Monthly Archives: January 2017

La necesaria comprensión de la Revolución Rusa (I)

Adjunto un breve reflexión sobre el magnífico libro Gulag: la historia de los campos de concentración soviéticos, de Anne Applebaum, premio Pulitzer en 2004, y editado por el sello de Random House Debate que dirige Miguel Aguilar. Applebaum, al igual que uno de sus maestros Richard Pipes (también editado por Debate), destaca la relativamente poco conocida historia de la Revolución Rusa y de los regímenes comunistas en general, a veces incluso idealizada por algunos, y que sin duda no tiene el estigma de otras ideologías como el nazismo o el fascismo pese a que el comunismo ha causado el mismo tipo de sufrimiento, terror y muerte, sino más.

Gulag

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En próximas entregas: La Revolución Rusa, Richard Pipes (Debate, 2016).

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La tiranía del igualitarismo

Desde el advenimiento de la crisis, y ya de antes, que uno de los temas que suele centrar la agenda política en los países desarrollados es el tema de la igualdad: es decir, los (supuestos) perjuicios e injusticias que se derivan cuando en una sociedad no todos tienen la misma riqueza o renta. Se trata de un tema en el que se suele ver un (falso, aunque solo en parte) “trade off” entre igualdad y libertad: lo cierto es que, bien analizado, libertad e igualdad van de la mano, eso sí igualdad ante la ley, igualdad de oportunidades, igualdad desde un punto de vista moral, no la “obsesión igualitaria” con la que algunos pretenden justificar todo tipo de ataques a la libertad y la propiedad.

El analizar las dos concepciones principales, desde un punto filosófico de la igualdad, es el objeto del último libro del economista liberal chileno Axel Kaiser, La tiranía de la igualdad (Deusto, 2017). El libro es una mordaz crítica a muchos de los mitos y errores de concepto que se dan en el debate político a la hora de explotar un tema sensible, que levanta pasiones y muchos sentimientos, y que se ha convertido en uno de los principales campos de batalla para la captación de voto desde la izquierda y también desde la derecha.

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Uno de los principales mensajes del libro es que la igualdad no es un problema. La igualdad más bien es una distracción, letal por cierto, del problema principal que no es otro que la pobreza. Al final, y como desgrana el autor en un texto tremendamente ágil y claro, es que la búsqueda de la igualdad supone atentar contra la libertad, la prosperidad y la moral imposibilitando un orden social pacífico. El libro, que tiene una fuerte carga de profundidad, explora los orígenes de la filosofía política liberal donde uno de sus principales axiomas es, precisamente, la igualdad ante la ley. El liberalismo es una filosofía política individualista donde el individuo tiene derechos frente a la colectividad.

Desde los moralistas ingleses del s. XVII y XVIII hemos entendido que todas las personas son iguales desde un punto de vista moral, político y jurídico. Una idea potente en la que se asientan el sistema político (con sus variantes formales) que conocemos como democracia liberal y que recoge, por ejemplo, la Declaración de Independencia de Estados Unidos. El liberalismo clásico, por lo tanto, no se preocupa del resultado (que depende de la habilidad, talento, ambición, ganas, suerte de cada uno), sino por el procedimiento, es decir que todos hayamos sido tratados de igual manera. Esta visión es la que permite que diferentes individuos puedan perseguir fines tan dispares como vender ordenadores, montar un hotel o jugar al fútbol sin agredir los derechos de los demás mientras consiguen sus objetivos. Este foco en el procedimiento nos lleva a preocuparnos por la igualdad ante la ley y la justicia (por eso es ciega, por qué no atiende a circunstancias particulares), el Imperio de la Ley, o la defensa de los derechos inalienables de las personas empezando por el derecho a la vida y la propiedad. Hoy, todo dicho sea de paso, terriblemente erosionados y de ahí también el estado de estancamiento económico y social relativo que arrastramos desde hace años.

