[*Doing the same this over and over again and expecting a different result….attributed to Albert Einstein]
The Eurozone is teetering on the brink of collapse, and much of the rest of the developed world including Canada has been stuck on a “low growth” or “no growth” track since the Global Financial Crisis hit.
In the 15 months or so that the Trudeau Government has been in power, it has so far failed to deliver on most of its election promises; and in the case of the many spending and deficit commitments that it made in order to get elected, it has taken a U-Turn away from fiscal probity. All without apology or sufficient explanation.
The GFC Policy Response here in Canada, fiscal stimulus accompanied by low interest rates, has helped finance governments’ debt and lowered funding costs, as well as preventing otherwise non-viable companies from having to declare bankruptcy. However, we can now see that this policy of “financial repression” has come at a substantial cost for Canadian households and long-term investors such as insurance companies and pension funds; as well as the economy as whole.
Despite years of unprecedented stimulus:
• There is no meaningful growth
• Credit losses have not been remediated, they have been papered over and remain on the books
• Banks have bulked up instead of declining in size as announced after the GFC
• Derivatives risk is much larger not lower
• The Federal and many Provincial debt loads have bloated since the GFC. Still, there has been no meaningful extension of the duration of public debt liabilities. Canadian Governments and corporates are carrying unprecedented levels of re-financing risk in order to economize on debt servicing costs and thus be able to finance day-to-day expenditures. (Ontario is now the most indebted sub-sovereign Economy in the World)
• Other unintended consequences of financial repression include growing asset bubbles (The TSX, Toronto and Vancouver Real Estate) , crowding out long-term investors in otherwise well-functioning private markets, increasing economic inequality, creating the potential of higher inflation over the long term, distorting private capital markets and encouraging speculation and mal-investment (ditto for real estate and the share market)
Moreover, the prolonged period of virtually zero interest rates has imposed a new set of risks and challenges for Canada as well as the major economies because it has encouraged debt accumulation instead of the needed de-leveraging. By our reading this means there has been NO EXIT from the Crisis Phase. The conclusion we make is that the policy response was and is mis-specified.
Principally these risks are that if consumption and investment spending are not responsive enough to the lower interest rates then the overall effect on real side growth could very likely be negative. Breaking it down, this is because an economy’s reaction to a change in policy, in this case a sharp drop in interest rates, consists of substitution effects and income effects. The substitution effect encourages higher real growth while the income effect retards real growth
According to the St Louis Fed (no less) addressing this topic, “The lower interest rate increases the price of future consumption, causing individuals to increase current consumption and reduce current saving—the substitution effect. The lower rate also reduces current interest income, which induces individuals to save more and consume less—the income effect. Consequently, consumption and investment can increase or decrease depending on the relative magnitudes of the income and substitution effects.”
What appears to be the case is that the income effect – essentially a reduction in interest income for households and financial businesses – has swamped the substitution effect rendering the policy mix impotent. According to the Bank of Canada, growth in each of calendar 2015 and 2016 was a measly 1.1 percent. The Bank expects growth of 2.0 per cent in 2017. Any way you slice it, to us the growth profile of Canada since the GFC adds up to a DEPRESSION.
Despite this lack of policy traction, the response by the authorities so far has been to double down on the strategy and to supplement it with deficit spending. For Canada this means that the hard won gains of reining in debt growth and wasteful spending commenced in the mid 1990’s by the Paul Martin Government and continued by Prime Ministers Chretien and Harper are being squandered by the Trudeau Government in order to chase rainbows in the hopes of finding a pot of gold.
There is a now rapidly growing disconnect between the Trudeau Government’s penchant for virtue signalling (and taking inane selfies while so doing) and its actual achievements. Despite all expectations to the contrary at present, Trudeau Junior may turn out to be a one-term flash in the pan.
On taking office the Liberals had an ideal opportunity to abandon the Crash-response policies adopted, wrongly and in haste, by the previous Government. They did not take this opportunity to fix what was so obviously not delivering the intended results. Our expectation, for the upcoming budget announcement from Ottawa is that the Trudeau Government will again fail to enact a course correction, and will instead redouble its spending initiatives and run up debt to the detriment of all Canadians.
Donald Trump is the man recently chosen by the people of the United States to deal with the legacy of Obama’s delusional politics and policies – including those which have appallingly offered vast sums of blood money and guarantees of peace and non-aggression to nations and organizations who have been avowed and implacable foes of the West for decades, while simultaneously shafting and selling out the West’s longstanding and true allies; which sought to substitute appropriate demonstrations of military power with an impotent combination of pseudo-Wilsonian high-mindedness and terroristic drone strikes; who accepted the Nobel Peace Prize while embarking on the most massive stockpiling of nuclear arms in recent history; and who preached tribalism and fanned the flames of race hatred and social division at home while blathering about the unity of man when abroad*
He was a President who was feckless, destructive, and arrogantly out of touch.
Not surprisingly, Obama also merits a lamentable report card as a steward of the economy.
It is worth noting that not only did the Republicans win the Presidency, they captured majorities in both the House and Senate and prevailed in most of the gubernatorial; posts that were up for grabs….and the state of the economy is probably the single most important factor in explaining this devastating defeat of the Democrats at the polls back on 8th November.
While current headline unemployment at just south of 5% is very low, it doesn’t tell the whole story of what is happening in the Labor Market. Recall our previous analysis when we pointed out that almost 10 million Americans are no longer in the labor force.
Quite simply, had the US had enjoyed a Reagan-paced jobs recovery the country would today have at least 12 million more Americans working. Unfortunately, the job creators that would have been needed for this to have happened are still absent as a result of regulatory red tape, Obamacare, tax hikes and other misguided assaults against households and small and medium-sized businesses.
