Monday, December 17, 2012

The Bank Of Japan Will Defeat The New Government

“Mr. Abe's economic platform consisted of more fiscal stimulus spending, to be financed by the Bank of Japan directly buying government bonds. In other words, printing money to bring inflation up to a new target of 2%-3%, compared to the BoJ's current target of 1%. But the central bank has expanded the money supply enormously, and demand for credit is so weak that it has been unable to stop deflation.”
---WSJ editorial, “Japan’s New Old Hawk”, Dec. 17th 2012

The Journal is giving the Bank of Japan credit for something it didn’t do. It is unclear where the Journal gets its monetary data for Japan. I get mine from the Fed, which show that money growth in Japan has been weak for twenty years, frequently going negative. M1, M2 and M3 growth rates have been bouncing around a very low mean of around 1% over those years. At present, under the BoJ’s supposedly reflationary policies, broad money (M3) is growing at 2.2%. Nominal GDP and industrial production have declined sharply since the crash.

The Journal is right that the BoJ has been unable to stop deflation, but that is due to its dogged pursuit of deflationary policies. It is now ten years since Ben Bernanke first explained to the Japanese the mechanics of NGDP targeting; only now is the government considering such a program. Twenty years of deflation and deficits have been wasted. Reflation is now the only way out for Japan, given its massive indebtedness.

The newly elected Japanese prime minister, Shinzo Abe, has embraced the advice that Bernanke gave Japan ten years ago: to target not interest rates, but either nominal growth or a target level of NGDP. Abe says that he will establish a monetary council, outside of the BoJ, that will set a 2% inflation target and a 3% NGDP growth target. If the BoJ ignores the council, he will take away the bank’s legal independence (long overdue).

I don’t know how to react to Mr. Abe. Most of what Japanese politicians say is meaningless. Japanese governments have been whining about the BoJ for fifteen years, so what’s new? My gut skepticism toward the Japanese political system suggests that one should not hold one’s breath waiting for a meaningful change in Japanese monetary policy. Furthermore, in typical Japanese fashion, the “radical” Mr. Abe has not called for a radical policy:  3% nominal growth will not change Japan’s debt dynamics when its fiscal deficits remain large (and will grow bigger under the new government).

Japan needs a radically reflationary policy now, not baby steps which are too little and too late. Bernanke advocated targeting the level of NGDP that would have occurred had the desired growth path not been interrupted. For Japan, that would be roughly 12% higher than today’s NGDP, not 3%. Mr. Abe is merely demanding that the BoJ do a tiny bit better than it has been.

Furthermore, students of Japanese politics will know that it will only take days for the Japanese media to proclaim Mr. Abe a failure and an embarrassment, no matter what he does or doesn’t do. In a year he will be gone, and the BoJ will still be there, “fighting” deflation.

This means that the Japanese economy will remain stuck in idle for another decade, the yen will remain strong, and the Nikkei (EWJ) will go nowhere.

Saturday, December 15, 2012

2013: The Year Of Printing Money

Assuming that the Fed implements QE3 as announced on Wednesday, I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now. By yearend, I expect nominal GDP growth to have accelerated from its current 4% to a level closer to 5%. I am therefore bullish about both economic growth and equity prices.

The quantity theory of money holds that nominal GDP growth is a function of money growth, and that money growth is a function of the size of the central bank’s balance sheet. Therefore, the central bank is able to control the level and growth rate of nominal GDP.

However, these are not constant relationships. As interest rates decline, so does monetary velocity, such that it takes proportionately greater increases in the money supply to produce comparable GDP growth. And similarly, the relationship between the central bank’s balance sheet and the money supply is also not linear, particularly as interest rates approach the zero bound. Keynes called these phenomena the liquidity trap in which monetary policy loses its power as the central bank “pushes on a string”.

While monetarist economists concede that these relationships are not linear, they do not accept that a central bank can ever lose its power to grow nominal GDP. And it is a bit ironic that the same voices that argue that monetary policy has lost its efficacy also argue that quantitative easing will lead to inflation. They argue that monetary policy is (a) powerless; and (b) powerful. They are wrong on both counts: monetary policy never loses its efficacy, and the current program of expansion will not lead to high inflation (just as the prior rounds of QE did not, despite dire warnings from the hawks).