Por el contrario, adoptar una visión de la igualdad consecuencialista, donde lo que cuenta son los resultados, es un enfoque que irremediablemente su consecución, argumenta perfectamente Kaiser, implica una agresión para con la igualdad ante la ley, la seguridad jurídica de las personas y conculca los derechos de las personas. Se trata, en definitiva, de un enfoque equivocado que llevado a la práctica resulta inmoral y liberticida: inmoral por qué es injusto, por ejemplo, que dos estudiantes, uno que sabe mucho y otro que sabe poco, saquen la misma nota; liberticida por qué la implementación de políticas que buscan la igualdad de resultado suponen una agresión a los derechos de propiedad de las personas en un dilema irresoluble.

El desconocimiento muchas veces de cómo realmente funciona la economía y que es realmente el liberalismo ha dado lugar a un sinfín de confusiones en el plano político y social con respecto a este debate hoy dominado por el dogma de lo público. Sin embargo, la igualdad SÍ es importante. Por eso es uno de los axiomas del liberalismo. La historia reciente de los últimos tres siglos es una lucha por la conquista de la igualdad, pero de una igualdad moral, una igualdad que no agrede derechos, una igualdad que respeta la propia naturaleza del hombre y que reconoce el carácter singular, único e irrepetible de cada ser humano.

Lo contrario, como también recuerda el autor, significa poner el énfasis en la envidia, un sentimiento como los celos, que quién lo sufre difícilmente lo puede controlar. Este es un análisis que ha realizado con gran solvencia la brillante economista de la Universidad de Chicago Dierdre McCloskey cuyo Bourgeois Equality es, sin duda, el mejor análisis y más completo que se ha hecho sobre el tema de la desigualdad y en donde en la ecuación del análisis se ha añadido la variable ética, no únicamente una visión utilitaria (aparte de manirrota y pobremente construida) como es el caso de Piketty (véase la crítica de Rallo), Stiglitz o, más recientemente, Branko Milanovic (de nuevo, con replica magnífica de Rallo). Como siempre digo, buena lectura.

 

Los límites de la economía psicológica

Adjunto la reseña al interesante libro de Richard Thaler Todo lo que aprendí con la psicología económica, editado por Deusto (2016). Se trata de una buena lectura que sirve para comprender la falla de la economía neoclásica y como la también llamada economía del comportamiento no plantea un método alternativo y conviene ser cautos a la hora de substituir el ‘homo economicus‘ por el ‘homo psicologicus’. Sin embargo, sí que los descubrimientos del Premio Nobel Daniel Kahneman y Cía. arrojan interesantes insights sobre algunos de los sesgos y mecanismos que configuran nuestra manera de pensar y de tomar decisiones.

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David Gordon on Mervyn King: Central Bankers are Losing Faith in their own Alchemy. Cobden

Mervyn King is the British Ben Bernanke. An eminent academic economist, who now teaches both at New York University and the London School of Economics, King was from 2003 to 2013 Governor of the Bank of England. In short, he is a very big deal. Remarkably, in The End of Alchemy he frequently sounds like Murray Rothbard.

King identifies a basic problem in the banking system that has again and again led to financial crisis.

“The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy — the creation of extraordinary financial powers that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters — from hyperinflation to banking collapses.”

How exactly is this alchemy supposed to work?

“People believed in alchemy because, so it was argued, depositors would never all choose to withdraw their money at the same time. If depositors’ requirements to make payments or obtain liquidity were, when averaged over a large number of depositors, a predictable flow, then deposits could provide a reliable source of long-term funding. But if a sizable group of depositors were to withdraw funds at the same time, the bank would be forced either to demand immediate repayment of the loans it had made, … or to default on the claims of depositors.”

Readers of Rothbard’s What Has Government Done to Our Money? will recognize a familiar theme.

Many have sought to salvage the alchemy of banking by resorting to a central bank. By acting as a lender of last resort, a central bank can bail out banks in need of funds to satisfy anxious depositors and thus avert the danger of a bank run. The alchemy of transforming deposits into investments can now proceed.