When fewer people are working and wages are stagnant, incomes don’t grow. That’s the real sad history of the Obama era as far as the US economy is concerned. If the Obama recovery had been just average, annual after-tax per capita personal income would today be over $3000 higher – more than 5% to the better.
In the event, voters ceased to be fooled by giddy talk about “hope and change.” They felt how tough the times had become and cast their ballots accordingly.
Another key statistic that stands out on the Obama record is the fact that the National Debt is now over 19 Trillion Dollars, or 106% of GDP. This means that the size of the debt accumulated in the first 230 odd years of the existence of the Republic, was just about doubled by Obama in the 8 years of his Presidency. The annual carrying cost of this debt monster is alone around half a trillion dollars a year.
And in terms of economic growth relative to the known history, the Obama recovery ranks dead last.
Good Luck and Godspeed to the President-Elect.
He will need it.
[* with an acknowledgment to TMD]
[** In the 2012 campaign, Obama said that Al Qaeda had been ‘decimated.’
The interviewer from the New Yorker Magazine then pointed out that “…the flag of Al Qaeda is now flying in Fallujah, in Iraq, and among various rebel factions in Syria; Al Qaeda has asserted a presence in parts of Africa, too under the ‘ISIS’ banner.”
Obama responded: “The analogy we use around here sometimes, and I think is accurate, is if a JV team puts on Lakers uniforms that doesn’t make them Kobe Bryant.” (For the non-sports fan, JV stands for junior varsity, and it usually means a high school or college’s secondary team.)
In fact, the people Obama mockingly referred to as a terrorist “JV team” in 2012, have developed into to the world’s most brutal terrorist network, being not only responsible for thousands of deaths in the Middle East but also linked to hundreds more in dozens of terrorist plots in the West. By mid 2016 ISIS was in control of thousands of square miles of territory in Iraq and Syria, though the U.S. military says the group been pushed out of swaths of land, especially in Iraq, since a territorial high point in late summer 2014. … ]
Recovery Partners has been around for five Presidential Election cycles.
Typically we have refrained from offering comment on these events. Without question however, the 2016 race has been an extremely fraught election campaign, and one that features candidates on both sides that are less than ideal. At the same time there are crucial issues that need to be resolved in the US in order to regain economic momentum and ensure peace. In this speech Silicon Valley entrepreneur Peter Thiel lays out the core issues in a very cogent and honest manner.
We agree with both his premises and his conclusions.
Peter is not affiliated with either the Republicans nor the Democrats.
Peter comes out squarely behind Donald Trump. Not in the least, as Thiel explains, this is because Hillary’s foreign affairs proposals risk a hot war with the Russians. In fact, tensions with Russia and China are arguably higher right now than they have ever been since the Cuban Missile Crisis; in part, because of Hillary Clinton’s aggressive talk against these powers while on the stump and threats about retaliation for unverified Russian “computer hacking” that have been made by Obama, Biden, and other administration officials. Donald Trump, on the other hand, is not provoking the Russians or the Chinese. At the same time he is proposing a rational approach to successfully address the pressing economic issues that the US is facing.
Global markets over the last several months were again bubbling with expectations that the Fed might be finally on the verge of jacking rates up in response to a strengthening economy. In fact, ahead of Friday’s Non-Farm Payroll employment release, predictions of the number that the Labor Department would announce for an increase in jobs ranged as high as 200,000. Many pundits were crowing that the US jobs market of late has been the strongest it has been in over 50 years.
Had the numbers come in on expectations this would have allowed the Fed to embark on a campaign of modest tightening of policy around the time of the next Board of Governors meeting in November – and the various economy-bullish prognosticators would have then been proved right. In the event, and for the umpteenth time in the last five years, this was not to be.
With the release of Non-Farm Payrolls last Friday, the headline number came in substantially below expectations at 156,000. Moreover taking into account all of the prior months’ revisions that were published, the net effect was in fact a decline in new jobs. The bad news oozing out of this release does not stop there:
The headline unemployment rate ticked back up to 5.0% from 4.9%
According to the Household Survey (a different report that the Non-Farm payroll report), September showed a gain of only 5,000 full time positions as measured against an increase of 430,000 part time jobs for the month of September. Most jobs growth has been part time, and this may be skewing the headline unemployment rate to reflect less unemployment than is really the case.
The labor force still shows no signs of growth or recovery. If participation in the labor force were the same size as prior to the onset of the GFC we would now be staring at a US unemployment rate well north of 10%. We first pointed out this grim statistic several years ago when we discussed the very significant drop in the Labor Force Participation Rate.
Along with this past Friday’s non-farm payrolls release we also learned that the Atlanta Fed has slashed its forecast of Q3 growth almost in half from 3.8% just a few months ago down to 2.1%
Why in fact would the Fed raise rates now when all indicators are slowing and showing an economy that is expanding at less than half of the pace of only two years ago? it is in essence an illogical expectation.
Therefore we see no reason to change our earlier predictions.
With Ted’s kind permission we have reproduced his observations here. According to him:
We are witnessing a breakdown of faith, outside central banks, in unconventional monetary policy (UMP). In recent days and weeks, the attack on UMP has intensified from a wide array of analysts including current and former monetary officials as well as highly regarded financial market commentators.
“New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns.”
As unconventional policy comes under attack, central bank credibility is eroded and diametrically opposing views are forming over what direction monetary policies should take next.
Opponents of UMP favor a gradual unwinding of unconventional monetary policies of key central banks, namely the US Federal Reserve, the Bank of Japan (BoJ) and the European Central Bank (ECB), including quantitative easing (QE) and negative interest rate policy (NIRP).
Supporters of UMP favor even more aggressive use of these policies, by both the BoJ and the ECB to combat slow growth and deflation now. Some advocate going further to implement “helicopter money” or monetary financing of new fiscal stimulus.
