“Mervyn King: Should we stay or should we go?” (MoneyWeek) by Merryn Somerset Webb

What’s wrong with the eurozone

Lord King: They’ve ended up in a situation where some countries have very large trade surpluses like, Germany and others in southern Europe large trade deficits. And there’s no mechanism now for correcting the changing competitiveness which happened in the first decade of the monetary union.

Merryn: Well, there is a mechanism. They could break up.

Lord King: Well, one mechanism would, indeed, be to break up. There are others which is carrying on with the misery of high unemployment in the south and maybe eventually they would see their wages and prices fall by enough to restore competitiveness.

Merryn: Yes. There’s an idea that you can internally devalue enough to make it work.

Lord King: Yes. Exactly.

Merryn: But this always seems to us… and I think you’re a fan of Bernard Connolly as well, aren’t you? I see you thank him in your book.

Lord King: I think he’s one of the people who had tremendous insight right through the period before the crisis, as well as afterwards.

Merryn: Yes. We had an interview with him the other day where we talked about this at length and we talked about the, you know, the misery and the impossibility, really, of the periphery countries being able to internally devalue enough to get to the right place without there being massive political unrest along the way.

Lord King: Yes. And we tried it in this country in the 1920s when we went back to the gold standard, at too high a rate and that was where you can argue that we needed to adjust our wages and prices by 10%. I think the periphery countries need to do it by more than that now but even 10%, we in Britain could not manage in the 1920s and we left the gold standard and it was only after countries left the gold standard that they were able to recover following the Great Depression.

The dishonesty of EU governments and why monetary union can’t survive

Merryn: One of the things that you say in the book is that you think government have been very dishonest with their electorates about the way the Eurozone has to work. They haven’t told the electorates that the only way for the monetary union to work is for there to be a proper fiscal union and a supranational organisation above democracies?

Lord King: Yes, and, of course, as soon as they get close to saying something similar to that they realise that there is popular discontent with that proposition. And, indeed, it comes both from the countries that would be required to pay for those in difficulty, like Germany, where taxpayers show no enthusiasm for paying what would be a large proportion of their GDP to countries in the south.

But, interestingly, the opposition also comes from the potential recipient countries because they have no wish to have the conditionality that would be required to persuade Germany to make these payments. They have to have some control over the size of the transfers if they’re to be made and there is no legitimacy in any framework in Europe for making those decisions.

And it’s very surprising that the five presidents in Europe in their reports or more recently, the German and French Central Bank governors keep floating the idea of a finance minister for the euro area, who would have the power to set spending and tax decisions for each country within the euro area. The idea that people in Spain are going to accept that someone in Brussels or Frankfurt is going to set their taxes and spending, why on earth are they bothering to vote for a government in Spain if they can’t decide on what are the most important issues facing their country?

So I think that we’re a long, long, way from having a political union which people accept where there’s legitimacy and decisions to make transfers from some parts of the monetary union to others and that’s going to be required if they’re going to keep it together.

Merryn: But if you can’t have that, which, as you say, seems incredibly unlikely, it seems impossible that the monetary union can hold?

Lord King: I think that that is a reasonable conclusion. Now, it doesn’t mean to say it will fall apart quickly. I think governments are struggling to keep it together. At present it keeps going because there is very high unemployment in the south which means those countries have much smaller trade deficits than they would do if they were to get back to full employment and, as a result, they don’t need to borrow very money from the rest of the world.

But if they were to have a significant financing requirement from the rest of the world, then I think they would be in trouble because I don’t think people would voluntarily finance that without the belief that Germany would underwrite those loans, eventually. And that’s the thing which Germany has always been resistant to doing in any formal sense.

On what’s wrong with the eurozone (and Brexit…)

Merryn: Yes. You’re really not making it sound very attractive, the Europe Union, I must say.

Lord King: Well, I mean, I think the prime minister, if he were here, would say that he, himself, finds nothing attractive about the monetary union but that isn’t the issue we’re been asked in the referendum. The referendum is about the European Union not about whether we would be in the monetary union.

Merryn: No, but we’d still be attached to an area that is in some political trouble?

Lord King: There’s no doubt that the major problems facing the European Union are the euro area, for one, and, secondly, mass immigration from outside the European Union itself. These are the two existential challenges facing the European Union. And there is a debate about what is our long-term relationship with the continent of Europe. Unfortunately, the debate so far, in the referendum, has not really focused on that.

Merryn: Yes. I was concerned when I saw you saying the other day that you weren’t sure which way you were going to vote yet because you were waiting to get all the information. And I thought, good God, if the ex-governor of the Bank of England doesn’t have enough information to decide how to vote on something like this, what will become of the rest of us?

Lord King: Well, what we want are not PR statements about, you know, exaggerated claims about either the cost of leaving or the benefits from leaving. What we really want, I think, is to hear politicians say what their vision is of the role of the United Kingdom in Europe and that could be a vision inside the European Union or outside it. But what it does require is someone to say, what’s the long-term future of the United Kingdom and our relationship with other European countries?

But, these issues are not being discussed in that way. What we’ve been told is, whether it’s statements from the government or other people involved in the debate or all these letters being signed by various people telling us what to do, they’re all assertions. They don’t contain any…

Merryn: And these bonkers numbers. It’ll cost you this or gain you this, things like that.

Lord King: Absolutely. We have no idea. I mean, one of the interesting things is to look back to 1975, the referendum, which I remember then, about whether Britain should stay in the European Union. And what is so striking about it is that the claims made at the time, turned out to be exaggerated. It’s very hard, looking at what’s happened since, to argue that either staying in the European Union led to our economic renaissance of Britain or that if we had left, it would’ve been a disaster. It didn’t make an enormous difference.

Now, that isn’t to say there aren’t big issues about membership of the European Union. There are. But I think the idea that somehow it’s either going to be bliss if we leave or a complete disaster if we leave is a gross exaggeration.

Merryn: So it might not make much difference one way or the other in the in the medium term?

Lord King: Well, there are important questions. I think they are about the relationship between this country and countries in Europe. After all, we went to war – two world wars – because of what was happening on the continent of Europe. These questions are very important.

But I think that the exaggeration of the economic costs and benefits is not helping people because they can see through this. People are saying things because they want somehow to persuade people to vote for their side and what we want… I would like to see people on both sides acknowledge that the other side have good arguments because there are good arguments on both sides and that’s not a surprising position. This isn’t a straightforward decision. If it were, surely we wouldn’t have had a referendum in the first place or we would have left many years ago.

How to make things better – with the IMF

Lord King: It’s very hard to know how it will end. What I do know is that monetary policy and monetary easing is not going to be the answer to get us back to a sustainable recovery. So I think one of two things are likely to happen. One, is that we will see over the next few years, decade, significant debt defaults as we’ve failed to adjust the big disequilibrium in the world economy and in our own individual economies, or politicians will come to realise that monetary policy has done all it can do, it’s bought time which they haven’t yet used but they will now start to use it.

Merryn: Do you think they haven’t realised that? I mean, I think, surely, politicians and central bankers have realised that they’ve gone, pretty much, as far as they can with monetary policy. It’s just that they don’t know what to do next?

Lord King: Well, there’s no shortage of things that they’re being advised to do but there isn’t the political will to do it. I do think that one of the problems coming out of the post-war type of economics, where economists wanted to be like physicists with very precise models that explained how the world worked, is the belief that if we just wait long enough and have enough monetary stimulus then the head winds in the phrase which is holding back recovery in the world, will go away and then everything will be fine.

Merryn: Everything will be fine. It will be unblocked, somehow.

Lord King: Yes. Exactly. And I think this is a serious intellectual mistake.

Merryn: OK. And why is that?

Lord King: Because we are in a disequilibrium in terms of the real economy. Some economies have saved too much and spent too little. Germany and China are the obvious, biggest examples of the countries like that.

Merryn: Yes. So these are the countries whose exchange rates have been fixed at too low a rate, effectively?

Lord King: Yes. And, one, because the strategy was to rely on export-led growth which was not a crazy thing to do when they started on this path but because China became such a big economy so quickly, then this was having major implications, not just for the world but for them too.

Merryn: And this was just an ordinary mercantilist attempt to follow in the footsteps of Japan and Korea, etc.

Lord King: Absolutely.

Merryn: It’s just that on this scale it causes imbalances on a different scale.

