Monetary policy is as much about politics as it is economics. It affects the ways in which wealth is created, allocated, and retained and it determines the balance of power between providers of capital and users of capital. In January one of my readers kindly passed on to me a link to an interesting report published two years ago by Bain and Company called “A World awash in Money: Capital trends through 2020”. According to the authors:
Our analysis leads us to conclude that for the balance of the decade, markets will generally continue to grapple with an environment of capital superabundance. Even with moderating financial growth in developed markets, the fundamental forces that inflated the global balance sheet since the 1980s—financial innovation, high-speed computing and reliance on leverage—are still in place.
There certainly has been a great deal of liquidity in the two years since the report was published, and I agree with the authors that this is likely to continue over the next several years, and maybe well into the next decade. I disagree with their assessment of the source of this liquidity — what Charles Kindleberger would have probably called the “displacement” (see Note below). I think policies that implicitly or explicitly constrained growth in median household income relative to GDP are more to blame than the changes in the financial system they cite because these plosives tended to force up the savings rate. The financial system changes are much more likely to be consequences rather than causes of abundant liquidity, although there is plenty of historical evidence to suggest that the two come together, and that they are mutually reinforcing.
I am especially interested in the authors’ claim that “the investment supply–demand imbalance will shift power decisively from owners of capital to owners of good ideas”, especially owners of “good ideas” in technology. This has happened before. Technology “revolutions” tend to take place when a huge amount of risk-seeking capital flows into very risky and often capital-intensive high-tech investments, generating large network benefits and creating tremendous rewards for successful technology ventures. Particularly for those technology projects that benefit from growing networks — railroads, telephones, video, the internet — there is a strong element of pro-cyclicality, in that early successes spur greater visibility and faster adoption, which of course creates further success. I addressed this process in a 2009 article for Foreign Policy, in which I described six waves of “globalization” in the past 200 years as having certain characteristics in common:
What today we call economic globalization — a combination of rapid technological progress, large-scale capital flows, and burgeoning international trade — has happened many times before in the last 200 years. During each of these periods (including our own), engineers and entrepreneurs became folk heroes and made vast fortunes while transforming the world around them. They exploited scientific advances, applied a succession of innovations to older discoveries, and spread the commercial application of these technologies throughout the developed world. Communications and transportation were usually among the most affected areas, with each technological surge causing the globe to “shrink” further.
But in spite of the enthusiasm for science that accompanied each wave of globalization, as a historical rule it was primarily commerce and finance that drove globalization, not science or technology, and certainly not politics or culture. It is no accident that each of the major periods of technological progress coincided with an era of financial market expansion and vast growth in international commerce. Specifically, a sudden expansion of financial liquidity in the world’s leading banking centers — whether an increase in British gold reserves in the 1820s or the massive transformation in the 1980s of illiquid mortgage loans into very liquid mortgage securities, or some other structural change in the financial markets — has been the catalyst behind every period of globalization.
Are we in such a period? We certainly were before the 2007-08 crisis, but every globalization period has been followed by a contraction which, too, has certain characteristics in common.
Because globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high.
This disruption has already occurred to some extent. After 2007-08, global GDP growth dropped sharply, the growth in global trade dropped even more sharply, we have seen soaring unemployment, and I expect that we will soon see a wave of sovereign defaults.
But this time may be different in one important way. The 2007-08 crisis may well be the first global crisis that has occurred in a period of credible fiat currency.
“Everyone can create money,” Hyman Minsky often reminded us. “The problem is to get it accepted.” Having money accepted widely is what it means to be credible, and in past crises, if money was credible it was constrained by the amount and quality of its gold or silver backing, whereas if it was unconstrained, that is fiat money money, it was not terribly credible. Were we still living in that world, we would already have seen a wave of sovereign defaults and the forced, rapid recognition and writing down of bad debts. We would have probably also seen a collapse in several national banking systems and an even more brutal economic contraction than what we have already experienced.
No more collapsing money?
“Panics do not destroy capital,” John Mill proposed in his 1868 paper to the Manchester Statistical Society. “They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” Our ability to postpone the recognition of the full extent of these unproductive works depends in part on our ability to expand the supply of credible money. If we are constrained in our ability to expand the money supply, one impact of the crisis is a contraction in money (velocity collapses) that forces lenders to write down debt. If money can expand without constraints, however, debt does not have to be written down nearly as quickly.
With the main central banks of the world having banded together to issue unprecedented amounts of credible currency, in other words, we may have changed the dynamics of great global rebalancing crises. We may no longer have to forcibly write down “hopelessly unproductive works”, during which process the seemingly endless capital of the globalization phase is wiped out, and we enter into a phase in which capital is scarcer and must be allocated much more carefully and productively.
Instead, the historically unprecedented fact of our unlimited ability to issue a credible fiat currency allows us to postpone a quick and painful resolution of the debt burdens we have built up. It is too early to say whether this is a good thing or a bad thing. On the one hand, it may be that postponing a rapid resolution protects us from the most damaging consequences of a crisis, when slower growth and a rising debt burden reinforce each other, while giving us time to rebalance less painfully — the Great depression in the US showed us how damaging the process can be. On the other hand the failure to write down the debt quickly and forcefully may lock the world into decades of excess debt and “Japanification”. We may have traded, in other words, short, brutal adjustments for long periods of economic stagnation.
Only the passage of time will tell us whether or not this is indeed the trade-off we have made or want to make. Argentina used to be the archetype of financial crisis, when a collapse in the supply of money caused massive debt write-downs. “This time” may indeed be different in the sense that there is a very real possibility, as the authors of the Bain study propose, of many years of “superabundant” capital, instead of the scarce capital that has historically characterized the post-crisis period.
Excess capital tends to be associated with periods of tremendous technological advances, and because these are experienced primarily by the technologically most advanced countries, the next decade might bring some benefit to the world’s most advanced economies — which will be all the more noticeable in the context of the low commodity prices that presage the end of “convergence”. The idea that advanced countries may outperform developing countries may seem shocking. For the past few decades the world has gotten used to the idea that economic convergence between rich countries and poor is inexorable.
But it isn’t. Over long periods of time, convergence has been the exception, not the rule. In periods during which commodity prices are high, or the advanced economies have created artificially high demand that developing countries can exploit (during war, for example), we are usually swept by waves of optimism and a firm belief in economic convergence. But once these conditions end, the high hopes quickly abate. I have written elsewhere, for example, of Albert Hirschman’s optimism during the 1950s and 1960s that led him and many others, especially those influenced by Marxist ideas of economic growth, to believe that development was primarily a technical problem. Once we had resolved the problem, as we seemed to be doing in the heady days of the 1950s and early 1960s, we could expect fairly rapid economic convergence.
By the late 1970s, of course, development economists were despairing over the seeming intractability of backwardness. Their models of linear development (most famously W.W. Roster’s “five stages” of economic development) were gradually replaced by more complex analyses of economies as “systems”, in which complex institutional constraints could distort or prevent convergence. The now (unfairly) discredited dependence theorists, for example, argued that under certain conditions convergence was not even theoretically possible.
Hirschman too became far more pessimistic about long term convergence, and began worrying about the nature of these constraints, even pointing out how misguided optimism itself could lead to highly pro-cyclical policies that reverse the convergence process, in part by encouraging the kinds of inverted balance sheets that I discussed in my blog entry of two weeks ago. The outpouring of almost comically muddled explanations of and forecasts for the Chinese growth miracle has been an especially egregious example of the way well-intentioned economic analysis has led to, or at least encouraged, worse outcomes. China’s cheerleaders have for many years encouraged policies that we are finally recognizing as foolish.
