Editor's Note: The following research note was written by Christopher Whalen of Kroll Bond Rating Agency. Whalen is a Senior Managing Director in the Financial Institutions Ratings Group. Over the past three decades, he has worked for financial firms including Bear, Stearns & Co., Prudential Securities, Tangent Capital Partners and Carrington. This piece does not necessarily reflect the opinion of Hedgeye.
This research note is based on my remarks to be presented at the Central Banking Series sponsored by the Global Interdependence Center in Dublin, Ireland and Madrid, Spain, September 29 and October 3, 2016, respectively.
The economist John Maynard Keynes said that ideas shape the course of history. He also noted that the difficulty in economics lies not so much in developing new ideas as in escaping from old ones. As we consider the prospects for the global economy in 2017 and beyond, we should keep Keynes’ prescient observations in mind, especially since many of the economic constructs that have guided public policy over the past century no longer seem relevant.
Since the 2008 financial crisis...
Global growth has slowed and the overall level of debt has grown. Individuals in many nations have made an attempt to reduce their level of indebtedness, but in aggregate since 2008 nations have gone on a debt-fueled spending binge encouraged by the fact that the cost of servicing public sector debt has fallen. Open market purchases of public and private debt have been employed by global central banks to push interest rates down to zero or lower, this in an overt effort to stimulate asset prices, shift investor risk preferences, and thereby, it is hoped, stoke higher levels of aggregate demand.
The chief engine of the gradual reduction in the general level of global interest rates has been the Federal Reserve System. Driven by political concerns in the late 1970s about rising unemployment, the Humphrey-Hawkins legislation has compelled the U.S. central bank to drive interest rates progressively lower. Casual observers of the Fed speak of a “dual mandate” for U.S. monetary policy incorporating full employment and price stability, but careful reading of the Humphrey-Hawkins law shows that the former is paramount and must be satisfied by the Fed before price stability may be considered.
Former Fed Chairman Paul Volcker was able to ignore the explicit will of Congress with respect to full employment when he fought inflation more than three decades ago, but more recent Fed chairs have followed the single mandate of full employment to its logical conclusion, namely zero interest rates and the expropriation of private income. In 1973 the economist Ronald McKinnon coined the term “financial repression,” which describes various policies that allow governments to “capture” and “under-pay” domestic savers. Such policies include forced lending to governments by pension funds and other domestic financial institutions, interest-rate caps, capital controls, and other oppressive expedients.
In 20th century America...
Credit was used to increase sales today as opposed to forcing consumers to save sufficient cash to purchase, say, an automobile or home in the future. The judicious use of credit increased demand for goods and services, and employment. Contrast the model of General Motors (NYSE:GM) in the 1930s under Alfred Sloan, who understood the power of leverage, with the narrow-minded, cash-on-thebarrel head mentality of Henry Ford.
Ford is credited with being the father of the modern automobile industry in the U.S., but Sloan’s use of credit to finance both production and sales allowed GM to effectively operate with little or no working capital and thereby dominate the auto industry for more than half a century. By World War II, Ford Motor Co (NYSE:F) was so much smaller than GM that it was usually compared with GM’s Chevrolet division.
Today, however, the policy of using ever cheaper credit to pull tomorrow’s demand into the present day seemingly has lost its efficacy. With most nation-states unwilling or unable to use fiscal expansion to stoke short-term demand, global central banks acting alone have been asked to somehow address the burdens of global over-capacity, excessive debt, rising unemployment and slack consumer demand. We should be grateful to our colleagues at the Fed and other central banks for trying, but it seems clear that new thinking is needed when it comes to both monetary and fiscal policy.
Looking at Chart 1, it is important to recall that the period prior to the 1960s was dominated by World War II and the financing needs of the U.S. government, needs which the Federal Reserve system dutifully facilitated until the early 1950s by keeping interest rates artificially low. With the peak in nominal rates in the late 1970s, however, the Fed switched priorities and became focused on the single mandate of full employment.