Lord King: Exactly. And I think people in China completely understand that but now they’ve got this terrible problem of knowing how they are going to shift resources from the export sector to the domestic demand. Can they do it in a timescale that makes sense given what the rest of the world is doing?

So far, they’ve shifted very few resources from the export sector to the domestic demand sector. They know they have to do it but, just like Western politicians, they’re naturally very conscious of where the jobs would be lost but they can’t see where the jobs would be created.

Merryn: Yes. And it’s very difficult to say. I mean, Japan never really did it successfully, did they? I mean, there was a lot of talk back in the 70s about Japan shifting from an export-orientated model to a services model and they never really quite got there.

Lord King: No, they didn’t. And it requires the willingness to make big structural reforms and to give up this pretence that fixed exchange rates are a good thing. And I think one of the challenges we face now it that, because the world economy as a whole is pretty weak, almost every economy could say, you know, if only the rest of the world was growing normally, we’d be fine.

Merryn: Yes, but it isn’t.

Lord King: But it isn’t and so we aren’t so what should we do instead? Why don’t we just temporarily – not permanently, of course – but temporarily push our exchange rate down? And so you see economies from Australasia to Japan through Asia to now, very much, the euro area, relying on trying to push down the exchange rate in one form or another.

Merryn: Everyone is just trying to steal little bits of everyone else’s growth, right?

Lord King: Yes. And the country that lost a bit from this is the United States, which has held back their recovery hence they now are concerned about the strong dollar.

But this is a zero-sum game and what we need to recognise is that cooperation should take the form not of going back but to, sort of, target zones for exchange rates, which would be a serious mistake but should take the form of accepting movements in exchange rates brought about by markets but cooperating in terms of a, sort of, plausible timescale over which we would take the measures which would vary from one country to another to correct the this disequilibrium between spending and saving in our economies.

Merryn: Just to clarify what I meant for readers earlier when I said they’re simultaneously too high and too low, rates are too low for there to be a proper balance between spending and saving and too high to stimulate investment in any way.

Lord King: Yes. Absolutely, and we got stuck in this position and one of the reasons it grew as a problem before the crisis and is still a problem today, is that it’s quite hard for any one country to know how to get out of it on its own because if you were to take measures that would, you know, as we tried to in 2010, would slow the growth of domestic demand, unless the rest of the world is growing normally, exports don’t take up sufficient slack to enable you to get back to full employment and have growth on the scale that we ought to be expecting after such a big downturn in 2008/09.

And so countries are reluctant to take that risk because they don’t know what the rest of the world is going to do. Somehow, we need to create a type of cooperation that reassures countries that we’ll all do our bit, even though that’s going to vary from one country to another.

Merryn: And this, you suggest, is led by the IMF, right?

Lord King: Well, it’s the one body that ought to be able to do it. Unfortunately, I think the IMF has become associated far too much with the political projects of monetary union in Europe and that has damaged its credibility in the rest of the world and I think some of the hangover from what happened in the Asian financial crisis.

The fact that the Europeans were deeply sceptical about the scale of lending by the IMF to Latin America and Asian economies and then when it became their turn to need IMF money, when the euro area got into trouble, there was no compunction on borrowing from the IMF on a much bigger scale.

Merryn: A much bigger scale.

Lord King: A much bigger scale. And I think this has created a certain degree of cynicism in the rest of the world about how the IMF behaves. And I think this is deeply unfortunate because I don’t think we’ll be able to create another institution.

Merryn: Yes, because if not the IMF, who?

Lord King: Well, I think there will not be global cooperation absent the IMF playing a stronger leadership role and it needs, probably, to change so many of its policies in order to be able to do that. I think there are certainly developments of cooperation within continents.

I mean, I think many of the new institutions created in Asia mean that the IMF will have much less of a role to play in Asia. But since many of those economies do need to make the same adjustment from exports to domestic demand, that isn’t going to help us very much.

Merryn: OK. So using the IMF to recreate flexible exchange rates is going to be tricky. The other thing – well, there’s several other things you suggest. One is working harder to improve productivity.

Lord King: I think in the end this is going to have to be – I know it sounds like motherhood and apple pie – but a sustained programme over ten years to improve the efficiency of our economy, would have the effect of leading people to believe that they genuinely would be better off in the future. Not immediately.

Merryn: Yes. But there’s a lot of talk about the productivity puzzle. They’re endlessly talking about it as a puzzle?

Lord King: Yes.

Merryn: Do you think it’s a puzzle or do you have a sense of why productivity is so low?

Lord King: Well, I think it’s hard to… Well, I think the question is what, sort of, computer models do you use to make these judgments? I think two things have happened. One is that in the immediate aftermath of the crisis, the banking system, understandably, was deeply reluctant to lend and that hit, particularly hard, new businesses so that innovation coming into the economy was probably held up for a while.

I think since then what’s happened is that one of the consequences of very low interest rates is that it persuades people to spend today rather than tomorrow. And, of course, what happens is, as time goes by, the tomorrow becomes today and you have to do even more.

What you’re doing as you engage in that process of continually easing monetary policy, is to create more and more concern that future demand will be weak and that lowers investment. And I think what we’ve done and what we’ve seen in the post-crisis period is very weak investment and what people have done is to say, well, rather than invest in capital equipment, we’ll hire more labour because we know that if there is a downturn coming towards us we can get rid of the labour quickly whereas we don’t want to be encumbered with a lot of capital equipment that turns out to be not very valuable.

Merryn: Yes. Do you think there is also an interplay, particularly in the UK, between productivity and the welfare system in the way that, particularly, our tax credit system encourages people to work part-time?

You know, I was very, very struck earlier this week when McDonald’s, which, as you know, is always criticised for its zero-hours contracts, announced that because everyone had their knickers in such a twist about the zero-hours contracts, they would introduce fixed-hour contracts. And the fixed hours that they offered people were 16 hours or 30 hours and, as you know, those are the number of hours that open the gateways to tax credits, depending on whether you’re in a couple or not in a couple.

And I looked at that and I thought, well, there it is laid bare, the interaction of the low-wage economy and the welfare system. And that has got to have an impact on productivity because you can argue about it endlessly but I think instinctively we know that a nation of part-time workers is probably less productive than a nation of fulltime workers.

Lord King: Yes. And it’s putting in artificial constraints on people’s choices about hours to work and hence the occupations that they may go to. And there’s no doubt that this interaction is important and, in fact, when tax credit systems have been introduced around the world, one of the concerns has always been that employers would work out how to make the taxpayer pay for a good deal of the effective wage.

Merryn: Which they clearly do.

Lord King: And the employers are sensible and they are smart and they can work out what kind of…

Merryn: And employees are sensible.

Lord King: Absolutely.

Merryn: I mean, this is not irrational.

Lord King: No.

Merryn: It’s entirely rational for McDonald’s and its employees to work together to define the hours that work for people to have the best possible incomes and lifestyles. So it’s not a criticism of their rational choices but it’s certainly a criticism of the system.

Lord King: Yes, and one the reactions of governments has been to keep pushing up the minimum wage to prevent employers offering wages and hours contracts that, you know, exploit the system of benefits with which they’re confronted and the difficulty there is that if you have that at too high a level, again, you are restricting the likely supply of jobs to people who would want to come in.

Merryn: Yes. So we’re ending up with bad policy on bad policy on bad policy which is pretty much the way policy normally works.

Lord King: No, indeed. Well, not always. I mean, I think that, you know, here’s a policy suggestion that I think ought to be manageable and would have real benefits which is that the Trade Round – known as the Doha Trade Round – which really got completely stuck in a rut because the major emerging market countries didn’t want to make further progress on agriculture, I think what the advanced industrialised economy should do, since they were the part of the world that had the financial crisis, is to say, well, we’ll now have conversations among ourselves with the industrialised world and sign new trade agreements focused on services.

And, indeed, the United States has proposed this, both with Asia and with Europe, and we need to make much faster progress on this because one of the things we learnt after the Second World War was that the expansion of trade is a real boost to productivity growth. People discover new products, new ideas, new processes. It stimulates thinking about how to improve what they’re doing.

Merryn: Gets competition going.

Lord King: Competition. And it enhances productivity growth. And I think that one of the things that would be completely manageable now would be to say, well, we really want to do this. This is something we have to do, and start to have serious discussions to free up trade and services and if we could do that then that would boost, you know, the supply side of the economy. And that would, in turn, lead people to believe, yes, maybe I will be better off in the future than I previously thought.