The idea of emerging markets having decoupled from the advanced economies has died, and I suspect the idea of convergence will soon become another victim of the crisis. If the world does indeed face another decade or two of “superabundant capital” in spite of economic stagnation and slow growth, the historical precedents suggest a number of other consequences.
The brave new world of weak demand and frenzied speculation
Last week I had drinks with one of my former Peking University students and we discussed some of the ways the global economy might react to a world adjusting from a global crisis with weak demand and excess liquidity. In no particular order and very informally these are some of the consequences we thought were likely or worth considering:
- During periods of excess capital, investors are willing to take on far more risk than they normally would. High tech is one such risky investment, and has historically done very well during periods in which investors were liquid and hungry for yield. This suggests that developed countries will benefit relatively because of their dominance of high tech, and the US will benefit the most.
But we have to make some important distinctions. The willingness to take excess risk is not necessarily a good thing socially. If it leads investors to pour money into non-productive investments, excess real estate and manufacturing capacity, or into investments that with negative externalities, excess risk-taking simply destroys wealth. The economy is better off, in other words, only if policymakers can create incentives that channel capital into entrepreneurial activity or into activity with significant positive externalities (i.e. whose social value is exceeds the value that investors can capture).
In several countries before the crisis, including the US, China and parts of Europe, a lot of overly-aggressive financing went into projects with negative externalities — empty housing, useless infrastructure, excess capacity — and it is important that this kind of risk-taken isn’t encouraged. Policymakers should consider the conditions under which excess risk-taking is channeled by the private sector into socially productive investments, for example into high tech, small businesses, and high value added ventures. With their highly diversified financial systems and incentive structures that reward innovation and entrepreneurialism, the US, the UK and perhaps a handful of “Anglo-Saxon” and Scandinavian economies, in their different ways, are especially good at this. Much of Europe and Japan are not. The latter should take steps to increase the amount by which they will benefit from many more years of high risk appetite among investors.
- Normally, developing countries only benefit indirectly from periods of abundant capital and excess risk taking because abundant capital tends to lead increased investment in developing countries and higher commodity prices. This, however, is perhaps the first time that excess liquidity has overlapped with a period of crisis and contraction, so it is hard to know what to expect except that the days of historically high hard commodity prices are well behind us (food may be a different matter). I suspect that developing countries are going to lag economically over the next few years largely because of high debt levels.
Why? Because one of the ways the market will probably distinguish between different types of risk is by steering away from highly indebted entities. Excess debt is clearly worrying, and while there will always be investors who are willing to lend, in the aggregate they will probably discriminate in favor of equity-type risks unless policymakers create incentives in the opposite direction.
- Developing countries almost never benefit from the high tech boom that typically accompanies periods of excess liquidity because they tend to have limited technology capabilities. Policymakers should consider nonetheless how to take advantage of what capabilities they do posses.
India for example has a vibrant innovation-based sector, but it suffers from low credibility and from regulatory and red-tape constraints that will make it hard for Indian innovation to benefit from global investors’ high risk appetites. New Delhi — and perhaps local state capitals — should focus on addressing these problems. If Indian technology companies are given the regulatory flexibility and if investors find it easy to put money into (and take it out of) Indian technology ventures, we might see India capture some of the benefits of what may be a second or third wave of information technology.
Brazil is another large developing economy with pockets of tremendous innovation but which overall also suffers from low credibility and distorted incentive structures — and way too much debt. I am neither smart nor knowledgeable enough to propose specific policies, but policymakers in Brazil, like in India and in other very large developing economies — and they must be large in order that their relatively small technology sectors can achieve critical mass — must develop an explicit understanding of the institutional constraints and distorted incentive structures that prevent the development of their technology sectors, and take forceful steps to reverse them.
- China is weak in high -tech innovation largely because of institutional constraints, including education, regulatory constraints, distorted incentive structures,and a hostile environment for innovative thinking (defying attempts to separate “good” innovative thinking from “bad”). Overly-enthusiastic American venture capitalists, Chinese policymakers, and Chinese “entrepreneurs”, many of whom have almost become Silicon Valley caricatures will disagree, but in my experience most China, and certainly those involved in technology, are very skeptical about Chinese innovation capabilities. For example, when I taught at Tsinghua University, China’s answer to MIT, my students regularly joked that the only way to turn Tsinghua graduates into high tech innovators was to send them to California.
The main reason for its weak track record in innovation, I would argue, is that in China, like in many countries, there are institutional distortions that directly constrain innovation, as I explain in my blog entry on “social capital”. There are also indirect distortions, most obviously extraordinarily low interest rates and the importance of guangxi, that made accessing credit or developing good relationships with government officials infinitely more profitable, and requiring far less effort, for managers than encouraging innovation.
It is politically too difficult to resolve many of these institutional constraints nationally. In fact we are probably not even moving in the right direction — for example Beijing has recently sharply reduced internet access within China for domestic political reasons, and it is a pretty safe bet that this and other attempts to secure social stability will come at the expense of a culture of innovation.
But if Beijing is reluctant to relax constraints at the national level, it might nonetheless be willing to do so in specific local jurisdictions. If there were pockets within the country operating under different legal, regulatory, tax and cultural systems, and much more tolerant of the political and social characteristics of highly innovative societies, China might see the creation of zones of innovation that would benefit from the favorable global environment. I am skeptical about the impact of the Shanghai free-trade zone on trade or investment, for example, but it could become a more credible center of Chinese innovation under a very different legal and regulatory system — much as Shanghai was, by the way, in the 1920s and 1930s. China has benefitted in the past from special economic zones, with different laws and regulations, dedicated to manufacturing. It might benefit in the future if it turns these into special “innovation” zones, also with very different laws and regulations — and above all a far greater appetite for the “bad” things that are always part of highly innovative cultures, including a wide open internet and tolerance for any kind of discussion.
- Excess liquidity and risk appetite makes it easy to lock in cheap, long-term funding for investment projects. Countries that have weak infrastructure, or whose infrastructure is in serious need of improvement, have today an historical opportunity to build or replenish the value of their infrastructure with very cheap capital. This is truly the time for governments to identify their optimal infrastructure needs and to lock in the financing. The most obvious places for productive infrastructure spending, it seems to me, are the United States, India and Africa.
The constraint in the US seems to be a politically gridlocked Congress unable to distinguish between expenditures that increase the US debt burden and expenditures that reduce it. Borrowing $100 for military expansion, higher government salaries, or an expansion in welfare benefits will increase the US debt burden, for example, but borrowing $100 in order to build or improve infrastructure in a way that increases US productivity by $120 actually reduces the US debt burden.
This mindset at the federal, state and local levels prevents highly accommodative money from flowing easily into infrastructure projects, and it means that the US will probably miss an historic opportunity to upgrade its infrastructure cheaply in ways that will boost growth for decades to come. The US must come up with institutional alternatives that will allow it to overcome these constraints, for example there has been some talk of a national development bank whose sole purpose was to raise money for infrastructure investment. That is a great idea if Congress can pull it off.