This policy fixation on targeting at least nominal employment had significant costs, including a steady level of underlying inflation that has slowly undermined consumer purchasing power (thus, today’s discussion of “income inequality”). The single mandate of full employment also facilitated periodic financial bubbles and crises resulting from the manic swings in Fed policy.
Central to any new approach to monetary policy must be the realization that the secular decline of interest rates, which is the centerpiece of financial repression, necessarily also drives deflation. Today, the Federal Open Market Committee frets over whether to raise the benchmark rates for federal funds and bank reserves a mere quarter of a percentage point. Yet anyone looking at the bond markets and, in particular, at bond credit spreads knows that there is not yet sufficient demand for credit to justify an increase in interest rates.
Without a sustained increase in the yield on investment assets, the world faces a protracted period of low or no growth and the eventual destruction of public and private financial institutions that depend upon investment returns.
Just as many organizations used to rely upon the returns on investments to bolster profitability in particular, today the global economy is suffering from a diminution of income as a result of more than 30 years of financial repression. The trillions of dollars annually that is transferred from private organizations and individuals to public sector institutions via negative interest rates and quantitative easing (QE) ranks among the most regressive, anti-growth policies ever witnessed in peacetime.
Of course, we can look back to Keynes and the 1930s for inspiration in this regard. But we can also go back further, to the time of Jesus of Nazareth confronting the money changers in the Temple of Jerusalem. Our modern-day central banks seemingly are making the very same error committed 2,000 years ago by Annas the Elder, who hoarded his ill-gotten gold to avoid taxation until the Temple was destroyed by the Romans in 70 AD.
Central banks from the Fed to the European Central Bank (ECB) to the Bank of Japan are depriving the global economy of trillions of dollars in income and thereby fueling a diminution of private economic activity. As KBRA has noted previously, the short-term increase in asset prices achieved by QE is illusory if not confirmed by a commensurate increase in income. But instead, negative interest rates are causing income levels to gradually fall. It may seem counterintuitive, but the only way to reverse the current deflationary spiral and gradually restore income to the global economy is to gradually increase interest rates and focus the energy and attention of policy makers on restructuring excessive levels of public and private debt.
Consider the example of Europe
For several years, the ECB has courageously attempted to use a combination of QE and negative interest rates to address the problem of bad debts in EU banks. Today, the official figure for non-performing bank loans in the eurozone is 1 trillion euros, though we suspect that the actual figure is considerably higher. The enormous overhang of bad debts on the books of EU banks is an obstacle to credit expansion and growth, yet Europe’s political leaders lack the confidence and the fiscal tools to move in a purposeful way to address the problem of bank solvency.
KBRA believes that as the U.S. learned in the 1930s and 2008, any successful private solution to the challenge of recapitalizing insolvent EU banks must begin with state support. Yet German chancellor Angela Merkel has ruled out public backing for Deutsche Bank (NYSE:DB), one of the largest universal banks in Europe. Private investors do indeed want to participate in recapitalizing EU banks, but first they must be assured that the net asset value of these banks is accurately disclosed. As with the U.S. rescues of Citigroup (NYSE: C) and American International Group (NYSE:AIG) in 2008, only a government-led process of restructuring and recapitalization can successfully begin this necessary process and make private investors willing to participate.
Some observers believe that we are doomed to a future with low growth and tepid inflation. We believe that the future prospects are far brighter, but only if public leaders find the courage to restructure bad debts and restore income to the global economy by ending regressive policies such as negative interest rates and QE.
We all need to take a page from the U.S. response to the financial crises in 2008, the 1980s and even the 1930s. Prompt, decisive action will help to restore function to markets and financial institutions, and renew confidence among a resentful and uncertain public. As we noted in an earlier report, “the price of political inaction is an increased likelihood of financial contagion, a result that will only make the present global trend towards political radicalization accelerate.”