And if that’s the case they’ll be less concerned about repaying debt too quickly, more likely to spend today, and that will help bring about the sort of recovery that we want and with higher productivity growth, that recovery will then be sustainable.

The lack of real investments for ordinary people

Merryn: Do you think that there are any safe investments at the moment? I’m having an argument with another FT columnist at the moment who tells me that I’ve been complaining about low interest rates and the distortionary effects of them on saving and spending behaviour, etc, and he sent me an email saying that, my problem was the belief that people are entitled to a return on their savings, and they’re not. I take his academic point but I think that it’s very harsh.

Lord King: Well, I think that’s far too harsh because I don’t think that a market economy that’s in any healthy state shouldn’t… There must be opportunities to invest at positive, real interest rates. Now, they don’t have to be, you know, particularly high, 3% or 4% after inflation.

Merryn: That would work for me, I can tell you.

Lord King: No, well, I mean, that used to be the norm for 150 years, probably very much longer and, on that basis, it is possible to say, there is an incentive to save for retirement and also, interest rates at that level plus once you start to think about risk, the required rates of return on investment projects, it then becomes an effective discriminator between good projects and bad projects.

Merryn: Yes. But where is that place for the ordinary investor? You know there was, in one of your Bank of England quarterlies back in 2011, there was a terrifying chart that has always stuck with me about the Bank of England, the expectations for Quantitative Easing and it showed how nominal asset prices would soar above real GDP growth and then as QE was sterilised, reversed, whatever, nominal asset prices would, sort of, collapse right back down again, pretty much to run along with the GDP.

And so, you know, I keep thinking about that chart and, of course, that day, one way or another, will come to when the great asset boom caused by phenomenally loose monetary policy, will come to an end and that, presumably, will be before I retire as a double whammy. So what is safe for a saver today?

Lord King: Well, there are safe assets in the sense that you could invest in index-linked gilts or government assets. They will repay what they claim to be offering you. The trouble is they’re not offering very much and it doesn’t give you a high return and one of the difficulties of very low interest rates is that people are tempted to take risks that they wouldn’t otherwise have taken because of the promise that they might get a higher rate of return.

But it’s risky and if the risks materialise then you lose more than the lost opportunity of a higher return, you lose much of the capital as well.

Merryn: So all your money is in index-linked gilts?

Lord King: So I’m very fortunate to have a pension scheme from the Bank of England. And this is not a moment to, you know, to believe that there are easy investment opportunities out there.

Merryn: So you’re not planning on switching your final salary into a defined contribution and then going out and doing a buy-to-let portfolio?

Lord King: I’m certainly not. I have a defined benefit pension which I receive and I shall carry on receiving that so I’m not going to take risks with that.

Merryn: We often hear from readers who are keen to take out their pension money to start buy-to-let portfolios but we suspect that’s not a rational response to the environment?

Lord King: Well, it is very unfortunate that people think that there is some opportunity out there. They don’t really understand that someone has told them that they can make a lot of money by investing in a different opportunity and, of course, when you’re faced with, effectively, zero interest rates, the temptation… you want to believe that there is something out there.

Merryn: But there should be.

Lord King: But in a healthy economy there would be.

Should rates have been cut before the crisis?

Merryn: Rates? Would you set rates differently?

Lord King: Well, I discussed this in the book and I think the problem is to know what the counterfactual would have been and we did, in fact, discuss quite a lot on the Monetary Policy Committee, whether it was sensible to have low rates in order to maintain adequate demand in the economy because, you know, we did debate the idea of raising interest rates to try and shock people into spending less at home with the hope that this will bring down the exchange rate and replace the lower consumer spending with higher exports.

But if we were the only country to do that, the chances are that by putting up interest rates rather than the exchange rate being shocked to a lower level, it might actually have risen, exacerbating the problem. I think only if countries could have cooperated together, could we have been sure that they would have worked.

And that failure to cooperate, I think, was part of the reason why countries kept on cutting rates to boost their own demand and, in fact, when everyone did that, it just made the whole problem worse.

The next crisis – and how to really create inflation

Merryn: Second question. Second important one is, it seems to me inevitable, even more inevitable now we’ve had this conversation, that there is another crisis coming. It seems unavoidable because your suggestions as to how we should avoid another crisis, while they would clearly work, I can’t see it really happening. Again, you saw it. I feel another crisis coming. What starts it? What do we watch for?

Lord King: I think the first signs of it will be the inability of borrowers to repay their debts. We’ve seen it recently in China with state-owned enterprises. We’ve seen it already in many cases in the Euro area, Greece being a good example but there are other potential sovereign borrowers who might find it difficult to repay and there are many banks that might find it difficult to repay.

So, if you add to that the problem of quite a lot of smaller emerging market economies that have borrowed, again, in US Dollars and have a currency mismatch between their borrowing and their lending and then you look again at the BRICS where this acronym which ten years ago represented the major emerging market economies Brazil…

Merryn: So dynamic and exciting back then, wasn’t it?

Lord King: Dynamic, exciting, the future will guarantee global growth. With the possible exception of India, they are all in bad shape, politically and economically. So the world is not in the sort of place that when we sat round the table in Washington in October 2008 and said, we will do what we have to do in monetary and fiscal policy and to ensure the financial system doesn’t fail, no one round that table thought that eight years later we would still be in a position of desperately having, you know, zero interest rates, negative in many countries, large amounts of quantitative easing, money creation.

And we did not believe that eight years on we would have failed to generate a world recovery. But that’s been the case and I think a non-economist would react to that by saying, well, I don’t really understand economics but surely monetary policy can’t therefore be the answer. And it’s only economists that seem to think it is.

Merryn: It is. Interesting. I know I said there were two more questions. There’s one tiny one. I also know you have to go but what about a big wave of debt forgiveness and I am sure you’ve read Adair Turner’s book and, for him, it’s so simple: one stroke of the pen, all the debt with the Bank of England is gone, the debt to GDP ratio collapses and we spend our way out of trouble.

Lord King: I don’t really understand how this can work. The money creation, whether it is in the conventional form of the central bank buying government bonds or whether it’s in the form of governments printing money and handing the money over to citizens…

Merryn: That’s the bit I’m hoping for. Vouchers.

Lord King: So the question is, is this really going to make you any better off? You will know the economy is no better off. I mean, there’s no productivity gained by just printing pieces of paper.

Merryn: And you will know that it’s not real money.

Lord King: And it’s not real money. And it’s actually identical to the idea of the government, today, cutting people’s taxes and selling bonds to finance that but selling it to the central bank which creates money. So we are already doing this. The real difference, I think, would be if people believe that the objective of printing money was something that was not being undertaken by the central bank – an independent central bank committee, to broad stability, but was being done deliberately recklessly, irrespective of the consequences for inflation.

Now, if that’s the idea which is to create people’s fear about future inflation, there’s a much simpler way of achieving this objective which is to abandon and abolish independent central banks and give politicians the power to set interest rates because I absolutely guarantee that the best way to raise inflation expectations would be to say that from tomorrow morning all decisions on interest rates will be taken by elected politicians and not independent central banks.

The best way for central banks to destroy their reputations

Merryn: I worry that’s a risk though, now we’ve been through of all this, you know, you could say, that central banks have lost an awful lot of credibility. People no longer believe in central banks and central bankers in the way that they used to. So they wouldn’t kick up at a change of policy like that in the same way they would have even three, four or five years ago, right?

Lord King: Well, certainly there is a concern in the United States that the Federal Reserve went beyond its mandate in the crisis. But I think, I mean, we, very carefully in the Bank of England, refused to go beyond our mandate. Politicians were often deeply unhappy about that. But we did not do things that we thought were equivalent to fiscal policy because they ought to be undertaken by the elected government.

Merryn: Quite right. Yes.

Lord King: And, I think that the risk to central banks is not that people will lose faith in them because of what they’ve done so far but if central banks were now to go further and do things which are, in effect, fiscal policy so some of the suggestions that the European Central Bank would buy private sector assets, for example, they would only do that because governments seem incapable of working together in the euro area to make a success of it.

But once the central bank inserts itself as a player like that, it’s moving away from a technical independent central bank, into a political actor and that is the way to lose your reputation.