- The constraint in both India and Africa is low credibility. Aside from concerns about the siphoning off of a significant share of the money that was earmarked for investment, especially in several African countries, foreign funding of infrastructure would come mainly in the form of debt financing, and this would almost certainly have to be denominated in dollars, euros or some other hard currency, which, given the size of the required funding, might raise questions about repayment prospects.
In the case of India it may be that under Prime Minister Narendra Modi the issue of credibility will be resolved, although my Indian friends tell me that we are far from resolving the issues of bureaucratic entanglement that hamstring attempts to put into place the kind of infrastructure that India needs. One way or the other India has a very rare opportunity, if it is able to put together a credible plan, to build out substantial infrastructure on very accommodating financing terms, and given its urgent need for infrastructure, the resulting increases in productivity would actually cause India’s debt burden to fall substantially.
For African countries the problem is far more complex. Not all African countries are the same, of course, but many if not most African economies are likely to be directly or indirectly very sensitive to commodity prices. Some African countries has been able to get funding from China beyond what has been available in the market, but as commodity prices decline, as many of the funded projects turn out to be less productive than planned, and especially as earlier loans to African and Latin American countries begin to come due, my suspicion is that China will face the same problems new lenders to African have historically faced. The path of regaining credibility for individual countries is likely to be slow and arduous.
———————-
Note:
From Charles Kindleberger’s “Anatomy of a Typical Crisis”: “We start with the model of the late Hyman Minsky…According to Minsky, events leading up to a crisis start with a “displacement,” some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects—canals, railroads, the automobile—some political event or surprising financial success, or debt conversion that precipitously lowers interest rates. An unanticipated change of monetary policy might constitute such a displacement and some economists who think markets have it right and governments wrong blame “policy-switching” for some financial instability.
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” build or improve infrastructure in a way that increases US productivity by $120 ” – can you give examples of these mythical investments? Or is this just construction lobby talk?
Even Europe has had 70 years to build all the infrastructure it needs, let alone the US that never suffered destruction.
Sure you can fix a bridge here and there with local! money, but that will not move the needle much. As far as cables and pipelines, leave that to the private sector.
Dan,
California has major issues with water scarcity. The reality about infrastructure is that infrastructure development is a very important national defense/security issue. Roads and bridges are, in my opinion, the least valuable types of infrastructure and usually the most wasted. However, better water transportation systems, better irrigation systems, better energy infrastructure to transport oil and natural gas to areas that’re heavily coal dependent (ex. Southeast US), and other projects like that would certainly provide massive economic benefits.
People are talking about Keystone XL like it’s a useful infrastructure project, but I think it’s just to help out rich Canadians that wanna export oil from the tar sands that the US doesn’t need. However, building pipeline infrastructure to transport oil/natural gas to remove coal from our system would be extremely beneficial and economically viable.
It’s a huge error to assume infrastructure is limited to only bridges/roads and having undeveloped infrastructure can not only create security issues, but it can completely destroy your environment.
“better water transportation systems, better irrigation systems, better energy infrastructure to transport oil and natural gas to areas that’re heavily coal dependent” – I said “leave that to the private sector” – they got plenty of money, and the will to solve problems if the government controlled by enviro-nuts would allow. But they don’t, so those projects remain mythical.
Same in Europe – what kills them is the anti-business mentality, not the lack of money.
Even if available, those projects would not make a big difference as the economy has moved to services.
Half decent infrastructure can change a country from having a major problem of water distribution, improper irrigation, and soil erosion. If you don’t take care of your environment, you create major problems. Do you know what improper water maintenance systems can result in? Rising water tables, which are horrible for reasons ranging from sanitation to environmental degradation. It’s just a transfer of risk to future generations, really.
Those projects won’t make a difference in a service economy? Apparently health doesn’t matter in a service economy. People don’t need proper food to eat at all. Do you ever take a look at a map and see the kinds of constraints countries can be placed under? If you don’t have a natural trade network there, there are times you have to impose your will on someone else in order to guarantee the transfer of resources. We can talk economic theory, but the real world has constraints. In reality, almost all of the decisions that we make are basically forced, particularly if you’re in a position of power. If you don’t make those decisions, you won’t hold power for much longer.
I agree with the anti-business mentality in Europe, but it’s not a matter of private sector vs everything else and it’s not like we can just choose what we want all the time. In reality, we have very few choices and the ones we do have are very limited, constrained, and aren’t as plentiful as we think they are.
BTW, if I have guns and you don’t, it doesn’t matter what you wanna do or what you think or how you feel. I can come in there, take your shit, and there’s nothing you can do about it. Whether you like it or not, this is the way the world operates. Infrastructure is a critical aspect of self-defense. Centralized governments are created for war, but war is necessary.
Why, ….merely the private sector?
The old dogma dies. Why? Darpa and moonshots from basic applied science to technology, material science, energy, storage, transmission, robotics, chip design, and so forth. Land Grant Universities, National Park systems, Inter-coastal Waterway, Fracking Technology, Internet, Computers, NASA and all of the innovations from the 1960’s that are hitting marketplaces today.
Why, leave to private sector, the only thing that has given is income inequality and bloated assets, with income streams to support asset values impinged in the long-term to the detriment of most who don;t even realize it, but will when they start freezing COLA’s and discussing the inadequacy of retirement savings, and how cutting costs of the margin has left long-term asset valuations on life support; with some refusing to pull the plug on tired old noise for reasons of ritual and belief.
Elon Musk’s Hyperloop. Theoretically cheaper and better than current fast trains.
Innovation thinking at its best.
Dan,
“Same in Europe – what kills them is the anti-business mentality, not the lack of money.”
It is amazing to me how some Americans have no clue about life in Europe.
At least in Germany, education system is better, healthcare system is better, infrastructure system is MUCH better, there is less economical inequality compared with the USA, better country to raise kids, and yet I keep hearing from cluless Americans how terrible life here is.
I had to go three times within the last 4 years to emergency room with me three kids because of relatively minor issues. Waiting time each visit in Bavaria? Average Under 3 minutes. Waiting time in California for comparable issues? Over three hours.
Dan, do you belong to top 1% of the reachest people in the USA? Are you a politician?
If not, you would ABSOLUTELY be better off if you were working in Germany.
Energy is about 3-6 times the cost in Germany too. They also have wasted a lot of resources on useless infrastructure. For example, they increased their maximum solar capacity by about 10 fold in the past decade, but they still get more energy from biomass because of the amount of cloud cover on the North European Plain. Also, 45% of the German economy is exports. Germany will experience a very severe recession when it’s all said and done. I think Germany will soon be the sickest country in Europe once they’re forced to adjust. I’d stay away from living in Germany cuz when it starts to go south, it’ll go south all at once.
As an American living in Europe for many years, my experience is very different. European health care and infrastructure live off the innovations of America (Phara/Telecom/Aerospace/Internet) and the comfortable lives in Europe would not be possible without the chaos, inequality and innovation of life in America. It is easy to be parasitic if you are a small country like Norway or Denmark. Europe is killing its host, and will suffer much greater damage than America, which can transform and re-organize after then next great rebalancing.
Hmmmmm…..can an example be given, is an example, under the premise that it need be given, able to suffice.
Certainly, the logic is quite clear. Capital is abundant, there are needed investments, investments that can create jobs, can generate income, taxes, wealth, subsidiary investments to support, and so on. Such, if designed correctly, could go to reverse dynamics that cycle supports for asset valuations lower.