Though he was one of the world’s leading central bankers, King finds fault with this “solution.” A local bank can be rescued by getting money from the central bank, but the process generates new problems. Thomas Hankey, a nineteenth-century Governor of the Bank of England, pointed out some of these in response to Walter Bagehot, the classic defender of the central bank as the lender of last resort:

[i]f banks came to rely on the Bank of England to bail them out when in difficulty, then they would take excessive risks and abandon “sound principles of banking.” They would run down their liquid assets, relying instead on cheap central bank insurance — and that is exactly what happened before the recent [2008] crisis. The provision of insurance without a proper charge is an incentive to take excessive risks — in modern jargon, it creates “moral hazard.”

Given the dangers of financial alchemy, what should we do about it? Again, King strikes a Rothbardian note. He writes with great sympathy for one hundred percent reserve banking.

Even though the degree of alchemy of the banking system was much less fifty or more years ago than it is today, it is interesting that many of the most distinguished  economists of the first half of the twentieth century believed in forcing banks to hold sufficient liquid assets to back 100 percent of their deposits. They recommended ending the system of “fractional reserve banking,” under which banks create deposits to finance risky lending and so have insufficient safe cash reserves to back their deposits.

Like Rothbard, King calls attention to the insights of the nineteenth-century Jacksonian William Leggett. King cites an article of 1834 in which Leggett said:

Let the [current] law be repealed; let a law be substituted, requiring simply that any person entering into banking business shall be required to lodge with some officer designated in the law, real estate, or other approved security, to the full amount of the notes which he might desire to issue.

King may to an extent resemble Rothbard; but unfortunately he is not Rothbard; and alert readers will have caught an important difference between King’s idea of one hundred percent reserve banking and Rothbard’s. King’s notion, unlike Rothbard’s, still allows banks to expand the money supply. The “liquid assets” need not be identical with the deposits: they need only be easily convertible into money should the need arise to do so.

King’s own plan to “end the alchemy” allows for substantial monetary expansion. He calls his idea the “pawnbroker for all seasons (PFAS)” approach. This is a form of “liquidity” insurance. Banks would have to put up in advance as collateral with the central bank some of their assets. This would act as a “form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed.” So long as the insurance had been paid, though, the central bank would still bail the bank out in a crisis by giving it more money. Contrast this with the plan suggested in the quotation from Leggett, in which if a bank could not redeem its notes, depositors could proceed directly against the bank’s assets. This allows no monetary expansion; and Rothbard’s plan is of course more restrictive still.

Having come so close to Rothbard, why does King shrink from the final step? Why does he still allow room for monetary expansion? He fears deflation.

Sharp changes in the balance between the demand for and supply of liquidity can cause havoc in the economy. The key advantage of man-made money is that its supply can be increased or decreased rapidly in response to a sudden change in demand. Such an ability is a virtue, not a vice, of paper or electronic money. … The ability to expand the supply of money in times of crisis is essential to avoid a depression.

But if the demand for liquidity suddenly increases, when the monetary stock is constant, cannot falling prices for goods satisfy the demand? King, here following Keynes, is skeptical. “Wage and price flexibility does help to coordinate plans when all the markets relevant to future decisions exist. But in practice they do not, and in those circumstances cuts in wages and prices may lower incomes without stimulating current demand.” Prices may keep falling indefinitely.

Other possibilities of coordination failure also trouble King, and underlying them is an important argument. Following Frank Knight, he distinguishes between risk and uncertainty.

Risk concerns events, like your house catching fire, where it is possible to define precisely the nature of that future outcome and to assign a probability to the occurrence of the event based on past experience. … Uncertainty, by contrast, concerns events where it is not possible to define, or even imagine, all possible future outcomes, and to which probabilities cannot therefore be assigned.

We live in a world of radical uncertainty, and thus we cannot be sure that relying on market prices to adjust to changes in the demand to hold money suffices to avert catastrophe. It is for this reason that resort to monetary expansion sometimes is needed.

This argument moves altogether too fast. It does not follow from the fact that Knightian uncertainty prevails widely that one must take seriously the possibility that prices and wages would fall indefinitely. In a situation of uncertainty, we cannot, by hypothesis, calculate probabilities; but this does not require that we take outlandish possibilities as likely occurrences that must be averted by the government. Some reason needs to be given for supposing that prices will continue to fall indefinitely. Why would entrepreneurs not be able to correct the situation, without resorting to monetary expansion? We are not faced with a dichotomy between exact mathematical calculation, in the style of an Arrow-Debreu equilibrium, and blind groping in the dark.