Interview with Russell Napier


Russell Napier, an independent strategist and market historian, likes to challenge investors’ comfortable assumptions. Based in Edinburgh, Scotland, he spent two decades as an equity-market and global-macro strategist at CLSA, the Asian brokerage, and now publishes a global macroeconomic and strategy report, “The Solid Ground,” on ERIC, an online platform he cofounded for investment research. He also created the Library of Mistakes, a financial-history library in Edinburgh, that he plans to replicate at universities around the world.

Napier has been bearish since 2011 on equities and commodities, and expects deflation to hit developed markets. He recently shared with Barron’s his views on the coming Brexit referendum, China’s currency, and today’s financial mistakes.

Barron’s: Britain will vote on June 23 on whether to leave the European Union. How do you expect the so-called Brexit vote to go?

Napier: It is too tight to call. The most important thing is that the move to a federal Europe is a massive constitutional change, which at some stage will need to be endorsed by the people of each sovereign state, usually by referendum. It is silly to believe this issue is just a United Kingdom thing. Look at polls all over Europe. People are voting for anybody who, whether on the extreme left or right, wants to maintain the sovereignty of that particular state within the European Union. That is completely contrary to the ability to have a functioning euro.

This is round one. The most important referendums will be those in the euro countries. I expect referendums in places like Finland, the Netherlands, and even Italy. European legislation is forcing Italy into a form of bank recapitalization, which won’t work and is bad for the Italian economy. Italy will move up the agenda quickly.

If the U.K. votes to leave, will Scotland push for independence again?

If Scotland votes to stay in and England votes to leave, there might be another referendum on Scottish independence. The problem would be that Scotland voted for something different previously, when it said it would continue to use sterling and wouldn’t have a border. If the rest of the U.K. is out of the EU, and Scotland wants to stay in, there would have to be a border. It would be difficult for Scotland to use sterling. If Scotland voted against independence last time, the Scots would really vote against it again. The shock and dislocation of having a border and passports, of not having sterling, are so big.

With several potential votes ahead, what is the outlook for markets?

The most important thing for investors would be exchange controls. If a member of the euro zone had a referendum on leaving the EU, temporary capital controls to protect financial stability would be politically justifiable. The dislocation associated with the speculation around the referendum would be huge. Provisions in the European treaties allow exchange controls under extreme circumstances.

The bigger picture is that open-end funds are facing greater illiquidity in their underlying instruments. There are $37 trillion of assets in open-end funds globally. Will politicians put up barriers to the free movement of capital, which would paralyze sections of the financial-services industry?

You recently wrote a report on policy singularity. What does that mean?

I invented the phrase to refer to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in [former Federal Reserve Chairman Ben] Bernanke’s famous helicopter speech. Briefly, the steps [taken by the Fed] included quantitative easing; effectively pegging the yield curve; providing forward [rate-hike] guidance; putting up the inflation target; and foreign-exchange intervention. The Bank of Japan has run through the entire range of Bernanke’s recommendations apart from the last one, which he calls helicopter money. [In a 2002 speech referring to the possibility of monetary-financed tax cuts, Bernanke referenced the late economist Milton Friedman’s assertion that a central bank could create inflation and economic growth by dropping money from the sky.]

Once the central bank runs out of ammunition, it turns to the government. In Japan, there will be open ears. If we all woke up one morning and every major developed nation undertook policy singularity, you’d have to believe in growth, inflation, and reflation. But if one country does it unilaterally, like Japan, what you’d get is a precipitous decline in the yen. While the Fed is struggling to create money and the Europeans aren’t creating any, the Japanese central bank/government can create as much as it likes. That would imply dislocations for China, Germany, and other markets. It could put a lot of countries in trouble.

How would helicopter money manifest in Japan?

It wouldn’t be about building more roads and bridges, but about [boosting] consumption. It would be along the lines of the government announcing that everyone in Japan with a child under 10 will live tax-free. The instant ramification would be much higher forecasts for the fiscal deficit, which would be funded by the central bank printing money. This puts money in the hands of people who might consume—people with children under age 10.

Did you know that Japan has a ministry for population growth, whose job is to drive the birth rate higher? Japan has tried everything else. If they have to go to the final step, they are prepared for it. I would be confident forecasting that the yen will be lower than 130 to the dollar within 12 months. [It was 105 last week.]

What other countries will adopt policy singularity?

Helicopter money is a long way off in the U.S. When it does come, it would be for building roads and bridges. In Europe, I can’t see how the banking system is robust enough to translate European Central Bank monetary policy into expanding balance sheets with more credit and more money. When the politicians are aligned with the central bankers, that is the end of independent central banking. It begins in Japan but it will spread.

You famously predicted the Chinese yuan will fall 20%. Lately it has held steady against the yen. What happens if the yen falls, as you expect?

The yuan’s price is the most political price in finance. China’s monetary response to economic slowing is constrained by its exchange-rate policy. If credit and monetary-policy growth rise to the levels required to sustain China’s debt-fueled growth, then the exchange-rate target can’t be sustained. If money growth rises to historical highs, it is reasonable to expect an exchange-rate adjustment of 20% or more. A fall in the yen is the perfect cover story. China could say, “Look, what do you expect us to do?” If the yen started falling, the yuan would follow, though not until after the U.S. presidential election. They would be too worried it would produce a Trump presidency.

What will the Fed do next?

The Fed’s hesitation to move interest rates higher reflects their understanding about the fragility of the global monetary system. On the national-income and product-account data, corporate profits are weak. Capex [capital spending] is beginning to slow, not that it was ever robust. Then you had that jobs number [the U.S. created just 38,000 jobs in May]. It is exceedingly worrying if you begin that slowdown process with interest rates close to zero.

I am not saying [Fed chief] Janet Yellen is completely out of bullets. She’s not in the same place as Japan or the ECB. But she has long conversations with [International Monetary Fund chief] Christine Lagarde, who has been warning everyone how fragile the global system is. She sees real distress in commodity producers. Yellen hasn’t been more aggressive in raising rates for reasons including China and Brexit. And [Japan’s Prime Minister Shinzo] Abe told the G7 that the world was on the verge of another Lehman Brothers crisis. Any interest-rate increase is more likely to be in 2018 than 2016. 

As the author of the book Anatomy of the Bear, you have some expertise in forecasting the stock market. What do you predict?

In a world where there is growth and inflation remains between zero and 4%, you get high valuations for equities. The current cyclically adjusted P/E ratio of 26 is high, but not exceedingly high. It could go even higher. The most damaging and dangerous thing for the equity market is deflation, because it means falling cash flows; if you have a lot of debt and can’t pay it, equity gets wiped out. Deflation often comes with credit distress. The market falls quickly, whether in 2007-2008, 1928-1929, or 1919-1921.

The market remains high today, but I see global growth falling and trade looking bad. We might slump to a recession with deflation. Markets move quickly when there is a credit distress because assets disappear. We saw that with Lehman. In the past two years, many borrowers have been in distress globally. I have long thought emerging-market debtors are the weak link, because they were borrowing in someone else’s currency. I still believe the stock market has to go below its March 2009 levels.

What do you make of the U.S. presidential election?

The presumptive Republican nominee, Donald Trump, is an arch-pragmatist, despite making ideological noises. If Hillary Clinton wins and the Democrats retake Congress, then the U.S. is much closer to helicopter money.

What asset classes do you like?

U.S. 30-year bonds; Singapore government debt, which yields slightly more than U.S. government debt; gold; and Japanese equities hedged into the U.S. dollar. When helicopter money happens, every investor in Japan will ask, “What the hell am I doing holding bonds?”

You founded the Library of Mistakes. What are some of the big ones being made in finance?

Many mistakes reflect overconfidence. The biggest financial mistakes are ones that bring down whole banking systems. We just had one built on the belief that U.S. residential property could never come down. The biggest mistake today is so-called macro-prudential regulation. For example, the U.K. just passed a law that will restrict a commercial bank’s ability to make mortgage loans based on the edict of the central bank. It is state intervention in the allocation of capital. It is capitalism with Chinese characteristics.

The job of a central banker is to set the price of money, and align the system to allocate credit and capital. Macro-prudential regulation is a return to the credit controls of Richard Nixon. Finally, in the U.S. today, there is the belief excessive leverage doesn’t matter because interest rates are so low. That isn’t true. The secret now is to degear, delever, and prepare for some bargains as things get cheaper. And if we get helicopter money, you have to reverse and regear.