No one can reasonably argue that a central bank cannot inflate its currency such that nominal GDP will grow. We have witnessed this phenomenon many times since the invention of fiat money in 17th century France. The central banks of Zimbabwe and Ukraine have been poster children for the power of the printing press, and have both succeeded handily in greatly expanding the size of nominal GDP.

As Bernanke argued to the Japanese, in extremis, there is nothing to stop the central bank from dropping money on the citizenry from the air. In 1933, when FDR decided to inflate the currency, he began to raise the dollar price of gold by arbitrary daily increments until he saw the overall price level begin to rise. He didn’t know very much about monetary policy, but he understood that by printing money he could cause inflation.

Now let’s look at the facts today. Since the crash, the Fed has engaged in two rounds of balance sheet expansion. (Note: I am using the Fed’s balance sheet and the monetary base interchangeably; they are very close in dollars.) In QE1, the monetary base grew by about $1 trillion. In QE2, the base grew by another $700 billion. In QE3, the Fed plans to grow the base by additional $1 trillion. Overall, the monetary base will have grown from $800 billion pre-crash to around $3.6 trillion by next Christmas (while inflation has remained subdued).

The money supply (M2) has grown by almost $3 trillion since the crash, for a total growth of 40%. Since the crash, nominal GDP has grown from $14 trillion to $16 trillion, an increase of 14%. The Fed’s plan is that by growing the monetary base by about a third in 2013, nominal growth will accelerate to a level that would allow unemployment to decline to from its current 7.8% to a targeted 6.5%.

Since the immediate recovery period after the crash, NGDP has been growing steadily at a subpar 4%. This third round of monetary expansion, if pursued, should lift that rate to a level above 5%, which is still less than robust but closer to potential (NAIRU).

If the Fed pursues QE3 as announced, inflationary expectations should rise next year as bond prices fall. This should be bullish for equities as returns from the “risk off” trade decline. With cash yielding zero and falling bond prices, equity inflows should rebound.

The equity risk premium today is still attractive at over 4% (earnings yield minus bond yield) and appears to be in solid value territory in a historical context. As the appeal of bonds diminishes, equity valuations should rise and the risk premium should decline.

My advice for 2013 is: Don’t fight Bernanke.

Wednesday, December 12, 2012

Thank God For Bernanke

The FOMC met this week and made the following announcements:

1. The Fed believes that, without further QE, economic growth will not be strong enough to generate sustained improvement in labor market conditions (i.e., unemployment below 7%).

2. The Fed will continue purchasing additional MBS at $40 billion per month, and will also purchase longer-term Treasuries at $45 billion per month, for a monthly increase in the Monetary Base of $85 billion (3%), or $1 trillion annually (36%).

3. If unemployment does not decline to 6.5%, the Fed will continue its purchases until such a decline is achieved. However, that does not mean that QE3 will necessarily end when unemployment goes below 6.5%.

4. To support continued growth, the Fed will maintain its zero-interest rate policy (ZIRP) for a “considerable time” after the QE program ends and the economic recovery strengthens. (A “considerable time” is understood to mean not before mid-2015.)

5. The ZIRP will continue at least as long as the unemployment rate remains above 6-1/2%, inflation is no more than 0.5% above the Committee’s 2.0% longer-run goal, and longer-term inflation expectations continue to be well anchored (e.g., the TIPS-Treasury spread remains low).

How should we Kremlinologists interpret these announcements? The good news is that Bernanke has managed to hold together his near-consensus in favor of unconventional monetary policy:
1. The Fed will continue QE, and will pursue ZIRP at least until 2015.
2. The Fed has announced an explicit unemployment target of 6.5%, which is the first time that it has operationalized its full employment mandate.
3. The rate of the Fed’s pace of asset expansion will more than double and will,  if pursued through the end of the year, represent a material increase (36%) in the Fed’s balance sheet and the monetary base.
4. The Fed will add purchases of Treasuries to the QE program, which settle much faster than MBS and will have an immediate impact on the monetary base.
4. The Fed is prepared to tolerate a higher-than-target rate of inflation in order to achieve its unemployment target.

The markets have reacted mildly to the announcement, with Treasury yields and gold prices rising to reflect slightly higher inflationary expectations.