King himself acknowledges that in the American depression of 1920 to 1921, no resort to the government was needed.

The striking fact is that throughout the episode there was no active stabilization policy by the government or central bank, and prices moved in a violent fashion. It was, in the words of James Grant, the Wall Street financial journalist and writer, “the depression that cured itself.”

It is encouraging that King cites the Austrian economist James Grant, but he draws from his work an insufficient message. “The key lesson from the experience of 1920–21 is that it is a mistake to think of all recessions as having similar causes and requiring similar remedies.” In view of the manifold invidious consequences, fully acknowledged by King, of government intervention, should we not rather emphasize the need to rely on the unhampered market? King nevertheless merits praise for coming close, in his own way, to many Austrian insights.

Why Fixing Trade Deficits Is Essential Barron´s by FRANK BERLAGE

 Trade and budget deficits will eventually catch up with us, and the effect on the dollar won’t be pretty.

In 1965, when we imported less, manufacturing employed 24% of the U.S. workforce. By 2015, substantial portions of our manufacturing base had moved overseas, and domestic manufacturing had shrunk to just 9% of employment.

The U.S. has now run a trade deficit for 40 years, and at present levels our annual current-account deficit of $400 billion to $500 billion will aggregate additional deficits of $4 trillion to $5 trillion in only 10 years. However, despite the largest cumulative current-account deficit in world history and a plunge in manufacturing as a share of our economy, the U.S. seemingly persevered without a definitive penalty.

So, do trade and balance-of-payments deficits really matter?

Not according to U.S. Sen. Ron Johnson, Congressman Ron Beyer, and many other U.S. politicians. However, history will attest that no country has incurred perennial trade deficits, imported and borrowed more than it exported or lent, and seen its currency live to tell about it.

Much of the demand for U.S. dollars is derived from its reserve-currency status, since the U.S. dollar is commonly held as a means of exchange and lending between independent third parties and not as much for claims on actual U.S. production. Therefore, Americans get the benefit of a higher value for their dollar, and this results in an ability to borrow capital and buy foreign products at lower prices, thus incurring trade deficits. Because reserve-currency status can prevail only alongside confidence in our dollar, the longer U.S. trade deficits go on, the greater the crisis when they cease, voluntarily or involuntarily. Consequences of imprudence often occur when least expected. The 2008 housing crisis is a case in point.

The approaching danger is that in one year or five, we will experience one $40 billion monthly current-account deficit too many, resulting in a decline in the dollar that extends in greater duration and magnitude than the economic climate might dictate. Economists will be mystified, but we will be catching up and paying penance for long decades of trade and budget deficits. On that day, nothing will save the dollar, not the corporate profits offshore, not more Japanese purchases of U.S. Treasuries, not presidential jawboning. Nothing.

At the outset, the degree of upward pricing in imports will overwhelm even the best of optimists. The Toyota, once closely priced to the Chevy, will double, and the U.S. consumer will rapidly devour all outstanding inventories of Chevys. However, enhanced foreign purchasing power will then bid up for domestic U.S. production, and the U.S. buyer will be priced out. Foreign investors will also buy up U.S. farmland, mines, and other industries on the cheap.

Understandably, it is hard to imagine such a scenario in today’s disinflationary economy. Nevertheless, unable to afford imported goods, Americans will seek to buy shoes, only to find they aren’t made in America. They will search for televisions, only to find they aren’t made in America. They will ruefully realize that the same applies to Rawlings baseballs, Gerber baby food, Etch A Sketches, Converse sneakers, stainless-steel rebar, Mattel toys, minivans, vending machines, Levi jeans, Radio Flyer wagons, cellphones, railroad turnouts, Dell computers, canned sardines, knives, forks, spoons, and lightbulbs.

Americans will wistfully wonder where their manufacturing base went and how they lost more than 63,000 factories just since the year 2000. 

