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Monday
Mar232015

QE and population ageing as macroeconomic externalities

This discussion of market failures and externalities is mostly a microeconomic discussion. Students will tend to encounter it, in the context of the classic case of the polluting industrial company whose marginal private cost, or supply, curve is not the same as the marginal social cost curve. A firm which dumps toxic waste in a river does not bear the full cost of such actions; society also faces a costs even if this is not taken into account in the firm's profit maximization problem. The solution according to the welfare theorems is for the social planner, the government, to tax the company forcing the firm to produce at a lower output relative to what would have been optimal according to its own marginal revenue and marginal cost curves. Profit maximization on the firm level must, in this case, give way to a socially more optimal outcome only achievable through government intervention. 

Back in November 2013, as the Summers' and Krugman's notion of a secular stagnation was garnering attention in policy circles, I introduced the concept of a global paradox of thrift and adverse externalities from living in ZIRP world. More specifically, I asked: What happens to global asset markets when large open economies either deliberately (beggar-thy-neighbour) or rationally increase their precautionary savings? 

 

The beginning and end of Bretton Woods II

In the years following the EM currency crisis in 1998 current account surpluses in the developing world surged giving rise to the discourse of global imbalances and Bretton Woods II [1]. The flow of savings due to rising external surpluses in EM has become one of the main arguments to explain the Great Moderation and also led former Fed chairman Ben Bernanke to formulate the concept of the global savings glut. Bernanke's speech in 2005, and those who agree with it, have generally been maligned for underwriting the attempt by policy makers to exonerate themselves for any culpability in sowing the seeds of the crisis in 2008. But as usual in the ongoing tedious slug-fest between Neo-Austrians and Keynesians/the establishment, this debate completely misses the point.

Anyone trying to understand what is going in the global economy at the moment should read the speech, and pay especial attention to the following.

In response to these crises, emerging-market nations either chose or were forced into new strategies for managing international capital flows. In general, these strategies involved shifting from being net importers of financial capital to being net exporters, in some cases very large net exporters. 

(...) 

According to the story I have sketched thus far, events outside U.S. borders--such as the financial crises that induced emerging-market countries to switch from being international borrowers to international lenders--have played an important role in the evolution of the U.S. current account deficit, with transmission occurring primarily through endogenous changes in equity values, house prices, real interest rates, and the exchange value of the dollar.

Ben S. Bernanke, March 10th 2005

Significant blood has been spilled in academic and policy circles over whether the policy pursued by emerging markets was a rational response or a simply a function of bad policy in pegging to the US dollar, essentially relying on the US economy as the consumer of last resort. Let us assume for a moment that building up buffers of reserves was partly rational. Faced with the prospect of a repeat of 1998, the decision to accumulate reserves in dollar assets, in part to counter rising dollar liabilities in the domestic economy, can be seen, in part, from the point of view of precautionary savings.

But in a global economy with free capital mobility, a coordinated increase in savings across such a large swathe of economies has costs, and it is exactly such costs that were partly counted during the crisis in 2008. The bust of the subprime bubble in the U.S. in 2007, and associated devastation on the global economy, could then be seen as partly driven by the negative externality of too much capital searching chasing little yield [2]. What was "rational" from the point of view of open economy in the developing world was not optimal from the point of view of the global economy due to the boom/bust effects of too much excess liquidity. In the language of negative externalities, the marginal global cost of rising surpluses exceeded the marginal cost of additional savings in EM economies. 

Today, accelerating capital outflows in China and collapsing oil prices offer evidence that the key drivers of Bretton Woods II, the global liquidity pump so crucial in driving low global interest rates from 1999 to 2008, are waning. Looking at the current plight of some EM economies, however, I cannot help but feel that we are potentially headed for a repeat of the aftermath to 1998. Booms and busts are a natural part of international capital flows, but if the global economy cannot sustainably accommodate external deficits in countries such as Brazil, Turkey, South Africa, India etc, without instability it stands to reason that these economies will ramp up savings to avoid becoming external borrowers. And who prey tell, will run the deficits then if these economies aren't going to. EM currencies have plunged since 2011, and if the bust worsens this year, the inevitable result will be a knee-jerk reaction to once again enter a cycle where external savings become the key objective for economic policy in these economies. 

But even before we write the obituary on Bretton Woods II, or grant it an extension, another process is waiting in the wings to take over, a force that could make EM FX reserve accumulation and recycling of petrodollars look like chump change.

 

Population ageing and QE: A permanent externality to global asset markets? 

In theory, a rapidly ageing economy should dissave and become net a importer of capital through a current account deficit. But the aggregation of microeconomic life cycle dynamics to macroeconomic capital flow dynamics is, in my view, flawed. Indeed, in practice it appears that rapidly ageing economies act exactly opposite to what theory predicts. Japan was the first example of a major economy getting stuck in ZIRP and QE, and the Eurozone is arguably the second. These economies are not characterised by dissaving, but rather by their desperate fight against it. 

Is it rational for a mature market economy with a large level of public debt and an expensive transfer state to dissave into old age? Is it conceivable that foreigners would finance deficit spending, and investment, in such an economy at yields at or below steadily weakening nominal GDP growth? I don't think it is, and the response by Japan to fight dissaving by attempting to maintain an external surplus and keep a positive net foreign asset position is an important case in point. Abenomics might yet fail, but it was the risk of Japan slipping into a sustained current account deficit and depleting domestic resources to buy enough JGBs that ultimately forced the BOJ to throw caution to the wind and start annexing the bond market and debase the currency. The Eurozone is earlier in the process, but the principle is the same. A weak euro, a rising current account surplus, and a dramatic acceleration of portfolio outflows in search for yield abroad, all with an eye to bolster the economy's net foreign asset position. The combination of current account surpluses in the periphery and a benevolent ECB has, effectively, defused the sovereign debt crisis despite notional debt levels growing larger since 2012. 