There are so many…bridges, water, electricity, energy (waste heat recapture), carbon storage, combined cycle, C02 sinks for enhanced recovery, really the list should go on.
Even, unto these, if you are into precious metals http://www.smithsonianmag.com/smart-news/millions-dollars-worth-gold-and-silver-lurk-sewage-180953960/?no-ist
Broadband, on and on, bridges….
Really, I neither believe that US infrastructure is as poor as can be imagined by some pundits (who usually have supported excess elsewhere) or so good that it will not for ever require building and rebuilding as with all things and everywhere for evermore. Your task is really a little silly isn’t it….
Can you provide examples, why would we need to…. but more specifically, the bridges that fell down in Ohio and Michigan…. waste water treatment, green-ways (cheap) that prevent fertilizer and nitrogen runoff into large bodies of water (from Mississippi to Chesapeake and further afield) that lead to loss in fisheries, livelihoods, asset valuations, etc and so forth. Ridiculous.
Yea, I tend to agree with you here. Infrastructure is important and it’s a mistake to assume infrastructure is limited to roads and bridges. Infrastructure is, when you think about it, a national defense issue. Improper infrastructure causes all sorts of problems.
In many developing countries, improper infrastructure creates sanitation issues, can trigger the spread of disease, can lead to massive amounts of environmental degradation, soil erosion, water pollution, unsustainable water usage, and a whole host of other issues. In my opinion, every single one of those issues is a national defense issue.
Hi Dan,
Not sure what your background is, but I think you are missing the point and I don’t mean that in an insulting way. The point is, that even compared to the private sector, the US government can borrow 30 year money very cheaply (2.28% today). To refuse to make a distinction between government spending that looks like pure costs in which no return can be calculated against and an investment that can earn it’s cost of capital is just being obstinate and/or simple-minded about the topic. If you allow that there are investments that can be made today that can yield more than 2.28% a year for the next 30 years, then it is by definition a waste and a loss not to make them. Remember, the execution of these investments can be done “privately” if that makes someone feel better about how the money will be allocated, but the financing of them will not be done more cheaply by anyone other than the US government and I would think no matter how anti-government spending you were, you could always argue that you want to increase productive investment (meaning one that exceeds it’s cost of, in this case, 2.28%) relative to unproductive investment.
Dan,
tell the poor people of New Orleans that improving the infrastructure in the city to avoid Katrina disaster was not needed. Nether would it be cheap if you want to do it right.
California could very much have a problem with drinking water if Sacramento River dam does not hold. And it is in extremely poor shape, I used to live there.
Those are off the cuff two examples. Infrastructure in the USA in VERY poor shape. Better then in Africa, but MUCH worse than in Germany.
Prof. Pettis,
I’d like to get your take on the link between capital abundance and population demography. Peter Zeihan (I don’t know if you’re familiar with his work, but he used to work for Stratfor) makes the argument that much of the capital boom we’re seeing was driven by population demography in the developed world: primarily the baby boomer generation.
Zeihan’s argument is that when people are young, they tend to borrow in order to go to college, buy cars, buy houses, and all the other stuff they need. As they get older, the earning power these people have increases and their kids/families grow up, which means that they consume less and save more. Once people reach the age of 55-60, the kids are mostly grown up, the house is mostly paid for, and you don’t have to shuffle your kids in and out of everywhere while their earning power is reaching its maximum. On top of this, when people reach the mature worker category, you save everything you can until the day you retire, when you don’t put in a penny more. So his argument is that we’ll see the entire world having an expanding amount of capital until the baby boomer generation in the entire developed world enters into retirement, which he says is about 2020 or so.
If Zeihan is correct, this capital abundance and globalization cycle should end within the next 5-7 years or so.
Excellent point (especially given it is related to my question).
East Asia and Europe are in the midst of population aging and shrinking, which are in part the cause of deflation and weak aggregate demand globally. QE, imo, will fail in Europe much as it has in Japan simply because an aging and shrinking country is not a good place to invest.
My question: Isn’t it a better strategy to build infrastructure and boost incomes in countries with growing populations?
Interesting point, Suvvy. Zeihan’s argument is well known in economics — I think it is called “consumption smoothing” — and there is no doubt that it explains part of the savings tendency, but I don’t think it is satisfying as a full explanation or even a strong explanation. I have at least three big problems with this argument. First, the numbers don’t really work at a granular level. Europe is older than the US, and Italy and Spain are older than Germany, but Europe saves more than the US and Italy and Spain save less than Germany. You might argue that this is because young people and retirees both have low savings rates, and that the US is full of young people and Italy and Spain full of old people, while Germany is in the middle, but I don’t think this is true at all. The age distribution in these countries is not nearly as dramatic as the savings distribution. What’s more, in the past decade we have seen sharp changes in US and European savings rates that cannot possibly be explained by equivalent demographic changes. Demographic changes occur slowly, but the changes in savings rates were far sharper and often reversed themselves. Something else must be happening.
Secondly, I haven’t seen Zeihan’s work and so I don’t know if he is doing this, but if you read my stuff regularly you will know that few things push my buttons harder than the nearly universal confusion between household (often called personal) savings and national savings. Zeihan’s theory is about household preferences, so it cannot explain most of the high Chinese and German national savings. What is more puzzling, if in those countries both household and non-household savings are high, and in Spain and the US there have been long periods when both household and non-household savings were low, wouldn’t we want an institutional explanation that doesn’t rely on household preferences? Household preferences might explain why household savings did what they did in those countries, but in that case non-household savings should have moved in the opposite direction, and yet they moved together. Again, it seems to me that there must be something else going on.
Third, we have perfectly good alternative explanations. Throughout history, countries with very high income inequality tend to have higher savings rates, whatever the population age distribution, and we have a boringly obvious explanation — rich people consume a smaller share of their income. With income inequality once again having soared in the past decade, why would we expect no upward pressure on the savings rate? Even the “anomalies” are easy to explain. The US and some peripheral European countries like Spain have high income inequality and low savings, but as I showed in several of my entries last year, because they absorbed huge amounts of net foreign savings, the only thing we need to reconcile the high savings associated with income inequality and the low savings associated with large trade deficits is either a credit-fueled consumption boom among the not-so-wealthy, or high unemployment. That seems to be a very precise explanation — first these countries had credit-fueled consumption booms and then they had high unemployment. The alternative model is so simple and elegant, and it fits the empirical data so precisely.
Another example of perfectly good alternative explanations is China in the past decade, or Japan in the 1980s. We know that the classic investment-driven growth model starts by forcing up the savings rate, which it does by forcing down the household income share of GDP (and, with it, the consumption share). This perfectly explains China’s high savings rate today, doesn’t it, and Japan’s in the 1980s? It also explains Brazil in the 1960s and the USSR in the 1950s, even though these had radically different age structures.
So I think consumption smoothing explains some of the changes, and I think urbanization also explains some of the changes (savings tend to rise at first in urbanizing countries), and I think the argument that rapid growth in income forces up savings (because our consumption doesn’t keep pace) explains some of the changes, but the changes are too dramatic, and these explanations work better at a very abstract level than when you do country to country and age to age comparisons. And anyway we have such a powerful alternative explanation that covers both the overall trend and the anomalies.