“Negative interest rates are a calamitous misadventure”

Ambrose Evans-Pritchard, Telegraph.

When the debt-laden world faces the next global downturn, it will need the full power of helicopter money, not interest rate gimmicks

The world’s central banks should take a deep breath and step back from the calamitous misadventure of negative interest rates.

Whatever theoretical profit can be mined from this thin seam, it is entirely overwhelmed by the slow ruin of the banking system.

Huw Van Steenis, from Morgan Stanley, calls negative rates (NIRP) a”dangerous experiment” that undermines the mechanism of quantitative easing rather than reinforcing it, and ultimately induces banks to shrink their loan books – the exact opposite of what is intended.

The market verdict on the Bank of Japan and the European Central Bank speaks for itself. Bank equities have crashed by 32pc in Japan and by 26pc in the eurozone since early December.

“Financial markets increasingly view these experimental moves as desperate,” said Scott Mather, from the giant bond fund Pimco.

The policy blunder is creating a false fear that central banks have run out ammunition. It is distracting attention from the real failings of the global policy regime: lack of willingness to launch a New Deal and inject money directly into the veins of the real economy through fiscal stimulus when needed, and arguably to do so with turbo-charged effect through central bank transfers rather than debt issuance.


STOXX® Europe 600 Banks


Narayana Kocherlakota, ex-head of the Minneapolis Federal Reserve,reluctantly backs NIRP as deep as -3pc but calls it a “gigantic fiscal policy failure” that central banks must resort to such absurdities.

Roughly $7 trillion of debt is trading at negative rates. Western states can borrow for next to nothing until the 2030s, yet they refuse to repair their crumbling infrastructure and invest in their future dynamism from fear of fiscal deficits.

Mr Kocherlakota wants it done by old-fashioned borrowing. If you are worried about high debt ratios it can equally be done by “helicopter money”, a plan proposed by Adair (Lord) Turner at a forum of the International Monetary Fund in November.

Let me be clear, I think the market ructions of recent weeks are a false alarm. We are not on the cusp of a global recession, and it is a first-order fallacy to suppose that a glut of cheap oil is bad for growth. The Atlanta Fed’s instant tracker of US growth for the first quarter has jumped to 2.7pc. China’s broad credit to the real economy reached a 33-month high of 14.6pc in January.

Global recessions typically begin when the world economy is running at 2pc above its natural speed limit, as you can see from the Pimco chart below. This forces the authorities to jam on the brakes to prevent overheating. We are nowhere near this level today. IMF data suggest that the global “output gap” is -1.2pc, leaving masses of headroom.



Yet this year’s tremor is a foretaste of what to expect when the current global cycle really does sputter out – perhaps in 2017 – and we face the post-QE reckoning and the end of the China bubble with worldwide debt levels some 36pc of GDP higher than during the Lehman boom. Historically, it takes 300 to 500 basis points of rate cuts to break the fall once a global recession sets in, and that we do not have.

The Bank of Japan and the ECB appear determined to double down with even deeper negative rates over coming weeks, even though critics warn that NIRP is entrenching the deflation-trap by pulling down long-term bond yields and jamming the signalling system of financial markets.

They have already pulled away the trap floor on long-term bond rates, inadvertently causing a fresh rush into these safe-haven assets as funds sniff the prospect of much lower yields. Japan’s 10-year rates fell below zero last week. This is hardly the way to arrest the deflation psychology of the Japanese people.

The distortions are now grotesque. The one-year euribor rate used in Spain to price floating mortgages (98pc of the total) is -0.012pc. This eats up the net interest margins of banks since they dare not charge depositors a fee, not yet at least. “It’s not healthy, it’s not sustainable, it’s mad,” said José María Roldán, head of the Spanish Banking Association.


Damage to bank earnings from each 10 basis point cut in rates

The German Council of Economic Experts said negative rates are devastating for German savings banks, Landesbanken and credit cooperatives, which rely on interest income for almost 80pc of total earnings.

Morgan Stanley said that once negative rates fall below 0.2pc, the damage to bank earnings goes “exponential” and ultimately endangers the whole system of free banking in Europe that we take for granted.

The policy is a tax on excess bank reserves and “effectively a tax on QE itself”. The more the ECB steps up QE, the more it increases those excess reserves and the greater the burden on banks caused by negative rates. The construction is becoming absurd.

Worse yet, negative rates are a creeping threat to civil liberties since the only way to enforce such a regime over time is to abolish cash, for otherwise people will move their savings beyond reach. Mao Zedong briefly flirted with the idea during the Cultural Revolution in his bid to destroy every vestige of China’s ancient culture, but even he recoiled.

The eurozone already plans to eliminate the €500 note – allegedly to hurt organized crime – and from there it is a slide down the scales to notes in daily use and then to curbs on quasi-money.



It is a step to Franklin Roosevelt’s gold embargo and Emergency Banking Act of 1933, when Americans were ordered to hand over their bullion or face 10 years in prison.

One policymaker in Davos this year let slip that drastic action to scrap cash would be needed to fight a decade-long war against “secular stagnation” once rates test the limits of -1pc or -2pc.

The Bank of England’s Andrew Haldane floated the idea in a speech last September, suggesting that central banks may have to take radical action to circumvent the constraints of the “lower zero-bound”.

Mr Haldane said NIRP reinforced by electronic money is a safer course than going down the “most slippery of slopes” by printing money to cover government spending.

Here he is wrong. As Lord Turner argues, there is nothing inherently more slippery about direct monetary financing of fiscal stimulus than any other crisis measure. “Everything we are doing is risky,” he says.

One can hardly claim that chronic use of QE to inflate asset prices and to stoke more credit is sound practice, or socially just.

A monetary policy committee can calibrate what is judged to be the proper level of debt monetisation needed to avert deflation in exactly the same way as the MPC or the FOMC calibrate interest rates.

The money creation must be permanent to avoid “Ricardian Equivalence”, where people anticipate that more spending now merely mean more debt in the future.

All debt accumulated by central banks under QE should be converted to perpetual non-interest bearing debt, and preferably burned on a pyre in public squares to the sound of trumpets to drive home the message that the debt has been eliminated forever. This will pre-empt the panic that might occur among investors and politicians should public debt ever cross some arbitrary totemic level.

Any New Deal should be funded in the same way – partly or in whole – with the same vow that the debt will never be repaid. The money creation should continue at the therapeutic dose until the objective is achieved.

There is no technical objection to this form of “fiscal dominance”, as monetary guru Lars Svensson told the IMF forum. All that is missing is political will.

Needless to say, the eurozone cannot venture down this path. Maastricht prohibits the ECB from overt financing of deficits and any such thinking in Frankfurt would lead to a court challenge and destroy German consent for monetary union. This augurs ill, because they will need it.

Thankfully, those of us with our own currencies, central banks and fully sovereign governments always have the means to prevent the collapse of nominal GDP and to avert debt-deflation. We can run out of wit: we can never run out of monetary ammunition.

“We Need the Pain that Comes with More Saving”

 C. Jay Engel, Mises Daily

The endgame of monetary side manipulations is upon us. Since 2008, central banks have done what they thought was needed to bring the markets back from the pain they experienced during the crash. The problem, of course, is that these Keynesians and Monetarists placed the high level of stock markets as the goal of “policy” and confused booming asset levels with economic growth.

The enemy of prosperity, in the eyes of global economic policymakers, is the desire of the consumer to save and  businesses to refrain — even in the short term — from investment. As such, their “solution” was the very poison that has infected the Western world over the decades: more credit, lower costs of money, more push for “consumer demand.”

The Current Orthodoxy Is Failing

But “easy” monetary policy has merely led to debt-ridden economies and a bubble that is increasingly being exposed as a complete farce. January saw a market pullback tease that reminded investors that what was pushed up artificially can’t be sustained forever. Monetary policy, even if it goes to negative interest rate territory with a vengeance, isn’t going to be the miracle drug needed to provide a better economic foundation. Austrians have long known this. The mainstream is just starting to publicly admit it.