The U.S. urgently needs a plan that will mitigate future long-term trade and budget deficits, an overall blueprint where everyone is better off, including our trading partners. Therefore, I propose that when the U.S. runs a trade deficit with any country for five years, an automatic import limit comes into play in the sixth year, mandating a reduction in the trade deficit with that specific country by 20%. A 10% increase in U.S. exports and a 10% decrease in imports relative to that country would fit the bill, but either way, an additional 20% annually mandated reduction in the trade deficit would continue for four more years until trade is balanced. Then, the law would go into hibernation for five years, allowing free trade with that country to resume. No tariffs, just a country-specific trade-deficit limit to act as a current-account safety mechanism to reduce the dangers of de-industrialization.

This gradualist method would also ensure that our trading partners’ interests would be aligned with ours, providing them with a strong incentive to buy more U.S. products. As a result, they would bring to bear innovative solutions on how to import more of our products so that they could export more of theirs. Ultimately, this would be a much firmer foundation for world trade.

However, modifications in our trade policy aren’t the only changes required for the U.S. economy to improve. We need a return to fundamentals that mandate significant reductions in corporate and personal income taxes, as well as government spending and entitlements. A flat tax of 22% at the federal level with a maximum combined state and local income tax of 4% would revive U.S. fortunes better than any single factor. It is no coincidence that Hong Kong, with a maximum 16% income-tax rate, has over the long term been one of the world’s best-performing economies. These fundamental changes would result in greater prosperity by increasing aggregate savings, investment, and demand.

If we fail to mitigate our long-term trade deficits alongside our cumulative budget deficits, we will eventually destroy many of our remaining industries, as well as our military.

Forty years of trade deficits might lead one to agree with what we are told; that trade deficits, like budget deficits, don’t really matter. However, as international economist Rudiger Dornbusch warned, “In economics, things take longer to happen than you think they will, and then they happen much faster than you thought they could.”

FRANK BERLAGE is the CEO of Multilateral Partners Global Advisory Group, a private-equity firm based in La Jolla, Calif.

Venetians, Volcker and Value-at-Risk: 8 centuries of bond market reversals (Paul Schmelzing)

Paul Schmelzing is a visiting scholar at the Bank from Harvard University, where he concentrates on 20th century financial history. In this guest post, he looks at the current bond market through the lens of nearly 800 years of economic history. 

The economist Eugen von Böhm-Bawerk once opined that “the cultural level of a nation is mirrored by its interest rate: the higher a people’s intelligence and moral strength, the lower the rate of interest”. But as rates reached their lowest level ever in 2016, investors rather worried about the “biggest bond market bubble in history” coming to a violent end. The sharp sell-off in global bonds following the US election seems to confirm their fears. Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded. History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 “bond massacre”.

Bond “bull markets” since 1285

Chart 1: The Global risk free rate since 1285

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As a contemporary of fin-de-siècle Vienna, Böhm-Bawerk witnessed a period of unprecedented internationalization, deepening trade relations, and technological innovation – associated with the parallel financial phenomena of the expansion of London-based merchant banks, and the growth in global capital mobility(triggering the heyday of the “cash nexus”). At this point, yields on the global “risk free bond” – then British consols – had fallen to an all-time low of 2.48% in 1898 (Chart 1). But not least his own enthusiasm should prove short-lived: soon after his writing, rates entered what Richard Sylla and Sidney Homer later defined as the “first bear bond market”.

Indeed, judging purely by historical precedent, at 36 years, the current bond bull market had been stretched. As chart 2 shows, over 800 years only two previous episodes – the rally at the height of Venetian commercial dominance in the 15th century, and the century following the Peace of Cateau-Cambrésis  in 1559 – recorded longer continued risk-free rate compressions. The same is true if we measure the period by average decline in yields per annum, from peak to trough. With 33 bps, only the rallies following the War of the Spanish Succession, and the election of Charles V as Holy Roman Emperor surpass the bond performance since Paul Volcker’s “war on inflation”.

Chart 2: Length and size of bull markets since 1285

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Modern bear shock markets, 1925-2016

It thus appears timely to ask about the characteristics of bear bond markets. Since Homer and Sylla’s first bear market, on our count the United States (the current issuer of the global risk-free asset) experienced 12 modern “bond shock” years, during which selloff dynamics cost long-term sovereign bond creditors more than 15% in real price terms.