However, this announcement should not be interpreted as a decisive victory of Bernanke and his doves over the FOMC hawks. That is because the Fed continues to tie its hands by (1) limiting the scale of its intervention to a modest level compared to prior QEs; and (2) limiting inflation and thus nominal growth. Were the Fed to go all the way and target a nominal GDP level (i.e., a nominal GDP of $X), it would not only tolerate but actually desire above-target inflation. As long as the Fed places a higher priority on its inflation target than on its employment target, it may never achieve the employment target, or at least not very quickly.

This helps to explain the market’s muted reaction. Yes, the monetary base will now start to grow for the first time since QE2 ended in mid-2011; that is bullish for nominal and real growth (especially helpful if the US goes over the fiscal cliff next month). But nominal growth will be limited to the sum of real growth and a maximum of 2.5% inflation, whether or not maximum employment is achieved.
In my opinion, that’s not good enough to get us where we need to go, and it is insufficiently radical to decisively move the needle on inflation expectations.

Bernanke keeps telling us that monetary policy is not a panacea; he is right that timid policies are not a panacea.

However, today's announcement is definitely progress, and the Fed is now intellectually and operationally far ahead of its global peers. And I might add that once the Fed actually begins to grow the monetary base by $85B/mo, that should go a long way toward cushioning the fiscal cliff.

Monday, December 10, 2012

The Super Marios Have Failed

“The underlying pace of monetary expansion continues to be subdued...The December 2012 Eurosystem staff macroeconomic projections for the euro area foresee annual real GDP growth in a range between -0.6% and -0.4% for 2012, between -0.9% and 0.3% for 2013 and between 0.2% and 2.2% for 2014. Compared with the September 2012 ECB staff macroeconomic projections, the ranges for 2012 and 2013 have been revised downwards.”
--ECB president Mario Draghi, Dec. 6th, 2012

Here’s a brain teaser. Look at the two Marios, Monti and Draghi. No one would deny that they are exceptionally intelligent and perceptive people. Any country or central bank would be happy to have either of them at the helm. They are both Ivy League-trained economists (Monti at Yale, and Draghi at MIT). Either of them can think rings around most European or American politicians.

And yet, they are both pursuing policies that can only end in disaster, not only for Italy, but for Europe. I can’t believe that I could possibly know anything about economics or monetary policy that they do not; that is a truism: they know everything. So how do we explain the reckless and suicidal policies that they are pursuing today? I can offer a political explanation for their behavior and a psychological one, but neither are adequate. Politically, neither has sufficient authority to reject deflationism and to embrace reflation. Psychologically, Italian technocrats like the two Marios labor under the northern prejudice about the Latins, that they are lazy and hopelessly corrupt. It is understandable that these incorruptible technocrats would like to prove that the Latins are not constitutionally inferior to the Protestants and can live with a hard currency. Those are reasons but not very persuasive ones.

It is hard to believe that they are fully conscious of the fact that the policies they are pursuing are wrong and that they are both guilty of misfeasance and nonfeasance. Somehow they have convinced themselves that austerity, deflation and depression are, in the long run, good for Italy and for the eurozone. After all, every northern country has gone through austerity at least once since 1980 and they have all emerged stronger and more competitive. Why shouldn’t the south? I have to assume that their thought-process is that starvation is painful in the short-run but beneficial in the long run. If so, then one must ask: how large must the pile of contrary evidence grow before they can admit error, or have they gotten in too deep to ever admit error? I can understand that it is hard to call off a war just as you are starting to lose.

I can appreciate Monti’s logic: he wasn’t installed by Europe into the Italian premiership in order to hijack the ECB or to exit the eurozone. He was installed to act as Europe’s local governor-general in order to ensure that Brussels’ orders were carried out to the letter, and that the corrupt politicians were unable to steal Europe’s money. Monti never had a chance to successfully revolt, although he tried (without success) at the June summit.

Now Monti wants to quit, and who can blame him? An honest professor in Italian politics is like Mother Teresa in Vegas. But I must say that one can only conclude that Monti has failed due to timidity or sheer exasperation.