The Savings-Glut Myth

However, the right lessons are not being learned by either the economic policymakers or the financial pundits. In fact, the most dangerous economic fallacies still underlie their entire financial worldview. For instance, there is the ever-constant theme that there is a “glut of savings” and that low consumer demand is the chief villain that stands opposed to economic stabilization. Martin Wolf, writes in The Financial Times:

that the global economy is slowing durably. The OECD now forecasts growth of global output in 2016 “to be no higher than in 2015, itself the slowest pace in the past five years”. Behind this is a simple reality: the global savings glut — the tendency for desired savings to rise more than desired investment — is growing and so the “chronic demand deficiency syndrome” is worsening.

The proper economic way of thinking does not blame the economic pain on savings, nor does it desire an artificial, government-driven, attempt to coax people into consuming and “investing.” In fact, the economic reality of the situation is that savers are to be praised, not admonished; and that the refraining from consumption is the very means by which malinvestment can be most swiftly liquidated.

For the Austrian-school thinkers, the collapsing of the bubble that results from people “hoarding” their money and refusing to purchase over-priced “assets” is the precondition for future economic growth. This is because it is the bubble, not the bust, that is the problem. The bubble is the time of malinvestment and mismatch between consumer time preferences and resource allocation that results from the artificial expansion of the supply of money. It is the falsification of interest rates that encourages investment into areas that the economy is not prepared to handle. And while in the near term the bubble appears as prosperity and good times, it is actually the very seeds of destruction being sown. It is this piece of the boom-bust cycle that is destructive and impoverishing. The bust is merely the needed adjustment that gives society the wonderful opportunity to “start over” and do it right this time. Unfortunately, we never actually get to do things right, because the economic bureaucrats in our unfree-market system fear the bust more than the boom. They have it all backward!

How Saving Heals the Problems Caused by Bubbles

So then, the so-called “global savings glut,” has the economic role of encouraging the readjustment of capital asset prices back toward their proper levels. The refusal to participate in the bubble, it is true, is harmful for the overvalued stock market levels worldwide. But what the mainstream does not understand is that overvalued stock market levels is a result of the underlying rot in the system itself. The pain to be experienced in a collapse will surely shock an entire generation of unprepared retirees, especially those relying on pension levels which are tied closely to stock market performance in the near to medium term.

But if the economy is ever going to slough off generations of central bank-induced malinvestment, if the economy is ever going to shift to a proper and sustainable foundation of capital accumulation, if future generations are going to live in a truly prosperous world, the pain is unavoidable. Propping up the markets and encouraging misguided consumption and malinvestments will be the death blow to western civilization. Only near-term pain can allow long-term growth. Economic savings are the cure, and to be welcomed with open arms.

“Bearishness Is Strictly For Informed Optimists”

John P. Hussman, Ph.D.

From a long-term perspective, we believe that investors have a strong opportunity here to reduce equity risk near the peak of a market cycle that has reached the second greatest overvaluation extreme in U.S. history (second only to the 2000 peak). Among the valuation measures we’ve found most strongly correlated with actual subsequent S&P 500 10-12 year total returns, market valuations have pushed to a level that is more than double their reliable historical norms. From these levels, we fully expect 10-12 year S&P 500 nominal total returns near zero, with negative real returns after inflation.

Notably, the completion of every market cycle in history has taken the most reliable equity valuation measures toward or below their historical norms – levels associated with subsequent total returns approaching 10% annually. That includes two cycle completions since 2000, as well as cycles prior to 1960 when interest rates regularly hovered near present levels. After an unusually extended speculative half-cycle, we doubt that the completion of the present cycle will be any different. It has taken the third speculative bubble in 16 years to bring the nominal total return of the S&P 500 since March 2000 to just 3.6% annually. It is not an act of pessimism to reject the notion that investors are doomed, from here, to suffer permanently elevated valuations and permanently dismal long-term returns. No. It is an act of historically-informed optimism.

From a shorter-term perspective, market conditions are more ambiguous. Our measures of market internals remain broadly unfavorable, but enthusiasm over yet another round of monetary intervention in Europe pushed the S&P 500 above its 200-day average last week, and credit spreads, though still wide, narrowed somewhat. At the same time, participation remains tepid, with fewer than 40% of individual stocks above their own respective 200-day averages, sponsorship is questionable, as evidenced by waning trading volume, and short-term conditions are clearly overbought. While a market break of even a few percent would be sufficient to clarify the technical picture and restore a steeply negative market outlook, there’s just enough ambiguity to keep our near-term views a bit more neutral at present.

The chart below shows the ratio of market capitalization to corporate gross value added on an inverted log scale (blue line, left scale), and the actual S&P 500 nominal annual total return over the following 12-year period (red line, right scale). For a mathematical decomposition, see Rarefied Air: Valuations and Subsequent Market Returns, which details why subsequent total returns are so strongly correlated with the log valuation ratio, and why the effects of changing interest rates and fundamental growth systematically offset each other over a 10-12 year holding period.



 Value investor Seth Klarman once wrote that “value investing is at its core the marriage between a contrarian streak and a calculator.” Benjamin Graham wrote “Buy not on optimism, but on arithmetic.” Unfortunately, at every speculative peak, a different message emerges, suggesting that the calculator is broken, that “this time is different,” and that “the old valuation measures no longer apply.”

As John Kenneth Galbraith wrote decades ago about the advance to the 1929 peak, “as in all periods of speculation, men sought not to be persuaded by the reality of things but to find excuses for escaping into the new world of fantasy.” Be skeptical of measures that show stocks reasonably valued today, but that are not strongly correlated with actual subsequent market returns in prior cycles across history. Be even more skeptical when most of the data is drawn from the past 16 years, because as noted above, the nominal total return of the S&P 500 over the past 16 years has been just 3.6% annually. Be particularly wary of arguments that propose that valuation doesn’t matter at all.

There are certainly points in history where low valuations were followed a decade later by another plunge to low valuations, resulting in 10-year returns that were not nearly as strong as one would have expected. There are certainly points where reasonable valuations were followed by an extreme valuation peak (or trough) a decade later, resulting in a 10-year total return much higher (or lower) than one would have expected. Over shorter horizons, the most spectacular outcomes have been where a valuation extreme in one direction was followed by a valuation extreme in the other. The 1929-1932 period stands out, when the Dow Jones Industrial Average plunged by 89.2%.

Critics of historically-informed investing use these outliers as evidence that valuations are meaningless. Yet all of these instances rely on the terminal valuation being an outlier. Investors are certainly free to accept market risk on the expectation that future valuations will be comprised of nothing but outliers for all time. But understand that expecting the S&P 500 to retreat by 45-55% over the completion of the current market cycle is not to expect an outlier. No, a decline of that magnitude would be a historically run-of-the-mill outcome from present valuations. The 2000 peak was the most extreme point of overvaluation in history, and the current market cycle has reached the second most extreme point of overvaluation in history. We expect the completion of this cycle to wipe out the entire total return of the S&P 500 since the 2000 peak, and then some.

One might argue that historical valuation norms are irrelevant in a world of low interest rates. Contrary to a century of evidence, investors have been led to believe that 10-year Treasury yields and prospective 10-year stock market returns should move tightly in sync. On that front, it’s important to recognize that over the past century, the correlation between 10-year Treasury yields and subsequent 10-year equity returns has been only 0.23. Indeed, if one excludes the disinflationary 1982-1997 period, the correlation between the two has been zero. Outside of the inflation-disinflation cycle from 1970-1997, the correlation has actually been negative, at -0.42.The same pattern holds even if the data is restricted to the post-war period. Investors vastly overestimate the relationship between 10-year Treasury yields and prospective equity returns, largely because they have overgeneralized a very specific segment of history – see Recognizing The Risks to Financial Stability for a detailed discussion, and how this relates to the “Fed Model.”

In short, our measures of valuations and market internals remain jointly unfavorable. Still, given a somewhat mixed technical picture, we have no strong near-term views. A market retreat of even a few percent, say, below 1975 on the S&P 500, would shift our outlook like a light switch to a steeply negative view as the most critical measures would again be wholly one-sided. Until that point, we’ll ease our table-pounding about crash risk. For contrarians, this at least briefly softens one of the loudest voices on the subject, which might be exactly the thing to get a crash going.

QE’s endgame

Global central bankers are locked in a contest to find out who can create the most psychotic variant of quantitative easing, Ben Bernanke’s grotesque brainchild, before irretrievably destabilizing the global financial system once again. Attached to an incorrect understanding of the Phillips Curve (which is actually a relationship between unemployment and wage inflation, and real wage inflation at that), central bankers seem to overlook that quantitative easing provokes neither inflation, nor employment, nor industrial production, nor real investment, nor consumption. The entire operation involves buying up income-producing bonds and replacing them with zero-interest money. Since every dollar of monetary base has to be held by someone until it is retired, the goal of QE is to provoke discomfort with the form in which investors are forced to hold their savings. That doesn’t encourage people to save less. They just look for alternative forms of saving.