Which of these policy scenarios plays out over the next few years will dramatically influence both economic and financial market outcomes, not only in the economies of the central banks employing unconventional policies, but across the global economy as the spillovers from the policies of the major central banks reverberate through global financial conditions.
The Critique of Unconventional Monetary Policy
Perhaps the most damaging critiques of UMP have come from current and former monetary officials.
In July, Claudio Borio, Head of the Monetary and Economic Department at the Bank for International Settlements (BIS), along with his colleague Anna Zubai, published a paper titled “Unconventional monetary policies: a re-appraisal“. The paper traces the use of UMP and reviews the evidence on the impact of such policies. Borio and Zubai wrote,
They were supposed to be exceptional and temporary – hence the term “unconventional”. They risk becoming standard and permanent, as the boundaries of the unconventional are stretched day after day.
Following the Great Financial Crisis, central banks in the major economies have adopted a whole range of new measures to influence monetary and financial conditions. … But no one had anticipated that they would spread to the rest of the world so quickly and would become so daring.
This development is a risky one. Unconventional monetary policy measures, in our view, are likely to be subject to diminishing returns. The balance between benefits and costs tends to worsen the longer they stay in place. Exit difficulties and political economy problems loom large. Short-term gain may well give way to longer-term pain. As the central bank’s policy room for manoeuvre narrows, so does its ability to deal with the next recession, which will inevitably come. The overall pressure to rely on increasingly experimental, at best highly unpredictable, at worst dangerous, measures may at some point become too strong. Ultimately, central banks’ credibility and legitimacy could come into question.
In August, just as central bankers were congregating at Jackson Hole, Wyoming for their annual get-together, former Federal Reserve Governor Kevin Warsh published another, more strongly-worded, broadside against UMP in an op-ed in the Wall Street Journal.
The conduct of monetary policy in recent years has been deeply flawed.
The economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.
The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its “forward guidance,” promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.
At the Jackson Hole meeting, Christopher Sims, the influential Professor of Economics at Princeton University, attempted to answer the question of why unconventional monetary policies, including negative policy interest rates, have been ineffective in boosting growth and returning inflation to target levels, with the following assessment:
“Reductions in interest rates can stimulate demand only if they are accompanied by effective fiscal expansion. For example, if interest rates are pushed into negative territory, and the resources extracted from the banking system and savers by the negative rates are simply allowed to feed through the budget into reduced nominal deficits, with no anticipated tax cuts or expenditure increases, the negative rates create deflationary, not inflationary, pressure.”
These critiques from current and former monetary policy insiders, give added weight to the arguments against UMP that have been coming from private sector analysts for years. To quote a few recent examples,
James Grant, Publisher, Grant’s Interest Rate Observer:
John Hussman, President, Hussman Econometrics Advisors:
“By driving interest rates to zero, central banks intentionally encouraged investors to speculate long after historically dangerous ‘overvalued, overbought, overbullish’ extremes emerged. In my view, this has deferred, but has not eliminated, the disruptive unwinding of this speculative episode. By encouraging a historic expansion of public and private debt burdens, along with equity market overvaluation that rivals only the 1929 and 2000 extremes on reliable valuation measures, the brazenly experimental policies of central banks have amplified the sensitivity of the global financial markets to economic disruptions and shifts in investor risk aversion.
The Fed has insisted on slamming its foot on the gas pedal, refusing to recognize that the transmission is shot. So instead, the fuel is instead just spilling around us all, waiting for the inevitable match to strike. We can clearly establish that activist monetary policy – deviations from measured and statistically-defined responses to output, employment and inflation – have had no economically meaningful effect, other than producing a repeated spectacle of Fed-induced, speculative yield-seeking bubbles.”
Russell Napier, Strategist and Co-founder of the Electronic Research Exchange (ERIC)
“Negative interest rates could, if filtered through into deposits in any significant way, lead people to prefer the banknote to the deposit. That used to be called a bank run.”
“Policy Singularity” refers to the time when monetary and fiscal policy can no longer be distinguished. It is the final step in Bernanke’s famous helicopter speech. Briefly, the steps [taken by central banks] included quantitative easing; effectively pegging the yield curve; providing forward 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.
At this moment I still fret more about the outbreak of deflation than inflation, but such concerns would have to be abandoned if ‘helicopter money’ were implemented. The likelihood of their eventual implementation grows by the day as the failure of monetary policy becomes more evident. ‘Helicopter money’ will produce higher levels of broad money growth and inflation. Crucially, the state will not respond by lifting policy rates to control such inflation. Crucially, the state will not allow the yield curve to reflect rising inflation expectations or debts, particularly short-term debts, cannot be inflated away. Crucially, the state will not allow the private sector to gorge itself on credit, the natural reaction when inflation is higher than interest rates. … This analyst meets few investors who don’t see that financial repression, the process through which the state manipulates the yield curve to below the rate of inflation, is the policy of choice for the developed world.”
A summary of the critique of Unconventional Monetary Policy would include the following points:
There is little evidence (according to the BIS and others), that the UMP implemented since the Great Financial Crisis has provided a significant, lasting boost to either economic activity or inflation.
There is strong evidence that UMP has had a significantly inflated real and financial asset prices. This has contributed to the widening inequality of income and wealth.
Even if there are short term benefits of UMP, these are subject to diminishing returns and raise the risk of fuelling speculative bubbles. When such bubbles burst, the dislocations tend to feed through to the real economy, possibly triggering recession and/or deflation.
Increasingly aggressive UMP narrows the room to maneuver of central banks and risks leaving them with limited policy choices for dealing with the next recession.
When the next downturn comes, central banks will be under political pressure to experiment with even more dangerous forms of UMP, including helicopter money (money financed fiscal stimulus).
Central banks’ independence is reduced as monetary policy becomes the servant of fiscal policy and the objective of targeting inflation gives way to the imperative of financial repression as the government requires that interest rates be held below the rate of inflation so that government debt can be inflated away.
