All the time, defaults (and the consequent write-offs against assets and equity) should continue to rise and eventually impose the necessary deleveraging that central banks have been fighting so vigorously.

 

The initial Gallup Poll rating on the Trump presidency was 45% approval 45% disapproval. The lowest previous initial approval ratings were 51% for Reagan and Bush Senior. The highest previous initial disapproval rating was 25% for Bush Junior. Trump will have to improve his ratings considerably to get the legislation he wants through the senate.

 

leigh.skene@lombardstreetresearch.com