As older workers nearing retirement, these two economies are simply trying to build a portfolio of assets off of which to earn income to pay the bills. For large open economies such as Japan and the Eurozone with access to consumption smoothing through their balance of payments, this response is, I would argue, perfectly rational. The alternative, prescribed by theory, would seem completely at odds with a stable macroeconomic situation. A rapidly ageing economy running a current account deficit is a recipe for disaster; ask governments in the Eurozone periphery if you do not believe me. 

But just as the marginal global cost of EM's rapid reserve accumulation from 1999 to 2010 was higher than the cost facing the accumulators themselves, so do the costs of persistent and large capital outflows from ageing economies likely represent a negative externality that is not adequately accounted for in hypothetical "optimal" growth strategy for the Eurozone and Japan. 

The current debate on the need, or otherwise, for the Fed to raise rates is a classic case in point. The dollar is surging, and the Fed faces the prospect of raising rates in a world where the two other major economies are likely permanently stuck in ZIRP. This need not deter the Fed from pulling the trigger; indeed I think it is very likely that Yellen will do just that this year.

But even the Fed does not set its policy in a vacuum. One of the key drivers of low long-rates in the U.S. is that money from Japan and the Eurozone are chasing yield, and a 10-year yield in the U.S. at 1.9% is suddenly a very good prospect with sub-zero rates in the other major currency areas. It is very likely that the Fed might not get "traction" on long rates even if they push up the funds rate. What is a poor central bank to do? As the Fed moves to increase short rates the capital inflows intensify potentially stoking the very excess and boom that it is trying to manage. Emerging markets of course have been here before, lowering interest rate in an attempt to ward off hot money coming in. This is an endemic part of global capital flows, and we will see more of this in the future.  

In a world where it is rational from a domestic point of view for major economies to rapidly expand their money supply, monetary tightening elsewhere becomes very tricky. If excess savings become the chosen growth strategy for more and more economies it is also possible to speak of a global paradox of thrift. I have previously described this as follows; 

If more and more economies are now faced with a negative natural rate of interest it means that (desired) savings will exceed investment even with ZIRP. This has crucial implications for global capital flows. You only need rudimentary algebra to see this in the context of basic national accounting. If S>I it can only mean that the current account is positive in an open economy and this is difficult to prescribe a universal growth strategy since you need someone to run the deficits.

The costs, or negative externalities, are financial instability. Volatility will remain very low for extended periods, only to rise rapidly as capital flows back to the savers in times of crisis. Global carry trade flows and the associated booms and busts provide ample evidence of this.  

The next obvious question is what to do about it? We don't have a global social planner to mitigate the costs of excess savings but discussions about whether China is a "currency manipulator" and G7 push, in 2006, for the BOJ to join Trichet and Bernanke in the "great interest rate normalisation" are both examples of how this externality can lead to conflict. How long will it take now, for example, before the U.S., the U.K. etc start probing the Eurozone about whether QE and ZIRP are a necessary combination in a world where the German economy are accelerating rapidly with a labor market that has never been tighter? It won't be tomorrow, but towards the end year is a good bet for when questions will start start emerging around the viability of QE at the ECB. 

At the end of the day, my message is fairly straight forward. Investors need to move on from a situation where central bankers are blamed for blowing bubbles and creating financial stability to an understanding of the reality they operate in. Super easy money and QE are sowing the seeds for financial instability and we are inevitably getting closer to the next denouement. But central bank involvement as some of the world's largest asset managers is likely here to stay. This is an objective fact, best kept separate from a discussion of whether it is a good thing or not. 

---

[1] - In fairness to the sources referenced above, especially Setser, the recycling of oil surpluses in the Middle East into USD was assets was equally important as EM surpluses. 

[2] - I can already hear the cries of protest. Clearly, the subprime crisis of excess in the U.S. financial system had deep domestic behavioural and structural roots too. I am not trying to fit a mono-causal explanation to any one boom/bust cycle here. But simply noting that easy money flowing from EM surpluses was part of the explanation. 

Monday
Feb092015

Regulative Mission Creep?

The financial sector has been regulated and fined into submission following the crisis, but the equity research team at Credit Suisse had a rebellious thought this weekend. In a piece extolling the virtues of dividend stocks, they postulate the following development:

As bond yields fall to zero, duration matching for pension funds and insurance companies becomes nearly impossible and, consequently, we believe there will be significant pressure on regulators to allow higher equity weightings. On the global equity strategy team, we see a scenario where pension funds and insurance companies are allowed to hold a bigger share of their assets in high quality equities if bond yields remain around zero for a prolonged period. The definition of quality, in our view, is likely to be a high credit rating and a history of no dividend cuts. 

It is interesting here to consider the craziness in benchmark fixed income securities, which has spread to non-financial corporate debt already in a visible bubble. If the equity geeks at CS are right, a change in regulation to help pension and insurance funds match duraction in a permanent ZIRP could then extend the bubble in yield into dividend equities. Some will argue that this is already happening, but if real money managers got the go-ahead to match duration using high quality dividend payers, expect the recent insanity of fixed income pricing to move into equities too. Regulators have been on a mission to stabilise the financial system since the near collapse in 2008 and 2009, but the discussion above indicates a dangerous dose of mission creep. We can't wait! 

Portfolio Notes: 

The time has come, we fear, to get rid of the punt in Eurozone banks. We may initiate it later on, but for the moment we prefer to accept defeat. We remain confident that the position in BP will continue to perform as inflation takes over from deflation to drive global asset markets, and we are also starting to nibble at selected down-beaten emerging markets. We have also, however, upped our cash allocation and intend to keep it that way.