Breakdown of faith in UMP threatens central bank credibility and legitimacy.
What is the Future of UMP?
Just because thoughtful people outside of central banks are losing faith in UMP does not mean that the decision-makers of the major central banks are planning to change their approach to monetary policy. On the contrary, it seems that advocates of UMP are committed to taking even more aggressive actions if their targets for economic growth and inflation continue to be unmet.
The central bankers and academics who gathered at Jackson Hole, perhaps anticipating and responding to the growing criticism of UMP, made the theme of their symposium “Designing Resilient Monetary Policy Frameworks for the Future“. Fed Chair Janet Yellen left little doubt that, in her opinion, UMP will play an important and possibly increased role in future monetary policy. In the event that the current expansion falters and the economy moves toward a recession, Yellen suggested that the tools of UMP would be resorted to once again:
In addition to taking the federal funds rate back down to nearly zero, the FOMC could resume asset purchases and announce its intention to keep the federal funds rate at this level until conditions had improved markedly–although with long-term interest rates already quite low, the net stimulus that would result might be somewhat reduced.
Despite these caveats, I expect that forward guidance and asset purchases will remain important components of the Fed’s policy toolkit. … That said, these tools are not a panacea, and future policymakers could find that they are not adequate to deal with deep and prolonged economic downturns. For these reasons, policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.
On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks, though adding them to our toolkit would require a very careful weighing of costs and benefits and, in some cases, could require legislation. For example, future policymakers may wish to explore the possibility of purchasing a broader range of assets. Beyond that, some observers have suggested raising the FOMC’s 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting.
In fact, Chair Yellen while solidly behind UMP measures adopted to date, was far from the most enthusiastic UMP advocate at Jackson Hole. Professor Marvin Goodfriend of Carnegie-Mellon University argued that, “It is only a matter of time before another cyclical downturn calls for aggressive negative nominal interest rate policy actions”. The aforementioned Christopher Sims called for helicopter money financed fiscal stimulus as follows, “What is required is that fiscal policy be seen as aimed at increasing the inflation rate, with monetary and fiscal policy coordinated on this objective”. Finally, Bank of Japan Governor Kuroda, who has overseen the most aggressive UMP to date, has no qualms about pushing ahead even further,
Looking ahead, the Bank of Japan will continue to carefully examine risks to economic activity and prices at each monetary policy meeting and take additional easing measures without hesitation in terms of three dimensions — quantity, quality, and the interest rate — if it is judged necessary for achieving the price stability target. QQE with a Negative Interest Rate is an extremely powerful policy scheme and there is no doubt that ample space for additional easing in each of these three dimensions is available to the Bank. The Bank will carefully consider how to make the best use of the policy scheme in order to achieve the price stability target of 2 percent, and will act decisively as we move on.
The Risks That Lie Ahead
With a developing professional view that UMP has gone too far, is subject to diminishing returns, and that short term gains from such policies are likely to give way to long term pain, there are significant risks to both the economy and financial markets no matter what path central banks decide to pursue.
With the US economy having performed relatively well in the disappointing global expansion since the GFC, the Fed is in the strongest position to begin to remove unconventional monetary stimulus. Indeed, the Fed has already begun to do so by tapering quantitative easing, by lifting the policy rate by 25 basis points last December, and by providing forward guidance that the policy rate would continue to rise. However, each of these steps have caused corrections in global markets for risk assets and sharply increased volatility. The greatest volatility has come in China and other highly-geared emerging markets as the promise of tighter US financial conditions has spilled over into tighter global financial conditions. In response to this volatility and to slowing economic growth, the Fed has pushed back the timing of it plans for hiking the policy rate and eventually reducing the size of its’ balance sheet.
Meanwhile, in an environment of slowing global growth and deflationary pressures, the adoption of negative policy interest rates, as well as continued large scale purchases of government bonds, by the BoJ and the ECB have pulled global bond yields down. At the low point in global bond yields, as much as US$13 trillion of government bonds had negative yields. Despite the Fed’s intentions to reduce monetary stimulus, US bond yields fell to near record lows. In Canada, where the BoC has been sitting on its hands for over a year, the effect of foreign central banks’ UMP has pushed bond yields to new lows, with the 10-year Canada bond yield falling below 1%.
The fall in global bond yields has had three effects: it has reduced mortgage borrowing costs which has boosted prices and encouraged speculative activity in housing markets; it has caused investors to reach for yield in risky investments; and it has encouraged even highly-indebted governments to relax fiscal discipline by boosting debt-financed infrastructure spending plans.
As consumer, corporate and government debt all continue to grow faster than nominal GDP, it becomes increasingly dangerous for central banks to remove monetary accommodation. Monetary policy increasingly becomes hostage to the need for financial repression, that is for interest rates to be pegged below the rate of inflation so that debt can be inflated away. Inflation targeting becomes less attainable and politically less popular.
Pushing further into unconventional monetary policies, say by moving towards “helicopter money”, also known as central bank financed fiscal stimulus, might provide some short-term gain (as has resulted from other less drastic forms of UMP), it is also likely to result in even more long term pain.
Since the policy response to the 2008/09 Global Financial Crash became fully known we have been consistent in our view that the “solutions” to the GFC are anything but, and that these “patches” have instead sown the seeds for a forthcoming, and much more destructive, market dislocation that must surely follow.
“When will this happen?” I have been asked many times over the past few years. The short answer is “I don’t know” Against the odds, fixed interest yields have continued to track lower while global stock markets have been reaching new heights.
Nevertheless we remain convinced of our analysis.