Europe’s only hope is for the struggling countries to unite and to confront Germany, the Bundesbank and the ECB head-on. Monti, Hollande and Rajoy (and the others) simply must demand that (1) the ECB target growth and not depression, and (2) that the ECB buys the bonds of the peripherals without conditions or limits. If they don’t do that, then eurozone growth will remain negative, fiscal revenues will stagnate, deficits will grow, and credit spreads will start to back up. Just because the ECB’s bogus announcement of chimeric bond-buying has temporarily convinced the markets that all will be OK, it can’t last. Another market convulsion is just around the corner.

Which brings us to Draghi and his “friend” Jens Weidmann of the Bundesbank. Draghi, like all central bankers, has placed a very high premium on “institutional credibility” and consensus-building, and an apparently low premium on successful policies. Yes, the ECB has a single mandate (price stability)  that it is fulfilling extremely well, as Draghi keeps emphasizing. But does the ECB really have a mandate to recreate the Great Depression, to bankrupt the peripheral countries and to destroy the eurozone? Was that the intention of the treaty that Italy, Spain, Portugal and Ireland signed?

I can only conclude that both men are brilliant but weak. Monti is afraid of Merkel and Draghi is afraid of Weidmann: “We can’t alienate the Germans, Finns and Dutch!” Why not? What have they done for the eurozone lately besides enforcing starvation?

It is astounding to me that a central bank of the importance of the ECB can casually forecast a shrinking GDP, as if it were an exogenous variable, like bad weather. The ECB advertises its failure by its own forecasts. Apparently Draghi and Weidmann are satisfied with a prediction of a real recession and zero to negative nominal growth. If my numbers are correct, Italy’s GDP today is 27 billion euros smaller in nominal terms than it was in 2007, industrial production is down 20%, and youth unemployment now stands at 26%. This is taken to mean that the bank’s policies are “on track”. They must serve a lot of Kool-Aid at the ECB snack bar.

Saturday, December 8, 2012

Greece Will Defy Europe Yet Again

It looks like the latest Greek bailout deal is about to be put to bed. Greece has passed the required legislation, the deal has been okayed by the relevant donor parliaments, and the debt buyback required by the IMF is almost complete. All systems are GO for lift-off.

However, this latest deal is not just a xerox copy of the prior (failed) deals. At the insistence of the donors, it contains what appear to be some real teeth. In trying to reconcile the need to prevent Grexit while forcing Greece to comply with its demands, the Troika wants to do to Greece what the US used to do to Central America back in the good old days. Just as the US Navy would take over customs collection until its bonds were redeemed, the Troika will take control of Greek revenue and expenditures, or so it believes.

The new deal includes the following conditions:

1. Disbursements are conditioned on Greek fulfillment of its specific promises. For example, the upcoming disbursement of 9.3 billion euros requires that the Troika certify that the Greek government met a January deadline for implementing tax reform. (It is unclear if that means merely passing the legislation or actually changing the tax system, a crucial distinction in a country where legislation means nothing.)

2. In the event that Greece’s budget goes off the rails (as it always had in the past), automatic spending cuts will kick in.

3. The Troika will administer a segregated account for Greek revenue and aid money to ensure that debt payments have first priority.

These unyielding conditions put the Greek government in an awkward position: whether to defy the people, or to defy the Troika. If past is any indication, Greece will defy the Troika. The Troika represents International Capital, the eternal enemy of the Greek working class. As a tool of foreign capitalist interests, the Troika lacks political legitimacy. The Greek government has an affirmative obligation to defy such forces. (In Greece it is always May 1968.)

The question is not whether Greece will fail to comply, but how soon. Probably next month, given their past performance. Better to defy now, while Europe is still writing checks, than to wait for time to pass and the German parliamentary elections to loom larger. The closer the elections get, the worse it will be for Greece.

Will the Greeks get away with it? They always have.

Friday, December 7, 2012

Moody's Will Downgrade The UK And The US

On Feb. 13th of this year, Moody’s changed the rating outlook on the UK’s Aaa rating from Stable to Negative. Moody’s said at the time that:
“A combination of a rising medium-term debt trajectory and lower-than-expected trend economic growth would put into question the government's ability to retain its Aaa rating. The UK's outstanding debt places it amongst the most heavily indebted of its Aaa-rated peers, alongside the United States and France whose Aaa ratings also carry a negative outlook.”