Aggregating these bear markets (chart 3), we find that, at 6.1% CPI year-on-year on average, “bond shock years” record inflation levels almost double the long-term trend, at 3.1%. Global growth equally is below average, though not in recession territory. Interestingly, during bond bear markets, US federal deficits, with 2.3% of GDP, actually fall slightly below the post-1945 average track record of 2.9%. An increase in the supply of bonds, therefore, seems not decisive to the weakening in price levels.

Chart 3: Macroeconomic outcomes in bear markets

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Bond turbulence, however, has traditionally struck investors in different shapes – especially since the time of Homer/Sylla’s first bear market. Below we present three types of modern bear bond case studies to illustrate that – while historically inflation acceleration has been a solid predictor of sharp bond selloffs – some prominent episodes appear less correlated with fundamentals, and can inflict similar levels of losses.

Type 1: The inflation reversal, 1967-1971

The “inflation reversal” leaves bondholders particularly bruised, and is most clearly associated with fundamentals: namely a sharp turnaround in realized consumer price inflation (CPI).  This  scenario correctly weighs on the minds of today’s reflationists. US bonds lost 36% in real price terms during 1965-1970, slightly outstripping losses during the 20th century’s first bear market (Chart 4). Annual CPI more than tripled in the same timeframe, from 1.6%, to 5.9%. Looser fiscal policies seem to have played only a secondary role in the 1965-70 bond sell-off, though the Vietnam War put some unexpected pressure on the federal budget. The deficit widened from just 0.2% in 1965, to 2.8% three years later – but USTs continued to decline when public finances swung back into positive territory.

Chart 4: The bear market of 1967-71

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Type 2: The Sharp Reversal, 1994

The 1994 “bond massacre” has attracted particular attention of late, and represents a second type of reversal, characterized by steep, but short-lived turbulence that is associated more with financial sector leverage and exogenous positioning – rather than macro fundamentals.

After bottoming in the autumn of 1993, US bond market yields started ascending quickly, even amid discount rates on a 30-year low. A rollercoaster performance followed, which saw bond volatility surge to levels not seen since the Volcker inflation fight. However, US bonds were firmly back in bull territory by 1995, adding 18.1% in prices after inflation.

Neither inflation expectations – which peaked at an unexciting 3.4%– nor fiscal policies, which remained on the steady Clinton consolidation path, offer satisfactory explanations for the rout. Though journalistic accounts link the sell-off with the Fed’s February 1994 decision to raise short-term rates, closer investigations suggest a loose correlation at best. As the data proves, volatility in US 10 year bonds started rising in Q3-1993, while official discount rates were only raised in May 1994 – at a time when volatility had almost peaked already (Chart 5).

Chart 5: The “Bond Massacre” of 1994

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Evidence from the financial sector rather suggests that the dramatic increase in leveraged bond positions by both US hedge funds and mundane money managers set in motion self-reinforcing liquidations once uncertainty over emerging markets including Turkey, Venezuela, Mexico, and Malaysia – all of which experienced sharp capital flow volatility – put pressure on speculative positions. Against current predispositions, it seems unlikely a sell-off today would trigger only a brief spark in volatility, and soon revert to the secular post-1981 trajectory.

Type 3: The VaR shock, Japan 2003

But as our third type illustrates, bond turbulence can be highly discriminatory across maturities. Given the latest decision by the Bank of Japan to target long-term bond yields, after a period of unprecedented yield curve flattening, parallels emerge to the 2003 Japanese curve steepening episode, sometimes dubbed the ”Value at Risk Shock” (Chart 6). Back then, markets underwent a notable rollercoaster of the term structure against the backdrop of “tapering fears” over the BoJ’s bond buying program, the Iraq War, and domestic tax hikes.

Chart 6: The Japanese bear market of 2003

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“VAR shocks” have especially deep impacts on the banking sector, whose profitability in the maturity transformation business tracks prevailing curve steepness. The dramatic flattening of the JGB term structure prior to March 2003 therefore went hand-in-hand with a sustained sell-off in the TOPIX bank index, which fell to multi year lows. Prominent financial institutions, such as Resona Group, had to be rescued through billion Dollar public bailouts.