The difficulty and stress involved in swimming against the tides of euphoria that are un-anchored to any semblance of realistic market values was recently described in vivid detail by Michael Lewis in his book “The Big Short” (also recently made into an excellent movie starring Christian Bale, Steve Carrell and others.) I have not read or seen a better description of this process. The pitfalls associated with being at odds with the general market opinion (while being right), include the risk of Gambler’s Ruin i.e. being too early and losing your bets as a consequence, being part of a corrupt game where the payout odds are stacked against you by underhanded participants, having the regulator or government change the rules favoring those whom you bet against, and other dirty tricks.
When these conditions exist there is in fact NO LIMIT to the potential divergence of market prices from a realistic point of objective value and NO PREDICTABLE TIME INTERVAL by the end of which sanity is guaranteed to have been restored to market behavior.
In looking at what the policy authorities, in their imperturbable smugness, are foisting on market participants and the general public today, I am also reminded of my experience running a new issue origination and derivatives trading operation in Japan at a time that coincided with the Japanese “Triple Yazu” Crash of 1989/90 involving the implosion of a Japanese stock price and real estate bubble of immense proportions.
By the late 1980’s Real Estate Prices in Japan had reached astronomical levels but there appeared to be no shortage of willing buyers. As a case in point, at the peak of real estate valuations, the Imperial Palace grounds, the Tokyo home of the Emperor of Japan, and measuring about 3.5 square kilometers in area, was a piece of
real estate that then alone exceeded in value ALL of the real estate in California, a geography approximately 100,000 times larger. For the Japanese this valuation differential did not seem odd at all; in fact the Japanese bureaucracy, Senior Japanese Corporate Executives and the general public thought the sky-high Japanese real estate prices to be a point of National pride.
All of these relative price changes came about, first gradually after the end of WWII (and the American occupation) and then gained momentum spurred by a mixture of greed, corruption and bad Government policy (implemented by imperturbably smug bureaucrats at the Japanese Ministry of Finance, the BoJ and MITI) that created the conditions for the euphoria and the inevitable blow-off.
A key contributor to this process was a new aspect of Japanese business practice that was known as “Zaitech”. This phenomenon and its results is more fully described in the text box following this blog. It proved to be the ruin of many Japanese market participants and has contributed to a decades long Recession (Depression – but none dare call it by name) in Japan.
What we have today is a variant of the practice of Zaitech that is currently taking place under the sponsorship of major Central Banks around the world.
Central banks have typically invested their foreign exchange reserves (or a portion of their reserves) in short-term, highly liquid and secure foreign government securities that they can always realize in case of crisis with a minimum loss of value. While such assets are intended to provide a liquidity buffer in times of financial stringency, money market assets yield low rates of return. And the current thinking from the imperturbably smug folks (ie central bankers) that brought you ZIRP and NIRP, is that the larger their reserves portfolios, the greater will be their opportunity cost of these low returns compared with returns on alternative uses of the funds. (You can almost see them imploring rhetorically that :”Something must be done!!”) The fact that the low money market returns are a direct result of the current ZIRP and NIRP policies implemented by the central banks themselves does not penetrate the ivory tower thinking that traps them in this logic loop.
Therefore to compensate for the (self-generated and imaginary) “lost” revenue on their reserves portfolios, key central banks around the world are now buying increasing volumes of equities as part of what is being rationalized by these powers that be as a “diversification” of their asset holdings. A recent survey of 60 central bankers, overseeing a combined $6.7 trillion, found that “low bond returns” had prompted almost half to take on more vastly increased risk in exchange for a few additional basis points of interest income.
If that does not give the average clear-headed person enough pause, here is an additional overview of this latest policy wheeze.
By the numbers, ,
China’s State Administration of Foreign Exchange (SAFE), the governmental agency in charge of administering the country’s foreign exchange reserves, has become the world’s largest public investor in equities.
The Swiss National Bank (SNB) has increased the share of equities in its foreign currency investments to 15 per cent,
The Bank of Israel has eight per cent of its foreign currency reserves invested in equities and plans to increase this to 10 per cent. Some other central banks that have diversified their holdings to include equities appear to be targeting a 10 per cent equity allocation in their reserves portfolios.
Other central banks that hold stocks in their reserves portfolios include the Bank of Japan (Reports are that they currently hold USD 120 Bn. of equities), the Bank of Korea, the Swiss National Bank, the National Bank of Denmark, the Bank of Italy, the Bank of Israel and the Czech National Bank.
The erstwhile conservative Swiss National Bank has what to certain central bankers that were interviewed on this topic have called “a globally well-diversified equity portfolio of roughly 6,000 individual stocks.” Of course, given the knowledge that in a Crash – something the liquidity buffers are meant to protect against – all correlations converge to 100%, meaning that there are no ex ante or ex post diversification benefits to be had in any event. So why hold 6,000 lines of equity?
Finally, it has been over two years since Negative Interest Rate Policies (NIRP) were ballyhooed by a collection of central banks – the ECB among them – as sure-fire catalyst for renewed economic growth. So far there has been no discernible impact in that regard. Instead, European savers have foregone almost Euro 500 Bn. of Interest Income since the imposition of NIRP, however, Europe’s savers have obtained no economic benefits in exchange for this sacrifice. In fact, Europe is struggling with growth that is barely above 1%, a slower rate of expansion than before the implementation of negative interest rates.
…..and now, their latest policy fiddle sees the Central Banks piling into share-markets, and buying equities at all time high prices in vast amounts, and using public funds to do so.
What could possibly go wrong ?
[Alex Jurshevski managed the Foreign Currency Liquidity portfolio for Bank of Montreal and contributed to the revamping and refinement of the Liquidity Policy for the Bank. While in New Zealand at the Debt Management Office he developed a liquidity policy for the Crown. At no time were equities considered an eligible investment for liquidity management purposes in either institution. Moreover, as described in the press and by representatives of the Official Monetary and Financial Institutions Forum (OMFIF) the push for equities investments by Central Banks as described is completely out-of-scope with respect to the Liquidity Adequacy Guidelines (LAR) adopted by OSFI in 2014 after consultations with other national financial institution regulators and the banking community.]