As I’ve detailed in other comments, provided that investors are favorably inclined toward risk-seeking (which we measure from the uniformity of market internals across a broad range of financial assets), zero-interest money can encourage each holder to treat it like a hot potato, trading it to someone else in return for a riskier but higher yielding security. The cycle then continues until every speculative asset is overvalued enough to offer a zero prospective return as well. This behavior has produced what all of us will view, in hindsight, as the QE Bubble.

So provided that investors are inclined to speculate, the main effect of QE is to amplifys peculative tendencies, enable borrowers to issue massive amounts of low-grade debt, and encourage malinvestment in unproductive projects that would never get funded at a higher hurdle rate. The current episode is really no different than the housing bubble, except that this one has been focused on speculation in equities and covenant-lite debt. Also, of course, we know how the housing bubble ended, and unfortunately, investors seem perennially incapable of recognizing a bubble until after collapses.

Understand, however, that QE fails to “work” when investors are risk-averse. In that situation, the higher potential yield on a riskier security typically isn’t enough to offset the perceived risk of a price decline. That’s why persistent monetary easing was wholly ineffective during the 2000-2002 and 2007-2009 collapses. While monetary easing may encourage investors to shift from risk-aversion to risk-seeking, that outcome is actually the exception, not the rule. Historically, the more accurate statement goes in the opposite direction: monetary easing only reliably supports financial speculation once investors are already inclined to speculate.

As for the effect of QE on the real economy, economists have known since the 1950’s that people base their consumption on what they view as their “permanent” income, not on the fluctuating value of volatile assets. Indeed, Bernanke himself wrote an empirical paper on the subject in 1981, and concluded “The response of expenditure to transitory income changes is as predicted by the permanent income model.” Put simply, there’s no theoretical or factual basis to expect a “wealth effect” to benefit economic activity as a result of Fed bubble-blowing in the financial markets.

The “counterfactual” of how the economy would have done without this intervention is readily available. Good macroeconomists know that this involves comparing the projections from a constrained and unconstrained vector autoregression (VAR). Regardless of whether one uses observable or “shadow” monetary measures (as Wu-Xia do), the result is the same: all of this reckless intervention has hardly moved the level of employment, industrial production, or real GDP even 1% from what one would have predicted based on the values of purely non-monetary variables alone.

It’s endlessly fascinating to hear central bankers talk about the effect of monetary policy on inflation and the economy, because they confidently speak as if the models in their heads are true – even reliable. Yet virtually nothing they say can actually be demonstrated in historical data, and the estimated effects often go entirely in the opposite direction. This is particularly true when it comes to inflation and unemployment – precisely the variables that are the targets of central bank policy.

For example, study a century of data and you’ll discover that few economic series, not changes in money growth, not even unemployment, are strongly correlated with inflation – with the exception of prior inflation itself, and only by extension, the level of interest rates. The GDP output gap can also be useful, but the relationship with inflation isn’t quite linear – the main value is to discriminate between “tight capacity getting tighter” and “slack capacity getting slacker.”

Since inflation is correlated from year-to-year, an above-average level of inflation in one period is typically followed by an above-average level of inflation the next. But inflation also tends to mean revert, so a high level of inflation in one period is typically followed by a slower rate of inflation the next period.

As for cyclical behavior, the strongest plunges in the rate of inflation follow points where a) real GDP is below estimated potential GDP and b) that output gap has worsened in the past year. The retreat in inflation tends to be particularly large if the rate of inflation has increased over the prior year despite those conditions. Conversely, inflation accelerates most reliably when a) real GDP is above estimated potential GDP and b) that output gap has improved in the past year, regardless of the level of unemployment. Notably, once information on the output gap and inflation itself is included, additional information about monetary policy doesn’t materially improve projections of inflation. That’s another way of saying that only the systematic component of monetary policy (e.g. what could be captured by a simple Taylor Rule) is relevant to the economy. Activist deviations from systematic policy don’t do anything but distort financial markets.

Beyond those general rules of thumb, what drives inflation? While many economists seem satisfied with having memorized a line from Milton Friedman about inflation being “always and everywhere a monetary phenomenon,” economic models of inflation turn out to be nearly useless for any practical purpose. It’s not difficult to explain inflation, using inflation itself as the main explanatory variable, and information on the output gap is also useful even if unemployment is not. But it’s very difficult to explain most episodes of inflation using monetary variables.

Yes, hyperinflation is always associated with monetary expansion, but monetary expansion isn’t actually enough. Examine major hyperinflations, and you’ll always find a government that has racked up huge external obligations to other countries, and has lost fiscal control by running massive deficits – effectively printing money to fund them. Hyperinflation involves a loss of both fiscal and monetary control, often coupled with a supply shock of some sort, and revulsion toward holding money itself because the willingness of the next person to accept it comes into question.

The long-term value of paper money relies on the confidence that someone else in the future will accept it in exchange for value, and ultimately, that’s a matter of varying confidence in the ability of the government to meet its long-term obligations. Early U.S. money such as confederate currency went to zero because that confidence was absent. Greenbacks held their value because of the expectation (validated in 1879) that convertibility with gold would ultimately be honored. Gold convertibility isn’t necessary, nor are balanced budgets required in the short-run, but confidence in long-run fiscal discipline is essential. If that confidence weakens – which may occur later in this decade, after the next recession – rapid inflation may emerge out of nowhere, and nobody will celebrate it.

Now, expansionary fiscal policies are fine when they result in the accumulation of productive capital by society (which can include infrastructure, workforce training, and even support for productive investment by fiscal means such as tax credits). Put simply, productive investment is the best avenue to expand potential GDP, increase employment, and reduce the likelihood of inflation. But when the primary use of fiscal policy is to wipe up the catastrophe of weak productivity, lost income, unemployment, and malinvestment created in the repeated aftermath of collapsed financial bubbles, the endgame is going to be stagnant living standards and a debased currency.

Ultimately, QE may finally create inflation by provoking a loss of fiscal control. My concern is that central banks have risked just that by encouraging yet another speculative bubble, heavy issuance of low-grade debt, and the diversion of savings toward unproductive investment. The inevitable fiscal consequences are likely to include bailouts, as well as urgency to expand income-replacement and transfer payment programs as the third bubble since 2000 collapses (which QE will helpless to prevent so long as investors remain risk-averse). Europe is approaching that endgame, and last week’s action by the ECB is evidence of increasing panic. Other economies are not far behind. The greatest risk is that Mario Draghi and other central bankers may ultimately get their wish for higher inflation, but not at all as they intend.

Janet Yellen And The Federal Reserve Are Losing Credibility

Peter Schiff, By Jason Shubnell

U.S. central bankers decided to maintain the FFR range at 0.25 to 0.50 basis points, keeping the discount rate at 1.00 percent.

While the Federal Reserve did see indicators of a strengthening labor market (along with projections of 4.5 percent unemployment by 2018), not all may be well. The central bank cut its 2016 GDP forecast to 2.2 percent from 2.4 percent previously, and also said global economic and financial developments pose risk for markets.

Fed Chair Janet Yellen spoke for about an hour to discuss the Fed’s outlook. However, is the Fed is losing credibility? Peter Schiff thinks so.

“The public knows that the economy is weak (that’s why Trump and Sanders are doing well),” Schiff told Benzinga in an email. “But the Fed can’t admit it and they are looking stupid as a result.”

Peter Schiff expects increasingly dovish movement as the year goes on, pushing down the dollar.

“Most economists are saying that the current pickup in Inflation must mean that the economy is improving,” Schiff said. “To reach this conclusion one must not only ignore the basics of economics but also the very many signs that the economy is currently weakening drastically… The optimistic conclusion is that wages will rise to match price increases. But that is not happening (the last payroll report showed a huge drop in weekly earnings). So what we have is rising prices and flat wages…a terrible mix for consumers.” 

Schiff said if the Fed were to raise rates in this environment, it would risk igniting a serious recession that would have huge political implications. Instead of risking this, he said, the Fed will continue to say that they want to raise, while hoping the economy will reverse course and strengthen.