Having said that I suspect that in 5-7 years we will see a reversal, but not because of demographics. All deep imbalances eventually must reverse. We saw the process begin in the US, and it will accelerate in Europe once we have sovereign defaults or write-downs (one of the three traditional ways in history that we reverse income inequality), and my guess is that we will see this happen well within 5-7 years. As for China, if they don’t rebalance non-disruptively before they reach debt capacity limits ,they will rebalance disruptively after they do so, and I don’t think we have 5-7 years of rising debt.
Sorry for the long ramble, but this is an important point. I think two things are certain. First, changes in the savings rate matter a great deal. Second, as a profession we economists are pretty muddled on the subject.
Zeihan does talk about China where he basically says their economic model is the Japanese one where they pool the savings of the population and have state banks dish out loans. He also says the goal isn’t profit, but throughput. He doesn’t really talk about it more than that (at least in his most recent book, The Accidental Superpower). He talks about the massive overproduction of the Chinese economy and expects a collapse of the financial system from the debt capacity scenario (this is a point where I’m not so sure I agree).
When he talks about savings vs consumption, I think he was referring to the economic model we have in the US (and particularly about the US). As you said, the rich consume more of their income than the poor, but not many young people are very rich. You just don’t see many loaded 25 year olds.
With regards to the EU, his argument is that once the Euro was created, capital could flow anywhere in the Eurozone with minimal limitations. So you had massive capital inflows into countries that did not have such high amounts of capital and goes on to say that asset bubbles in these places were inevitable.
From what I’ve read of him, he seems to have a decent grasp of economics and finance, but I don’t think he really understands it inside and out. I don’t agree with everything he says and seems to take a similar view to Stratfor, which isn’t surprising because he used to work there. His geopolitical stuff seems to be pretty good, but I think his work lacks a complete understanding of the financial side so there are major factors that he doesn’t seem to consider.
Either way, the one point he seems to make that I have difficulty arguing with is how economies with sharply aging populations can have consumption led growth. If you’ve got a lot of people in retirement or entering retirement with a very small population that’s young, I don’t get how you can get consumption-led growth. Of course, if a country is very low on the development scale, all bets are off. With that being said, I find it difficult to see how many of these European countries (ex. Germany, Spain, Italy, and others) that’re relatively developed and have aging populations will ever see consumption led growth for a while.
Anyways, it seems to me like he grasps some of the financial aspects, but it’s not something he’s excellent at by any stretch of the imagination.
Nice to read the follow-up Michael great posts, most notably yours by the way:)
“I find it difficult to see how many of these European countries (ex. Germany, Spain, Italy, and others) that’re relatively developed and have aging populations will ever see consumption led growth for a while.”
Thanks for bring this matter into the loop. This commonsensical view is most certainly what explains a lot of the consumption patterns in Western Europe:
1)Just ask marketing people and sale-staff! Ask German companies when they target France, for instance…
2) Just ask your financial advisor what is savings ratio for household age level. Include the household size in the loop. Demography as well.
Inequality matters. Cultural patterns as well. But demography is a VERY part of the whole explanation. That the demography, stupid!
And that of course apply to “public spending” to some extent as well. Check the size and growth education budget. Demography does play its role.
The excellent Bill McBride on Demographics and GDP.
http://www.calculatedriskblog.com/2015/02/demographics-and-gdp-2-is-new-4.html
Combined with the FIAT currency innovation now we have digital money or digital means which could impact somewhat the picture:
1. In China we can see the Alipay wallet with digital transactions allowing households to bypass interest rates limits.
2. Digital wallets in third world and rural countries allow easy access to money and transaction, something which is almost impossible before. This can grow really, really fast.
Just my 0.02 cents to consider.
Excellent post as usual. Just fyi, here is the proper link to the referenced report.
http://www.bain.com/Images/BAIN_REPORT_A_world_awash_in_money.pdf
Thanks, Colin.
In the US any infra-structure financing that isn’t done as block grants to the states is a waste of money. The Big Dig in Boston is an example of how to poor federal money into a hole in the ground. At least block grants would be allocated in state legislatures.
Most infrastructure spending in the US comes from state and local governments anyways. The real problem with a lack of American infrastructure is underwater private sector and local/state government balance sheets. Step 1 should be to have massive debt writedowns for the middle class, which seems to be getting completely wiped out.
Hi, Michael. Great entry today in your blog. I´m a follower from Argentina so the title of your article pretty excited my reading, and the content left me thinking about one issue you didn´t mention. You say that Argentina, as the rest of the developing countries, are entering in a unknow race for abundant capital capture, as the developed nations can´t stop the printing money machine without rewriting debts, at least and for a couple more of years, if not decades. In that race, I think Argentina is meeting some of the primary points that you pointed in for a country in the need to capture investment cash. So that left me asking myself what does it mean that “can monetary policy turn Argentina into Japan”. I could have fully understand the picture you had paint in the article if you mentioned that Argentina has very low exposure to debt impayment to foreing investorts, as Japan. My country increased it´s nominal public debt in the Kirchner years but it done it by paying the IMF, arrenging with Paris Club and ICSID. So it’s newly created debt in these years was mainly with local public entities, like the ANSES (the public social security institution), our central bank and local lenders. That gave the government the monetary tools (or the freedom it comes without the IMF breathing in your neck on a daily basis) needed to spurr economic growth and some investment, amid very good commodities prices, at least 2012. So, from the point of public debt exposure to foreing investors, I see Argentina and Japan in a similar ground. ¿Is this (my) thinking considered in your analysis, the GDP % exposure to foreing investors of theses countries? I think you tried to explain the global monetary situation we are entering, of “post” crisis excess liquidity, and the meaning of that for developing countries like mine. You considered public debt impayment exposure as an important thing but didn’t developed from there into the argentinian case
So I basically had to ask. Also because the Kirchner strategy in the fiat currency world you had painted for the comming years is begining to make more sense than never, at least to me. It’s not really all about the amount of debt but also who is your lender. That’s the point Japan is probing, amid it’s decades of stagnation. That said, I don’t ignore this strategy wasn’t possible with the rising power of China in international matters.
Salutes from Argentina;
Nicolás Deza
This is interesting….
might Michael be discussing the uncharted territory of Monetary policy, the vast growth of M2, and conditions that, in the case of Japan, have stemmed deflation, on the back of government debt taking, over a period of time, stagnation, but a slow, rationalization of the excess, to a more stable lessening, but not an extremely volatile, growth-deflation structure of relations.
Argentina since 1990 has seen its m2 increase by 100,000%, near vertical of period since 2000’s, and while external debt is no greater a predictor of crisis than internal, is all the excess money sloshing around, leading to a different structure of occurrences than normally occurs post-crisis?
Thnaks, Nicolás, but you may have been assuming more sophistication in my title than I intended. The two countries are largely metaphorical.
Argentina classically has external debt crises, which means, since it cannot create the currency needed to “resolve” its debt, Argentine crises are on one end of the spectrum. Once the game cannot continue, payments are stopped, credit and money contracts (the relevant money, by which I mean the dollars or euros needed to repay the debt), and you quickly move to writing down the debt.
Japan represents the other extreme. The BOJ can credibly create the currency in which the debt is denominated, and so you do not get the brutal collapse in money and credit that you do in Argentina. Instead, you get stagnation for two decades, going on three.
Which is better? I suppose we might find out in the next decade or so.
Hi Michael,
Great post as always. My question is to ask now that what degree can we interpret the increased use of censorship under Xi Jinping yet another necessary step towards ultimately reforming the economy? I recall that not too long ago, you argued that the ongoing centralization of power is likely related to the CCP’s desire to successfully fight back against the elites currently benefiting from the status quo.