From the early 1960s to the late 1980s, Japan had one of the highest economic growth rates in the world. In the 1970s. In part this was due to the importance of using land as traditional collateral for loans. Land and Real Estate speculation was in fact a key part of that bubble economy. Japanese land prices were traditionally high, partly due to the mountainous island nation’s small amount of available land and various restrictive practices regarding agricultural production, house construction and zoning laws. Because of its high value, banks always accepted property as collateral for loans, and in the Post-WWII period, land came to serve as the engine of credit for the entire economy.
With hindsight, by the 1980’s it was clear that stock prices and land prices were becoming unsustainable. In 1984, however, the Japanese deregulated their financial markets adding fuel to the expansion of the price bubbles.
The bubbles were further fueled by what the Japanese termed “zaitech,” or “Financial Engineering,” whereby which the gains from speculation became an integral part of corporate earnings statements. This practice was encouraged by bankers and derivatives dealers eager for easy profits from the sale of complex real estate or equity-linked financial structures to company financial managers caught up in the euphoria. For a brief period of time Zaitech became so ingrained in Japanese corporate culture that to not be engaging in zaitech as a CFO or CEO of a Japanese non-financial company would have been seen as a major badge of shame – a big no-no in that society.
The sad reality was that zaitech simply involved a number of irresponsible investing practices – excessive leverage, poor investment targets, zero risk management, etc.
In the environment of low interest rates and easy access to credit, many new players entered the financial markets as a consequence, pushing prices ever higher (This behavior was backstopped by a generally held belief that the Government, the BoJ and the very powerful Japanese banking cartel had a common interest in seeing land and share prices go higher and would not let them fall.)
Non-financial Company Profits were very often recycled back into further speculative market activities again and again. Some firms also chose to hide profits by investing in illiquid high risk assets such as Fine Art, Whiskey and Golf Courses.
As the Japanese stockmarket kept zooming higher and higher, corporations happily reported their speculative profits as increased earnings, and also, paid no tax on large proportion of the profits that had been recycled into illiquid high risk assets.
Investors would then rush to purchase company shares, driving their prices and earnings even higher and providing more funds for additional speculative moves.
By the end of the decade, this self reinforcing speculation completely dominated the activities of many businesses: In fact it has been estimated that as much as 40 to 50% of total reported profits from Japan’s largest corporations were derived from zaitech during that period.
By 1989, Japanese government officials were growing uneasy about the skyrocketing values of the stockmarket and land valuations. Thus, by May 1989,the BoJ began to tighten monetary policy by raising interest rates, Undeterred, the Stock Market reached its all-time high on December 31, 1989 (so that all corporations and banks could book the higher closing prices on their year end statements!) . However in January 1990, stock prices began to plummet and along with a fast-softening real estate market, severely punished everyone who had not taken their chips off of the table.
As the stockmarket kept falling, the BoJ was repeatedly forced to intervene in a futile attempt to try and revive the markets and stave off recession. This did not happen. The share market, at its nadir, was down almost 80% and Real Estate prices fell by a similar amount.
Since that period of time, Japan has been mired in a slow growth trap, and has experienced much weaker growth than any other major industrial nation. Some might even call it a “Depression”.
After wading through the various commentaries on the Brexit vote we came upon this piece by David Stockman writing for the Daily Reckoning which we now offer up for your perusal. As our readers will note, his essay is completely congruent with the views that we have expressed on these pages and in our media appearances over the past number of years regarding the actions taken by Central Banks and the un-elected nabobs in Brussels following the Global Financial Crisis:
“At long last, the tyranny of the global financial elite has been slammed good and hard. You can count on them to attempt another central bank based shock and awe campaign to halt and reverse the current sell-off. But it won’t be credible, sustainable or maybe even possible.(this has already happened, now we wait) The central banks and their compatriots at the European Commission, IMF, White House/Treasury, OECD, G-7 and the rest of the Bubble Finance apparatus have well and truly overplayed their hand. They have created a tissue of financial lies; an affront to the laws of markets, sound money and capitalist prosperity.So there will be payback, clawback and traumatic deflation of the bubbles. Plenty of it, as far as the eye can see.On the immediate matter of Brexit, the British people have rejected the arrogant rule of the EU superstate and the tyranny of its unelected courts, commissions and bureaucratic overlords.”
Hear, Hear! we say.
Apart from what Mr Stockman wrote, what we find particularly ominous is the denial of reality, expressed by media and political elites in their immediate reaction to the voting result, not only in Europe but also here and in the US and elsewhere. Most of this comes about as a result of complete ignorance, whether intentional or not of what EU membership has meant to the average person on the high street in the UK and a total failure to properly understand and objectively assess the sequence of events that have led us to this point.
Anyone who thinks the EU has been good for Britain, its people or British industry simply hasn’t paid attention to what has been systematically ripped off from the UK and the consequential loss of opportunity for its young people, among other things, that Britain is having to endure. For example, the following list is courtesy of one of our occasional contributors (NB This is only a partial account of what has happened in the last five or so years.).
According to the information we received:
1. Cadbury moved its UK factory to Poland in 2011 financed with an EU grant.
2. Ford Transit moved to Turkey 2013 with an EU grant.
3. In 2015 Jaguar Land Rover (JLR) agreed to build a new plant in Slovakia with an EU grant. JLR is owned by Tata, the same company which in the last 8 years has reportedly bankrupted Britain’s steel works and emptied the workers’ pension funds.
4. Peugeot closed its Ryton (was Rootes Group) plant and moved production to Slovakia with EU grant.
5. Recently it was announced that the British Army’s new Ajax fighting vehicles are to be built in Spain using Swedish steel at the request of the EU to support jobs in Spain. The original plan was to build the vehicles in Wales with an EU grant.