“But the more likely scenario is that the Fed does nothing while promising to do something,” Schiff‘s email said. “But if the economy weakens further, they will have to officially call of future hikes, and perhaps go back to zero. They will of course have to ignore any additional signs of inflation to do so. When the market realizes that, the dollar will plunge, and non-dollar markets and gold will outperform.”

Schiff then highlighted the current decline in U.S. manufacturing would be the first time since 1952 that Industrial Production has declined for four straight months without the U.S. economy not being in recession. A worse-then-expected 0.5 percent month-over-month plunge (near the worst since 2009) led to a 1.0 percent year-over-year drop, the fourth monthly decline.

The market responded positively following the 2 p.m. ET release. The Dow closed at its highest level of 2016 at 17,325.76. The SPDR S&P 500 ETF Trust SPY spiked sharply following the announcement, closing up about 0.6 percent at $203.39.

Schiff concluded by saying Yellen’s biggest loss of credibility today was when she said “April remains a live meeting.”

“There is literally no one in the world that expects a hike in April,” Schiff said.


BONUS TRACK: World’s Second Largest Reinsurer Buys Gold, Hoards Cash To Counter Negative Interest Rates


The world’s second-largest reinsurer, German Munich Re which is roughly twice the size of Berkshire Hathaway Re, is boosting its gold reserves and buying gold in the face of the punishing negative interest rates from the European Central Bank, it announced today.

As caught by Mark O’Byrne at GoldCore and reported by Thomson Reuters this afternoon, the world’s largest reinsurer is far from alone in seeking alternative investment strategies to counter the near-zero or negative interest rates that reduce the income insurers require to pay out on policies.

Munich Re has held gold in its coffers for some time and recently added a cash sum in the two-digit million euros, Chief Executive Nikolaus von Bomhard told a news conference.

 “We are just trying it out, but you can see how serious the situation is,” von Bomhard said.

The ECB last week cut its main interest rate to zero and dropped the rate on its deposit facility to -0.4 percent from -0.3 percent, increasing the amount banks are charged to deposit funds with the central bank.

Munich Re is one of the largest reinsurance companies in the world – It oversees €231 billion in investments. A small 3% allocation to gold would equate to buying gold worth €8.19 billion. At the current spot price of €1,130 per ounce that would equate to 7.2 million ounces or 225.4 tonnes of gold bullion

The news is interesting and we believe that other institutions will follow in their footsteps and diversify into gold in order to protect themselves from negative yields. We have not heard of any other non central bank institutions diversifying into gold but it stands to reason that a small percentage will follow in Munich Res footsteps.

* * *

It isn”t just gold: the German company confirms that when rates turn negative enough, physical cash will be increasingly more valuable.

As Bloomberg reports, the German company will store at least 10 million euros ($11 million) in two currencies so it won’t have to pay for the right to access the money at short notice, von Bomhard said at a press conference in Munich on Wednesday. “We will also observe what others are doing to avoid paying negative interest rates,” he said.

Institutional investors including insurers, savings banks and pension funds are debating whether it may be worth bearing the insurance and logistics costs of holding physical cash as overnight deposit rates fall deeper below zero and negative yields dent investment returns. The ECB last week cut the rate on its deposit facility, which banks use to park excess funds, to minus 0.4 percent.

“This may well become a mass phenomenon once interest rates are low enough — the only question will be where that exact point is,” said Christoph Kaserer, a professor of finance at the Technische Universitaet in Munich. “For large institutions, that may be the case sooner rather than later. The ECB will react with countermeasures, such as limiting cash.”

As Bloomberg adds, Munich Re’s strategy, if followed by others, could undermine the ECB’s policy of imposing a sub-zero deposit rate to push down market credit costs and spur lending. Cash hoarding threatens to disrupt the transmission of that policy to the real economy.

Munich Re, which oversees a total of 231 billion euros in investments, wants to test how practical it would be to store banknotes, having already kept some of its gold in vaults, von Bomhard said. This comes at a time when consumers are increasingly using credit cards and electronic banking to pay for transactions. Deutsche Bank AG Chief Executive Officer John Cryan has predicted the disappearance of physical cash within a decade.

“This shows the difficulties that the ECB is facing in its efforts to stimulate the real economy,” said Andreas Oehler, a professor of finance at Bamberg University in Bavaria. “Charging negative rates on overnight liquidity doesn’t stimulate longer-term lending. All it does is make companies’ and institutions’ payment transactions more expensive.”

Incidentally, once the Fed’s infatuation with playing central planning doctor fizzles as the economy relapses into an accelerating downward spiral, negative rates are coming to the US next, as such the real-time experiments of how to evade a repressive monetary regime such as those conducted by the Munich Re CEO will be particularly useful to those who want to protect their assets once NIRP crosses the Atlantic.


“Helicopter Money to the Rescue” by Frank Hollenbeck (Mises)

Following the unconventional monetary policy of negative interest rates, central banks are now considering an even more desperate measure: “helicopter money.” Milton Friedman is credited with this idea:

Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community. Let us suppose further that everyone is convinced that this is a unique event which will never be repeated.

The goal of such a policy is to put money directly into people’s pockets to boost aggregate demand. The post-2008 QE policy had similar objectives. The lowering of interest rates was intended to boost bank lending and indirectly consumer spending. Instead, the result was a boom in asset prices and a surge in excess reserves. The idea of helicopter money — in contrast — is to bypass the middleman, the banks, and provide funds directly to consumers.

How would such a policy be implemented? One idea is for a tax rebate financed by more government bonds purchased by the central bank. The tax cuts would be financed by printing money. The only real difference between helicopter money and the QE implemented since 2008, is that the private sector would be spending the money instead of the government. A large part of the debt issued since 2008 to finance government spending has been purchased by the central bank. It now holds $2.5 trillion of the $19 trillion dollars of US debt, effectively monetizing much of the additional borrowing since 2008. The effect on aggregate demand would simply be for the private sector to spend the money instead of the government sector. It would be a continuation of the current policy of financing expenditures by creating intrinsically worthless pieces of paper.

There’s Never a Shortage of Demand

Of course, this is a very Keynesian perspective that the economic problem is a lack of aggregate demand. The reality is that we never have a shortage of demand. The reason we work, we produce, is to consume; there is never a lack of demand. The primary function of prices is to ration output against an insatiable desire to consume or demand. As Ricardo said in 1820, “men err in their production; there is no deficiency of demand.”

The problem is never one of insufficient demand, but of supply being misaligned with demand. This faulty widespread educational indoctrination about aggregate demand is the poison eating at the heart of macroeconomics and similar to past universal beliefs in truisms that were never true — like the sun revolving around the earth.

The economic literature has focused on the permanency of such a helicopter drop. Such a policy is seen by contemporary economists as more effective if it was permanent. If so, people would expect inflation and advance their purchases to take advantage of current lower prices. In a Keynesian framework, this is viewed as beneficial since it would move demand forward. A similar but opposite argument has been promulgated to demonize deflation (see here and here). Of course, people are not lab rats, and they formulate their expectations on a multiple of different factors. They may even pay higher prices if current purchases better align with the timeline of needs. This is why few buy Christmas presents during January sales.

Another excuse for helicopter money is to allow the central bank to reach its 2 percent inflation target. As though 2 percent was some magical number that would allow the economy to reach its economic sweet spot.

Problems with Money Creation

Of course, 2 percent growth over 35 years cuts the purchasing power of money in half. It is a wealth transfer from the late recipients of the money, wage earners and the poor, to the early recipients of the money, the government and the banking sector: the central bank acting as a reverse robin hood. Also such monetary shenanigans simply interfere with the function of prices to allocate resources where society deems most urgent (see here). The reality is that there is no empirical or theoretical justification to support a 2 percent target. The period of the greatest growth in the US during the nineteenth century, from 1820 to 1850 and from 1865 to 1900, was associated with significant deflation. In those two cases, prices were cut in half.

Common sense states that you cannot repeal the law of scarcity by printing intrinsically worthless pieces of paper to finance private or government expenditures. If that were true, counterfeiting would be legal and Zimbabwe would be like heaven. The initial effect of such printing is a temporary illusion of prosperity which begets more printing leading to ever increasing amounts of distortion to prices.

Friedman’s comments about helicopter money included an important caveat: it is unlikely that the helicopters would fly only once.