Though the TOPIX recovered, and realized Japanese inflation only accelerated modestly, the sudden steepening of the JGB curve from the middle of 2003 posed a new set of challenges: calibrated risk management structures, known as “Value-at-Risk” models, required banks to shed JGB assets once their price started plummeting. Since most banks followed similar quantitative signals, and exerted a traditionally strong home bias in their fixed income portfolios, a concerted dumping of government bonds ensued.

Conclusions

What does the historical track record imply for current markets? A pessimistic reader could certainly identify gloomy ingredients for the “perfect storm”: the potential for a painful steepening of bond curves, after a sustained flattening as in 2003, coupled with monetary tightening; and a multi-year period of sustained losses due to a structural return of inflation as in 1967.

On the one hand, the anecdotal fear that a repeat of a 1994-type of bond crash is likely seems somewhat exaggerated, given progress on bank leverage regulations – while the current global capital flow cycle has already almost fully reversed from the cycle peak.

Type-1 and Type-3 bear markets warrant more attention. Global inflation dynamics are picking up, at a time when Central bankers voice more tolerance for “inflation overshoots”. Though currently bank equity investors are cheering the steepening of yield curves, meanwhile, the 2003 Japan episode should fix regulators’ attention on the growing home-bias in government bonds. Problematically, the IMF has warned that VAR risks have risen “significantly” in Japanese financial institutions after the financial crisis, given a continued build-up of JGB concentration in balance sheets. In Europe, the trend is equally one-directional: Italian monetary financial institutions, for instance, hold 18% of their assets in domestic government loans and securities, up from 12% in 2008. In most geographies, these bonds, despite efforts to the contrary, remain mainly held in “available-for-sale” portfolio buckets, where they have to be marked-to-market.

On balance, then, more than to a 1994-style meltdown, fixed income assets seem about to be confronted with dynamics similar to the second half of the 1960s, coupled with complications of a 2003-style curve steepening. By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias.

Paul Schmelzing is an academic visitor to the Bank from Harvard University’s History Department.

Link

Harvard Academic Sees Debt Rout Worse Than 1994 ‘Bond Massacre’ Bloomberg, by Anchalee Worrachate

If you thought you had already read the gloomiest possible prognosis for bonds, wait until you read this one.

Paul Schmelzing, a PhD candidate at Harvard University and a visiting scholar at the Bank of England, said if the latest bond market bubble bursts, it will be worse than in 1994 when global government bonds suffered the biggest annual loss on record.

“Looking back over eight centuries of data, I find that the 2016 bull market was indeed one of the largest ever recorded,” wrote Schmelzing in an article posted on Bank Underground, which is a blog run by Bank of England staff. “History suggests this reversal will be driven by inflation fundamentals, and leave investors worse off than the 1994 ‘bond massacre’”.

Schmelzing, whose research focuses on the history of international financial systems, divided modern-day bond bear markets into three major types: inflation reversal of 1967-1971, the sharp reversal of 1994, and the value at risk shock in Japan in 2003.

The Bank of America Merrill Lynch Global Government Index of bonds fell 3.1 percent in its worst-ever annual loss in 1994 as then-Fed Chairman Alan Greenspan surprised investors by almost doubling the benchmark rate. Treasury 10-year yields surged from 5.6 percent in January to 8 percent in November.

 

Bank of England

The current bond market is facing the “perfect storm” of potential steepening of the bond yield curve, monetary policy tightening, and a multi-year period of sustained losses due to a “structural” return of inflation resembling that of 1967, he said. Last quarter was the worst for government bonds since 1987, according to data compiled by Bloomberg.

Global inflation expectations, as measured by the yield difference between nominal and index-linked bonds, have risen to the highest since May 2015 after falling to a record low in February last year.

“By historical standards, this implies sustained double-digit losses on bond holdings, subpar growth in developed markets, and balance sheet risks for banking systems with a large home bias,” Schmelzing said.