6. Dyson gone to Malaysia, on the back of an EU loan.
7. Crown Closures, Bournemouth (Was METAL BOX), gone to Poland with EU grant, once employed 1,200.
8. Marks and Spencer manufacturing has relocated to the Far East courtesy of an EU loan
9. Hornby models gone. In fact, all toys and models are now gone from UK along with the patents all financed with EU grants
10. Gillette gone to Eastern Europe courtesy of an EU grant.
11. Texas Instruments Greenock vacates to Germany with EU grant.
12. Indesit at Bodelwyddan Wales gone with EU grant.
13. Sekisui Alveo said production at its Merthyr Tydfil Industrial Park foam plant will relocate production to Roermond in the Netherlands, with EU funding.
14. Hoover Merthyr factory moved out of UK to Czech Republic and the Far East by Italian company Candy with EU backing.
15. ICI integration into Holland as AkzoNobel with an EU bank loan. Within days of the merger, several factories in the UK, were closed, eliminating 3,500 jobs.
16. Boots sold to Italians Stefano Pessina who have based their HQ in Switzerland to avoid tax to the tune of Â£80 million a year, using an EU loan for the purchase.
17. JDS Uniphase, now run by two Dutch men, bought up companies in the UK with Â£20 million in EU ‘regeneration’ grants, created a pollution nightmare and just recently closed it all down leaving 1,200 out of work and an environmental clean-up that needed to be paid for by the UK tax-payer. They also reportedly drained the pension fund dry.
18. UK airports are owned by a Spanish company.
19. Scottish Power is owned by a Spanish company.
20. Most London buses are run by Spanish and German companies.
21. The Hinkley Point C nuclear power station to be built by French company EDF, part owned by the French government, using cheap Chinese steel (that reportedly has catastrophically failed in other nuclear installations.) Now EDF say the costs will be double or more and delivery of the facility will be very late if it ever does come online.
22. Swindon was once Britain’s leading producer of rail locomotives and rolling stock. Not any more. Now it’s Bombardier in Derby; and due to their losses in the aviation market, that could see the end of the British railways manufacturing altogether even though Bombardier had EU grants to keep Derby going (which they diverted to their loss-making aviation side in Canada, thus hobbling the UK operations.)
23. 39% of British invention patents have been passed to foreign companies, many of them in the EU
24. The Mini cars that Cameron recently trumpeted as an example of British engineering, are built by BMW mostly in Holland and Austria. His campaign bus was made in Germany even though British domestic bus manufacturers include Plaxton, Optare, Bluebird, Dennis and others.
25. There are no major technology companies still running and profitable in the UK.
Please note that there are no cases of any events like this occurring to the benefit of the UK or UK businesses over the same time period.
The British for their part are also not ignorant of the social costs of EU membership, including the forced impoverishment (austerity) of their neighbors in the EU since the onset of the Debt Crisis.
They are also acutely aware of the many costs of the forced immigration that has been mandated by the EU – including the displacement of senior citizens and UK veterans from council housing accommodations as well as the deleterious impact of middle-aged rape gangs that were grooming young English Girls (and a smaller number of Boys) in the Rotherham suburb – for almost 20 years – while this atrocity was being covered up by a compliant and toothless Home Office fearful of being labeled “racist”
The ultimate conclusion to all of this, including the fallout over vote result itself has still to play out. Based on the Squabbling and Squawking we have seen so far, and the knee-jerk continual re-playing of the “Fear” card by the Brussels elites, this final outcome and the path to that result, promises to be a very messy and uncertain affair indeed.
Ted Carmichael, the respected former Chief Economist at JP Morgan Canada, has recently published research that shows why the Canadian public should be extremely wary of taking the Federal Government’s explanations and rationale for its revised spending plans at face value.
According to him “It is somewhat surprising to me that in recent days, the Governor and the Senior Deputy Governor of the Bank of Canada have gone out of their way to tell members of the press that they believe that Canada’s latest fiscal stimulus will have a substantial positive effect on real GDP. Mr. Poloz and Ms. Wilkins seem to be arguing that one of Robert Mundell’s Nobel prize winning theoretical insights does not apply to the Canadian economy, the very economy where Mundell pointed out that his theory was most likely to be true. They seem to be arguing that the 2010 empirical results of the NBER and of the BoC’s own researchers, which showed zero or very low fiscal multipliers are not to be believed.”
What this means in essence is that once the Stimulus Programs have run their course is that all we will be left with is no growth on record and a large pile of debt that will have to be paid off.
Do NOT Consume This Product if you plan to Drive or Operate Heavy Equipment (*May Cause Asset Bubbles, Drowsiness, Hyperactivity, Flatulence; Diarrhoea; Depression, Recession, Stock Market Crashes, Delusions of Central Bank competency, Hallucinations; War, Famine, Disease and Death)
Late last week Bloomberg TV aired a program about everyone’s favorite bogey man – the Canadian Housing Market. The show, graced as it was by some very formidable analysts, economists and investors should have come up with a much better synthesis of the situation and a more incisive view of why we are where we are.
Entitled “House of Cards” Bloomberg put forward the proposition that the Canadian Housing Market MAY be overvalued and prone to a Price Correction…. The interviewer, at times sporting a pair of “Miss Manners” glasses, tried valiantly to get to the bottom of the story but she was not successful.
This is because what the Interviewer and the Bloomberg producers and copywriters seem to have missed entirely is that it has been the expressed aim of the Monetary Policy adopted as a crash response to create the very increases in the asset prices that the TV program was tasked with researching – housing being only ONE of the affected markets. The fact that the Canadian Housing market is or appears overheated is no accident – it was a policy objective (and obviously a known outcome, ex ante).
Broadly speaking, there are three distinct ways in which the brand of monetary policy that has been implemented was expected to kick start aggregate demand and to thereby by re-start the economy.