I second this question, following Prof. Pettis last posts it does seem that the optimism has been replaced by something else.
I think it is most certainly part of the process of centralisation. I suppose I could discuss this in greater detail but I am not sure it is appropriate enough to merit broaching what can be quite a sensitive topic. Sorry.
So I’m wondering if there are any policy tools, however unlikely to be exercised, that can remedy the Japanification problem. It seems to me that monetary policy alone may exacerbate wealth inequality by driving up asset prices (by lowering the discount rate). Additionally, in the U.S. we have a big problem with underfunded pensions that are going to struggle to meet their obligations. These pensions, of course, will ostensibly finance the retirements of largely middle class households. I’m thinking maybe a permanent payroll/income tax cut combined with a hike in capital gains and dividend tax rates would help solve the problem. In general, I wonder if the policy synthesis should be more calibrated to target an appropriate real interest rate to achieve long term macroeconomic stability.
I’m not sure how to deal with the U.S. becoming the victim of beggar-thy-neighbor monetary policy.
After 44 years of abusing the international status of the $, it takes only a few months of excess JPY and EUR issuance vs. USD for the US to feel victim of beggar-they-neighbour policy? That’s amusing (apart from the usual if implicit double standard). That’s by far the biggest achievement of QE so far. Stephen, the solution is so obvious, it is in front of your eyes since 1971 for the slowest minds and since 1944 for the sharpest. Get rid of the international status of the $. After all, it’s only an exorbitant privilege if you are the only one to have it (subject to the exorbitant burden of an ever rising debt load of course), but not if China, Japan, Australia, Europe and everybody else is appropriating this unlimited issuance capability to debase against the $ and shift the entire weight of the world adjustment onto the US. So, if the US could stop blocking the necessary reform of the world monetary system as it has been doing for decades, that would not only be much appreciated but it would also appease your legitimate concern. Better late than never. Not sure what took so long?
I very thoughtful essay, as always!
With regard to “making money”, Minsky’s, “the problem is getting it accepted” is an observation about the centrality of the state in creating currency demand, primarily through the enforcement of taxes. The apparently open ended possibilities of fiat money in a post GFC world have only been plumbed to the uses of finance itself. The ability of central banks to reflate finance independent of the real economy has allowed the ECB to continue to bleed the periphery and the US to continue to foam its runways for its TBTF banks with the incomes of the middle class.
To this extent and American analogue for Guangxi was created with the Citizens United ruling: what had been an informal, black market for political power here has been transformed into an open, legal marketplace. The first result is that laws are rewritten to facilitate the power of economic incumbents. Following is a collapse in small business formation and accelerating failures of small businesses. At the same time Congress is defunding the IRS, which re-focuses its efforts on small business and individuals who can’t afford to tangle with it. The consequences of QE, infinite money for those who don’t really need it, and taxing only those who can’t afford it can’t really help on long term credibility. But “markets can stay irrational longer than you can stay solvent”, or maybe alive!
The salience of this to your essay is I suspect you are over estimating American firms in particular in their ability to innovate and generate real returns in this environment. I suspect most major American firms have learned it is a much more dependable bet to purchase a favorable legal environment in our market for legislators than to incur the very real risks of actual investment or innovation. Likewise our top technology companies, while active in the market for helpful laws, have also been active in the market for start ups, more frequently buying them to mothball or shut down, the “investment” being protection increasingly impregnable incumbent advantages.
While China’s Guangxi is old and ours is new, in China, at least from this distance, there still seems to be a residual respect for the billion plus citizens who’s real needs appear to be being met increasingly well. This contrasts, at least from this distance, to our situation where government policy is still actively focused on making living standards lower. While “the reserve army of the unemployed” are still used as a monetary tool, there is no central authority with any particular concern for the average citizen. This deteriorating situation appears to be accelerating with Obama only striking a “populist” tone once entirely powerless to effectuate any of it.
While it may have been the case that America innovated, to the extent our political market place institutionalizes itself this will increasingly not be the case as the representation that is being purchased is representation for incumbent large corporations, even as we undermine our own tax base by defunding the IRS. This is what Greece’s generals did as a precondition for relinquishing power: they made themselves and the elites they identified with immune to popular sovereignty, guaranteeing eventually the failure we see now.
The point I’m trying to make is that as they say, “past performance is no guarantee of future returns” applies equally to nations. QE and fiat money have decoupled monetary authorities from the real economy to the extent they are willing. In the west they have been very willing. The result has been to make money express itself ever more clearly as power: as we see in the Troikas demands of Greece; as we see in the C Suites of America’s TBTF’s still populated by princes made kings on the public dime by this president.
Real improvements in the west, I suspect, will next result from dramatic political change. Real investment is just to risky when you can play with fiat controlled by a government of your friends.
One of the things I’ve noticed when reading or thinking about developmental economics is that the human resources just aren’t there, in terms of educated, experience personnel, and sophisticated social organisms, whether that be trade groups or the DOT, such that financial capital can impact this countries beneficially. I also think that elites in most countries, including Western ones, are very suspicious of the means of improving human talents and improving the economy’s access to them (for example, there’s a long ago, but forgotten blogpost where bad roads in Haiti were explained to be allowed that way so only people using large SUVs could use them). They always seem to interpret services to the masses as entirely supplementary at best–consider Koch or Art Pope’s domination of state politics and the drive towards defunding public schools among other tactics. Xi’s attitude is really quite normal in the grand scheme of things. Keeping China in the frame, wasn’t one of Yasheng Huang’s themes in his famous book about 80’s Chinese capitalism that the era of microcapitalism ended because it empowered too many people outside of the centers of Chinese authority? And when I last looked a couple of years ago, for all that money China has poured into its economy overall, I thought it was a real shame that rural areas do not seem to be well capitalized at all in agriculture or any kind of makes-sense industry. In Venezuela and the countries lining the Gulf of Guinea, capable technicians seems to be an insurmountable stumbling block to using oil to advance themselves, and new cadres just seems very slow to bloom.
Not to be pedantic but if there is truly excess capital, then any use of it may be of benefit. While the returns to whom the capital belongs may be negative, its disbursement would ultimately increase demand. Otherwise the capital, being excess, will sit idle and deteriorate in real value until it reaches an equilibrium with demand.
Thank you for the reference to our article. We would be delighted to talk further.
I would not be surprised at all if we ended up with a world full of Japan’s. And Japan is only getting worse and worse. Keeping our heads on straight is important during these tough times. Thank you for the article.
In Oct. of 2013 I asked the good professor if he was was implying that the middle class in the U.S. was doomed. Of course that was too unspecific a question, and he could not be expected to predict policy responses. But today I read in the comments section: “Step 1 should be to have massive debt writedowns for the middle class, which seems to be getting completely wiped out.” If I’m reading this comment from the professor correctly, perhaps he is now weighing in on the subject.
But then again, most of what I read here seems to be rather bullish on the U.S., at least in comparison to the rest of the world. I guess it all depends on where one is in the game of lending vs. debt. ‘Neither lender or borrowing be’ is no longer an option, if it ever was.
Oops! I apologize for putting words in the professor’s mouth. I thought I was quoting him but I was quoting Suvy. Maybe I was blinded by seeing what I wanted to see, my point of view reflected back to me. Or I was just in a hurry? So my next investment will be a pair of reading glasses.
