The end game approaches for monetary policy

Brett Gillespie

The Super Investor

This week I was encouraged to see Shayne Elliott, CEO of ANZ, raise the following;

Shayne Elliott… has called on federal Treasurer Josh Frydenberg to convene a summit to discuss the broader economic implications of zero per cent interest rates and quantitative easing.

It is a big question. And I think there is an obvious answer (of which I am in good company).

But before I provide that answer, we need some context.

There is a long history on economic policy fads, or orthodoxy, being applied without question until something breaks. Often when the policy is adopted, it works remarkably well. But a rule-based framework is inherently inflexible, and eventually something has to give.

Let’s quickly start with a brief a history of the gold standard which led to the “inflation standard”

  • The international gold standard emerged in 1871.
  • Thirty-three years later, in WW1, all countries abandoned the gold standard.
  • Post WW1, they all returned, some quickly, some waiting 5 years.
  • In 1934 Roosevelt, devalued the USD conversion rate (v gold) by 69%.
  • After WW2, the Bretton Woods system was developed. All currencies were valued relative to the USD, which was convertible to gold.
  • Some twenty-seven years later, in 1971, Nixon suspended the Bretton Woods System, and it collapsed in 1973.
  • The 1970’s marked a decade of high uncontrolled inflation, before Volcker stepped in in 1980 with an explicit (and only) goal to tame inflation.
  • In 1990, NZ pioneered inflation targeting. Canada followed in 1991, the UK in 1992 and Australia in 1994. It then became common for developed economies, and spread to emerging economies in the 2000’s.

Now consider this.

The appeal of a gold standard is that it arrests control of the issuance of money out of the hands of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance, a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy is not just to prevent inflation, but also deflation, and to help promote a stable monetary environment in which full employment can be achieved. A brief history of the U.S. gold standard is enough to show that when such a simple rule is adopted, inflation can be avoided, but strict adherence to that rule can create economic instability, if not political unrest. (my underline)

We have had an inflation standard now for the best part of 30 years. I would argue this simple rule is now “creating economic instability, if not political unrest.”

Interestingly, looking at my brief history above, 30 years is about the usual time for a simple rule to lead to economic instability and political unrest. Certainly, we are now seeing that in the developed world.

So, what’s next?

Well, related to Shayne’s question, we are seeing tremendous pressure build on governments, and here in Australia Frydenberg in particular, to “change” the governments obsession with a fiscal surplus and embark on infrastructure spending.

In particular from the RBA governor, Phillip Lowe, in his domestic speeches, but also as Chair of the BIS financial systems committee, which this week said the following;

"The room for monetary policy manoeuvre has narrowed further," said Claudio Borio, head of the monetary and economic department, in the BIS September quarterly review.

"Should a downturn materialise, monetary policy will need a helping hand, not least from a wise use of fiscal policy in those countries where there is still room for manoeuvre."

Admittedly, all we are witnessing here is the first mild foray into dismantling the economic orthodoxy that has prevailed over the last 30 years. None the less, the US has already abandoned that fiscal orthodoxy under Trump. And there are growing calls for Germany to embrace fiscal ease. With monetary policy largely exhausted in the developed world, but with developed world growth slowing, the focus is naturally turning to fiscal policy. And with interest rates so low, it seems a no-brainer for governments to borrow (despite record levels of peace time debt in the developed world.)

But is it a no brainer? Is it the only solution? Well, it is the only solution within the current economic orthodoxy. But as Shayne alludes too, is it not time to ask if the current orthodoxy is right? I strongly believe so.

Because let’s consider what has been achieved with the current orthodoxy. Certainly, central banks have achieved their goal, low and stable inflation. And indeed, today we are witnessing the lowest unemployment rates in much of the developed world since the 1960’s. One might suggest it has been a spectacular success!

Yet wealth inequality in the US has rarely been worse.

Piketty does a good job if explaining the history of inequality. In essence, it boils down to the return on capital is higher than growth of wages. Hence those with wealth will continue to get wealthier than those without (in normal times. As you can see from the chart, wars destroy wealth).

So, there is a natural bias towards inequality developing in peace times. Unfortunately, the policies pursued by central banks in the last decade have turbocharged this inequality.

Why? Because zero rates have turbocharged the asset markets. Great if you are invested.

Not so great is you have no assets. Then you are relying on growth in your wages. Real wages growth to be precise. And wage earners in the US have been getting a raw deal for 40 years now.

Which is why Trump has been so successful. He has tapped into this resentment in middle America. Indeed, the populist movements in Britain, France, Germany, and Italy (to name but a few) are all doing the same.