One; the Fed (and other central banks) reduced the quantity of financial assets available for trading in the private sector, in so doing the central banks lowered the rate of return on these assets (which is the same as raising the price of the assets since the price of a financial asset and the yield are inversely related). The fall in the interest rate creates an incentive for more investment and more consumption of durables, which in turn should boost output and employment.
Two; these policies can increase inflation expectations. The increase in expected inflation lowers the real interest rate (the real interest rate = nominal interest rate – the expected rate of inflation). The fall in the real interest rate would have the effects outlined above, i.e. create an incentive for more investment and consumption of durables, which then spurs output and employment.
Three; the increase in the price of the financial assets (Stocks, bonds, Housing, etc) due to the inverse relationship between the price and the rate of return noted above. This makes people feel wealthier, and it is hoped that this wealth effect will spur more spending thereby generating an increase in output and employment.
Thus as we have indicated in the past when interviewed or when otherwise speaking on these issues, the handwringing by politicians, bankers, government bureaucrats and central bankers over housing price developments is nothing more than a cynical ploy designed to (1) misdirect the Canadian public into believing that these guys did not aim to rig the markets from the get-go; (2) demonstrate that “They are on top of the situation” and “Know what they are doing”.
However, apart from several commentaries that Recovery Partners has delivered on these blog pages, in public appearances and elsewhere since 2008, what has not been said by anyone else commenting on these issues is that the influences over aggregate demand that these policies are able to generate are:
Uncertain in magnitude,
Transitory; and, most importantly
Come at the cost of generating huge price distortions in the underlying private assets markets
As such, the various bubbles that have been created since 2007 are the ALL the bastard children of the central bankers’ own recent invention:
The Bubbles in the Stock Markets
The Bubbles in the Commodity Markets
The Bubbles in Foreign Exchange Markets
The Bubbles in Interest Rate Markets
The Bubbles in Real Asset Markets
The Bubbles in Derivatives Markets that reference ALL of the Forgoing
So it is also no surprise that….
the bloom is off the rose in the oil market;
the Canadian Stock markets depending on how measured, evaporated 1/3 of the capital invested in them during 2015;
commodity markets are in a bear phase across the board.
Global economies ended 2015 on a sour note and the picture of persistent sluggish growth is unlikely to change (Note that Recovery Partners called a Depression one year ago. Growth is still very weak and there are more economies and borrowers in a financially vulnerable state than there were back then.)
So for example, the trumpeting until recent months that the US had achieved energy independence through oil extraction via fracking will prove to be wholly illusory because many of the companies involved can no longer pull oil economically and they are either, or will go, bankrupt.
As we have stated in the past, the proposition that Monetary Policy can exert a growth impact on the real economy through an asset channel, AND that it will be significant, AND that the Fed and other central banks can predictably control this effect within reasonable tolerances and time-frames as contemplated by Bernanke, Carney, Draghi and the rest of the Central Bankers of recent vintage, is at best a bet made against very long odds by people who really have no skin in the game.
What comes next?? ….many might reasonably ask
What comes next is that we will all soon find out if the downside of these policies is larger than the upside has proven to be.
Overnight the Chinese Stock Market dropped almost 6%…….without warning.
I recently gave a speech in Toronto where I used the following sequence of pictures to illustrate our assessment of the developed economies.
The pictures are from Seffner, Florida where in late 2013, a cover collapse sinkhole opened up without warning underneath a man’s house and swallowed him alive.
Despite the best efforts of several teams of rescuers, his body was never recovered. In the aftermath of the tragedy, the subdivision was condemned as unsafe for human habitation, the remaining houses were leveled, the reclaimed housing lots were backfilled and sodded with new lawns, and the entire neighborhood area was secured with chain link fencing.
From a distance everything looked safe after this remediation activity had concluded. That is, until a much larger sinkhole opened up in the exact same spot just a few months ago.
Low interest rates have helped finance governments’ debt and lower funding costs, as well as preventing otherwise non-viable companies from having to declare bankruptcy. However, we can now see that this policy of “financial repression” has come at a substantial cost for both households and long-term investors such as insurance companies and pension funds; as well as the economy as whole.
Despite years of unprecedented stimulus:
There is no meaningful growth in the major economies
Credit losses have not been remediated, they have been papered over and remain on the books
Banks have bulked up instead of declining in size as announced after the GFC
Derivatives risk is much larger not lower
Sovereign debt loads have bloated since the GFC. Still, there has been no meaningful extension of the duration of public debt liabilities. Sovereigns and corporates are carrying unprecedented levels of re-financing risk in order to economize on debt servicing costs and thus be able to finance day-to-day expenditures.
Other unintended consequences of financial repression include potential asset bubbles, crowding out long-term investors in otherwise functioning private markets, increasing economic inequality, creating the potential of higher inflation over the longterm, distorting private capital markets and encouraging speculation and mal-investment
Moreover, the prolonged period of virtually zero interest rates has imposed a new set of risks and challenges for the markets and the major economies because it has encouraged debt accumulation instead of the needed de-leveraging. This means there has been NO EXIT from the Crisis Phase.
Similar to a sinkhole, the policy response since 2008 has been slowly eroding the foundations of economic stability and future growth. Besides the impact on long-term investors’ portfolio income, the consequence for capital market intermediation is of great concern because artificially low or negative yields “crowd out” the diversification of funding sources to the real economy, thus representing a risk for financial stability and economic growth potential at large.
By lowering yields and distorting private market signals, financial repression also supplies a disincentive for governments to tackle pressing public policy challenges (pensions, structural spending problems, infrastructure investment) and thus advance the structural reform agenda.
Not in the least this state of affairs has allowed Zombie Corporations and Zombie Governments to continue to issue LARGE VOLUMES of debt to investors.
What will these obligations be worth in the event of financial disruption?
When the Crash comes, it will be sudden and extremely destructive.