The quote from Bain is typical of how the “experts” are systematically omitting the real causes of the staggering global debt build up since the early 1980’s. Reliance on leverage? As if man developed a sudden taste for leverage in the early 1980’s. High-speed computing? And in what sense exactly was the spread of high-speed computing a primary cause of the global debt snowball in a way that for instance the spread of more capital-intensive automobiles or household appliances in the 1950’s was not apparently? As for financial innovation, this is indeed a self-reinforcing by-product of mushrooming debt and of currencies and interest rates jumping around post Bretton-Woods, certainly not a primary cause. This is all the more surprising that Bain has the real primary cause of the global debt build-up right in front of its eyes when it remarks that “the shift began with the end of the Bretton Woods system in the early 1970’s”. It is as if Bain didn’t want to dwell on the real causes, perhaps because of the risk of upsetting clients (refer to comments from Michael Pettis in the previous article). Of course, none of Bain large corporates or governments or financial institutions client is very likely to have any strong desire to acknowledge the real causes of the global debt snowball. Any secondary reason or symptom sound a lot better to their interested ears. And so, unsurprisingly, the “experts” are systematically wrong and never see anything coming. For instance, according to the report, Bain “discovered” in 2012, ie. 16 years after the fact became observable, “that the relationship between the financial economy and the underlying real economy had reached a decisive turning point”. No joke! “The rate of growth of world output of goods and services has seen an extended slowdown over recent decades while the volume of global financial assets has expanded at a rapid pace”. In other words, Bain apparently discovered in 2012 the “balloon economy” which is visible like the nose on the face since the mid-1990’s (remember the “irrational exuberance”?) and is the logical consequence of the unbalanced world trade system and the resulting duplication of credit on a worldwide basis to the point that the system can only cope with the ever increasing debt load by suppressing ever more interest rates, which inflates financial assets even more, which allows trade imbalances to grow ever wider, and so on so forth till equity is entirely wiped out from the system. But the “experts” are always putting forward secondary explanations (bankers greed, lack of regulatory supervision, computerised trading programs, etc) as a fig leaf to keep the real causes out of public sight. Is it any surprise then that the general public trust in the “experts” has utterly collapsed?
Having completely missed the root causes of financial capital puffiness, the report then does a decent job at describing the symptoms and the investment implications in chapters 1 to 3. But, frankly speaking, there is hardly any value added left in this exercise as it has been done millions of times and the yield-chasing behaviour higher up the risk curve, the chronic bubbles (which the blind Fed can never spot) as capital overflows the size of real economic assets, the cross correlation of asset classes returns as money creation lift all boats simultaneously, the financial returns more than 100% attributable in aggregate to money creation with negative implicit returns from real economic activity are all very well known by now. They are mere generalities at this point. So you end up with completely tautologic advice, for instance: “Those that can react with speed and adaptability will be best able to identify the winners, steer clear of the bubbles and generate superior returns” or “In today’s capital abundant times, the ability to identify owners of good ideas and help them achieve their full potential will be the hallmarks of investing success” or “In addition to fine-tuning their project return analysis, companies with the ability to develop compelling intellectual property and attract and retain top professional, managerial and technical talent will best be able to overcome the biggest barriers to sustained profitable expansion through the balance of the decade.” Frankly, do you really need a Bain consultant for that kind of tautologic statements?
In the current cycle, the combination of superabundant capital chasing a not superabundant number of good ideas was best seen in the biotechnology space. Over the last 4 years, earnings per share of the Nasdaq Biotech have been growing on a +23% annual pace, showing that the ideas behind these ventures are indeed working. But share price have been growing on a +35% annual pace over the same period as excess money creation (which is not yet capital by the way as it has not yet stood the test of enduring value creation, it might as well crash and evaporate tomorrow) overflowed this attractive business sector, turning it into a financial investment with a mediocre risk-reward at this point as price is now 45% ahead of earnings over the last 4 years. Rather typically, when Bain writes in 2012 that “asset bubbles will percolate most commonly in commodities, from basic raw materials and agricultural products to precious metals and rare earths” is precisely when these particular bubbles started to deflate. May be the advice that “companies will need to strengthen their bubble-detection capabilities by building on insights derived from the long-term fundamentals of their businesses” applies to Bain itself.
I don’t understand the claim that the previously inevitable contraction of monetary conditions following hyperextension is no longer possible now that we live in a fiat currency system. We live in such system since 1971 and there has been many contractions in many asset classes over the decades (see for instance figure 2.1 page 13 in the Bain report), some contractions being induced by central banks (eg. Volcker) and more being endogenously triggered by market participants selling as valuation became over-extended, the selling becoming self-reinforcing due to unwinding of leverage into a falling market. In fact, over recent decades, most asset classes (with the exception of developed markets bonds) exhibit the amplified oscillator “boom-bust” pattern, with the creation and destruction of means of payment being the amplifying factor on the way up and on the way down respectively. The impact on real economic growth, both in terms of the consistent weakening of the long term trend and in terms of the amplitude of cyclical fluctuations, from this violent swings in asset values has been very noticeable, with recessions in 1974-1975, 1981-1982, 1991-1993, 2001-2002 and of course 2008-2009. So, the evidence rather suggests the opposite conclusion that the fiat currency system is in fact amplifying the swings in monetary conditions to the detriment of the real economy.
Indeed, the risk of a long economic stagnation as a result of the fiat currency system has already materialised a long time ago (though it is still possible that it deteriorates further): based on data from the World Bank and the US Census Bureau, the decennial average growth of real world GDP per capita was +3.3% in the 1960’s before the shift to a fiat currency system in 1971, +1.9% in the 1970’s, +1.4% in the 1980’s, +1.4% in the 1990’s, +1.4% in the 2000’s. The real growth trend has been consistently weakening despite (because of?) exponentially accelerating monetary expansion. Given that this weaker economic growth trend has also been very distorted in its distribution both between and within countries and regions, with soaring income inequality within countries between capital owners and ordinary employees, the real trend experienced by a very large majority of people in developed markets over several decades has actually been negative, which is the definition of economic stagnation.
The notion that “with the main central banks of the world having banded together to issue unprecedented amount of credible fiat currency, we may have changed the dynamics of great rebalancing crisis” and that “the historically unprecedented fact of our unlimited ability to issue a credible fiat currency allows us to postpone a quick and painful resolution of the debt burdens we have build up” is especially problematic in my view. If you consider that central banks picked it up exactly where the commercial credit system left it in 2008 and that, apart from this technicality of which institution actually create fiat money, the monetary system is fundamentally unchanged, it is then possible to rewrite the beginning of the sentence as follows: “With the main commercial banks and bond markets of the world having banded together to issue unprecedented amount of credible fiat currency (at an average pace of +8% p.a. since the early 1980’s), …” But then it becomes immediately visible that the conclusion that the resolution of rebalancing crisis is made smoother doesn’t hold because, precisely, it led in 2008 to a great rebalancing crisis. Instead, the end of the sentence could become “… we may have enabled global imbalances to grow to a stretched level, precipitating the 2008 rebalancing crisis and the near collapse of the world monetary system.” The solution to reload the system with even more money creation with the central banks replacing commercial banks as the main source of issuance then appears not as something new at all but simply as a flight forward in what has already been tried many times before with results ranging from poor to disastrous.