Perhaps a revolution? Indeed, we are witnessing a revolution. My point though, and to bring it back to Shayne’s question, is that the current economic orthodoxy is not the correct path. It is accelerating the imbalances that are driving inequality, resentment, the rise of populist governments and nationalism.

So, is fiscal policy the answer? It’s helpful. But it is not the answer. Why so? Because globally, developed market debt levels are too high.

As a rule of thumb, based on “This time is different” by Rogoff and Reinhart, around 100-120% debt to GDP has eventually created instability and crisis in the past. And historically there are only two solutions. Inflation or default. The US and Europe don’t have much “room”.

Mind you Australia has a lot more “room” to expand fiscal policy. Our debt to GDP ratio sits at 40%. It drops to the teens when we look at net debt (i.e. include the government assets).

So sorry Josh, you have plenty of room to spend (and maintain a AAA rating).

But that is not the big picture I am inching towards. The big picture is the time is coming to embrace a new orthodoxy.

Let me explain why. Quite simply, more debt is not the solution. Expanding fiscal policy might seem logical enough when interest rates are so low. Particularly in Australia, with low net debt. But much less so in Europe and America. At some point this debt needs to get re-paid. Remember it was only six years ago that the European Union almost broke apart because debt levels in Greece and Italy were considered unsustainable.

The equation for debt repayment is simple. For a country to reduce its debt over time, it needs;

Nominal GDP growth + primary budget surplus > average nominal interest rate on debt.

When rates rise, as we saw with Italy six years ago, the debt outlook quickly becomes unsustainable. Today, thanks to central bank aggression, we have a very low number on the right side of the equation. That makes debt sustainability a reasonable proposition. But given nominal growth is so low globally, it also makes debt reduction virtually impossible for most developed countries.

Hence the focus of central banks has been on increasing nominal GDP, by adopting policies to lift both growth and inflation.

But they can only achieve this by encouraging more debt. In the short-medium term this boosts asset prices. And wealth inequality. In the long term, it leads to unsustainable debt positions and a revolution by the asset deprived.

We are approaching that long term.

So, what is the answer? That is the wrong question. The answer is simple and well understood; higher nominal GDP growth. Higher nominal GDP growth reduces debt, but can be expected to improve wages, particularly under the right policies.

The question is;

“How should policy makers achieve higher nominal GDP growth?”

So far policy makers have looked for the answers within their own codes, so to speak. But they haven’t considered a new code – a new rule or the adoption of a new orthodoxy.

They continue to navigate around the elephant in the room. We have a fiat money system! One can always create inflation with a fiat money system simple by printing money and handing it out. Indeed, Bernanke eloquently explained this in his famous 2002 speech (advising the Bank of Japan on how they might escape deflation);

Each of the policy options I have discussed so far involves the Fed acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices. Even if households decided not to increase consumption but instead re-balanced their portfolios by using their extra cash to acquire real and financial assets, the resulting increase in asset values would lower the cost of capital and improve the balance sheet positions of potential borrowers. A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

Recently the idea is being more widely debated in central bank circles. I was referred to this article from Blackrock which describes how helicopter money might be implemented. In short, a central bank can advise the government of a permanent monetary financing of a fiscal expansion, so as to aid the central bank in achieving their inflation target.

Why has this not been done to date? Because history has shown the printing press to be like heroin to governments. It just can’t be done in moderation. The French revolution and the Weimar republic are seared into policy makers’ DNA.

But it can be done. With caution. By a trustworthy institution independent of politics. With certain rules in place to guide when and how this policy is to be used. So that the central bank can achieve its inflation target.

And then think about the implications. Rather than boosting (real) asset prices, it would boost (real) incomes. It would directly address the wealth inequality. Boost nominal GDP. And allow debt ratios to fall. Frankly it is a no brainer.

Will it happen? I think so. It is getting more and more currency in the academic discourse. But it might take another crisis (recession) for authorities to take the leap. Maybe we need to look to NZ again to lead the charge…

What you should be doing is watching that space. We are seeing the first steps. Trump expanding fiscal policy. Germany considering a fiscal expansion. Central bankers, the BIS and the IMF encouraging governments to relax fiscal policy. Certainly, the next couple of years expect fiscal policy to become more supportive. Then in the next recession expect helicopter money.

Unless Shayne convinces Josh beforehand!

Brett Gillespie


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Brett Gillespie
Brett Gillespie
Chief Investment Officer
The Super Investor

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