On Nov. 14th, Moody’s stated that:
“We will need to assess the Aaa rating and negative outlook in the first few months of 2013, in light of what the government’s Autumn Statement reveals about the [government’s] assurances that the debt trajectory will stabilise and start to decline within the rating horizon.”

On Dec. 5th, HM Treasury published its Autumn Budget Statement which provided revised projections for government revenue, expenditure, borrowing requirements and debt trajectory for 2013-18. The UK Office for Budget Responsibility analyzed these projections and compared them with the coalition government’s 2010 “fiscal mandate”.

The OBR concluded as follows:
"We now expect Public Sector Net Debt (PSND) to peak at 80% of GDP in 2015-16, compared to a peak of 76% of GDP in 2014-15 in our March forecast. PSND is pushed higher as a share of GDP by weaker nominal GDP growth, higher net borrowing, and technical asset reclassifications. The Government now appears more likely than not to miss its ‘supplementary target’, which requires PSND to fall as a share of GDP between 2014-15 and 2015-16. We now predict that PSND will rise by 1% of GDP in 2015-16, falling by 0.8% a year later. In the absence of the reclassifications, we estimate that PSND would be stable as a share of GDP between 2015-16 and 2016-17, and then fall in 2017-18."

So it would appear that Moody’s will have to decide early next year whether to (1) confirm the UK’s Aaa rating with a stable outlook; (2) place the UK’s Aaa rating on review for possible downgrade; or (3) extend the negative outlook.
The somewhat negative conclusions of the OBR would seem to provide sufficient rationale for a review and subsequent downgrade to Aa1, which is what I expect.

I say this after having looked at the UK’s key statistics and ratios at HM Treasury, the Fed, Moody’s and the Economist. What I saw wasn’t very pretty. Admittedly, data is backward-looking. But there is no evidence to date of an inflection point in the key numbers having been achieved, and no reason to expect one anytime soon. When a simple extrapolation predicts a crisis, it is hard to accept a projection that includes an upside-down hockey stick in the out-years without a compelling story to go with it. That story depends on economic growth.

For the UK’s debt trajectory to correct, the UK will have to do more than trim expenditures--it will have to grow its economy in nominal terms in the high single-digits. Right now, UK nominal growth is far below take-off speed, and real growth is negative, that is to say, shrinking, which is not good for debt ratios. The fiscal deficit remains very large (7-8%, depending on who’s counting) despite three years of fiscal austerity.

The UK’s problem is the world’s problem: inadequate fiscal revenue growth, caused by an incompetent central bank that thinks that the welfare state can survive with revenue growth in the low single digits. Indeed, the coalition government has nothing to do with the problem, aside from tolerating Mervyn King and his bank’s incompetence. Central bank independence is second only to the monarchy as a British institution.

I will concede that the UK is the European equivalent of New York State, with vast unproductive regions supported by a volatile financial sector located on a single square mile. By living off the golden goose, other industries are neglected and suffer adverse terms of trade caused by an overvalued currency. The country’s fate is in the hands of the City, which hasn’t recovered from the crash.

But that doesn’t excuse the failure of the BofE to act appropriately during and after the crisis. If one were to rank central banks on their badness, I would place the BofE third, after the BOJ and the ECB, and ahead of the Fed which is only half-bad. Indeed if I am not mistaken, the genius Mr. King raised interest rates when the crash was gathering downward momentum, undoubtedly to prove his cojones and to ensure the bank’s “credibility”.

So I do not blame the government for the coming review and subsequent downgrade, but I think it’s coming. After removing France’s Aaa and placing the US Aaa on review for downgrade, it would be hard for Moody’s to argue that the UK’s rating is fine. Its numbers are as bad as those of France, and much worse than those of Canada and Australia (now a global paragon of sovereign creditworthiness).

The US’s Aaa is in Moody’s crosshairs now as well, since Moody’s review for downgrade is focusing on the ability of the ruling circles to achieve a decisive program of deficit reduction and debt-trajectory stabilization. That would of course be the fiscal cliff, which no one seems to be defending as a policy option. Assuming something wonderful doesn’t come out of the lame duck session, Moody’s will probably downgrade the US to Aa1 in the first quarter. While I think that would be a big mistake from an expected loss perspective, it would be consistent with Moody’s sovereign rating criteria.