In other words, the fiat money system might not so much give us more time to rebalance less painfully as it might allow us not to rebalance and to instead perpetuate the imbalances for longer at the cost of an even more painful rebalancing later on. It is gamble on a massive scale, not thoughtful policy. It is gamble with poor odds as well.
Also, given that money is a deeply entrenched social convention whose perception can only change very gradually over very long period of time (extending over several generations) before reaching a potential tipping point, it may be way too early to conclude that the fiat currency currently being issued in abundance is credible. The words “unlimited”, “unprecedented” and “credible” usually don’t go so well together. Over a shorter time horizon, it may be more correct to simply say that we don’t have any other practical choice than to accept fiat currency, whether or not its credibility is strengthening or deteriorating. We can simply note a rising number of attempts at alternative currencies, for instance Bitcoin among many other exemples.
At the end of the day, “superabundant capital” is just a more politically correct name for the “ballon economy” in which we unnecessarily live since 1971 by virtue of an undesired, unilateral and – let’s not forget – temporary decision of a US President whose strength of character and judgement has been questioned shortly after. In such “ballon economy”, while we only know after the facts which projects were in fact useless and destroyed value, it is a certainty that the proportion of such wasteful projects is greatly increased. We have already discussed elsewhere (in the comments to “How to link Australian iron with Marine le Pen”) how the blurring of the entire price system of the market economy by excessive money creation makes the capital allocation process – the engine of genuine wealth creation – ineffective and ultimately leads people making real investment decisions to defence and retrenchment, ultimately leading to lower living standards over time. Moreover, there is strong evidence to suggest that the benefits of money creation are entirely captured by businesses and retained as profits, driving savings up and income and wealth inequality to dangerously stretched levels with the consequences that you have described in “Economic consequences of income inequality”, ie. rise in unproductive investment, rise in debt-fuelled consumption and ultimately rise in unemployment. Again, we reach that same dead end.
There is no doubt that many recent and current policymakers believe that debauching the currency is the best way to save the capitalist system and they have bet $12 Tr on that so far with remarkably little to show for it to their people. Perhaps this is why some policymakers like Mervyn King are now actively trying to repent upon retirement, may be as a hedge to their historical reputation. Lenin, on the other hand, thought that debauching the currency was the best way to destroy the capitalist system. Clearly, someone among the sorcerer’s apprentices is badly wrong on this rather fundamental question.
One thing seems clear though, there is no way back on the road to exponential money creation. “The more that is issued of a fiat currency, the more will be wanted. The supply doesn’t satisfy the demand, it excites it … it creates an increasing desire for more ; and the more it is gratified, the more insatiable are its cravings. There are two reasons for this: one, that, as the currency is expanded prices are raised correspondingly, and the more currency is demanded to effect the same exchanges ; the other, that the speculation inevitably following the raise of prices leads to an enormous extension and repetition of indebtedness, which requires, for its discharge, a greatly increased amount of the circulating medium. Thus, by the action and interaction of these causes, the demand for the issue of this kind of currency is certain to be greatest when it is already redundant. All this, of course, is quickened and helped by the fact that the manufacturers of this currency are ready and eager to crowd upon the public all it will take, like a very earnest friend who thrusts his purse into your hands before you are quite decided that you wish to borrow”. This describes so perfectly the current situation of non-stop easing by central turns, in turn or together, that it feels like it was written last week. In fact, it was written by Amasa Walker in his book “The Science of Wealth” published in … 1866. Welcome back to the future!
If the Fed would now go for token tightening, it would be a perfect repeat of 1928 … with more players globally and worse initial employment conditions … Then, the political consequences of the depression would finally make it possible to reform the dysfunctional world trade and monetary system (assuming that the political consequences don’t lead to military conflicts and leave enough goodwill for international cooperation, which is perhaps not a very realistic assumption).
I see nothing at all that is different this time. On the contrary, all the usual and well document ingredients of attempting to suppress the symptoms by financial reflation rather than addressing the causes, leading to formidable speculative frenzy followed by sheer panics are all there perfectly recognisable.
The extent to which policymakers, assisted by the “experts”, have been willing to remain blind to the real causes of this precarious global situation despite the accumulation of evidence and the wake-up call of 2008 has been absolutely astonishing. The crisis is above all a leadership and intellectual crisis.
MP- great thoughtful article. I wan to answer the question in your title, “Can monetary policy turn Argentina into Japan?” My answer is no. While I agree that monetary policy is as much about Politics as Economics,, monetary policy is only short-term noise on the path of national economies. Absent the Monetary Noise, the driver of economic growth are institutions supporting free trade and productive enterprise (Anglo-model, which Niall Feguson popularizes).
Argentina has none of those organizational qualities to turn it into Japan- Argentina is remain mired in low-tech infrastructure, corruption and declining living standards. Debt and funding for Argentina may be cheap, but it cannot subsitutute for productive investment. The negative yields on soverign bonds in Euroland is screaming loudly that the Glut of Savings in not a massive (and artifical supply) of liquidity from central banks, but an intensely determined effort “not to risk any money”. The demand destruction of investment greatly outweights the increase in supply (whether demographic, central banks, or emerging markets). All we see is the price of credit (which is now negative, but I am arguing it has much more to do with negative change in demand, rather than the consensus view of an increase in supply.
Your proposals for an “infrastructure fund” to deploy some of Savings Glut- is admirable from an economics point of view. A historic opportunity for nations to deploy cheap capital. But you are missing the cause of the problem, which is a lack of risk appetite. Politics and Organizational structures are more important that economic arithmetic. A governement-funded infrastructure bank would “guarantee profits” and hire elites and unions to do the work. The effect would be the opposite and the risk-takers of the world, and the median income earners would be left out. Look at the UK effort to build out its Energy Infrastrure- guaranteeing Nuke plants and Wind Turbines with prices at multiples of the market price for energy.
Argentina’s future is not a glide path towards zero interest rates, but instead more like a failed-state with civil war with near term. The factions within the security service (and recent murder of Nisman) are just an illustration of what is to come for Argentina on a larger scale.
Monetary theorists have to broaden their perspective on the drivers of economic growth- and not the specific levels of M1, M2 or Debt or the taylor rule. Negative interest rates that we see today are unprecedented- and monetarists are going to see their credit-flow models are profoundly limited in the real world of geopolitics, gun and private actors.
MP- on another note, I would like to see an indepth view of Yanis Varoufakis… He is a smart economist with non-traditional views (different views but similar iconclast image like yours). He is now in a position of power, and I wonder if you would consider being the Chinese Finance Minister after a Chinese meltdown? What do you think of academic economists entering politics? big topic.
On the subject of “guangxi”, I like to point out that it isn’t solely a China phenomenon. There are plenty of examples throughout the world – e.g. Qatar World Cup bidding process (at international level), or, say, a ticket to the Wimbledon (at corporate level to build relationship with clients).
Further, to perform a “guangxi” action, this does not necessarily entail monetary benefit to others. Non-monetary forms can be anything such as a social gathering of a business event, happy hour after work. For a more positive terminology, this would be called networking.
“Developing countries almost never benefit from the high tech boom that typically accompanies periods of excess liquidity because they tend to have limited technology capabilities”
Great article as usual, but I’d just like to point out that the cell phone has probably benefitted China, India, and even much of Africa (where it is more commonly used as a wallet than in the US) even more than it has developed countries.