Global Market Volatility and Negative Interest Rates of 2016

Global Equity Market Composite Indexes

Soon after the New Year holidays was over markets volatility reappeared, stock prices started to tumble and the fragility intensified. The signals are becoming much clearer that not only the United States economy is slowing down, but also we are much closer to a new financial crisis. These were, of course, expected. After the Fed’s first interest rate rise, I wrote on December 15, 2015, that; 

”it is hard to believe that an extra 25 basis point move … will provide any signal about the path of normalization, particularly when the situation in Europe and China is so precarious”.

 And I predicted that: 

“The more likely scenario is a heightened level of uncertainty and a possible financial crisis when this season’s holidays are over.”

In a backdrop of a global growth that has increasingly conditioned on the availability of central banks’ interest-rate stimulus and quantitative easing, several rationalizations have been assumed would generate growth and correct imbalances; including soon to be lower long-term interest rates,  further market making efforts, generating expansionary wealth effects and liberating ‘animal spirits’, which are noted as the so-called new policy tools for central banks to manipulate the level and slope of the yield curve! Assuming that these policies have been successful in preventing a global melt-down after the Big Recession, a hypothesis that its validity cannot be tested, it is clear that they have not been effective in generating sustainable vigorous growth rates to close the gaps both in the labour and goods & services markets. Furthermore, their distortive effects on capital markets, favouring interest sensitive investments particularly in the construction industry is creating an inertia that would hamper investment in knowledge-based manufacturing and communication industries, pushing up high debt levels even higher.  

Back in the July last year, I predicted  the continuous weakness in China’s stock markets and wrote: 

“Just a quick glance at the Shanghai Se Composite Index (SSE) makes it quite clear that share prices were and still are overvalued.”  

I warned about the Fed's Balance sheet and suggested that 

“the steady rise of share prices in the US cannot be entirely divorced from what happened in China. Yes, as Milton Friedman used to say ‘inflation always and everywhere is a monetary phenomenon’ and a greater part of this asset price inflation is also a monetary phenomenon. A Pandora's box that when opens up will be creating an enormous amount of misery.”

  A week later that month China’s stock market dropped by 8%. The Shanghai index dropped 3.6 percent on January 14^th this year, contributing to a decline of more than 20 percent from its December high. Stocks in the United States fell to their lowest levels since late August. The S&P 500 stock index was down 8 percent for 2016 and close to 12 percent below its benchmark high reached in 2015, and the Russell 2,000, a measure of small-cap stocks, showed a 23 percent decline from its peak.

Encountering the market volatility, investors are clamouring again towards fixed investments like government bonds. As a result, the yield on the 10-year Treasury note declined to 2.05 percent from 2.09 percent in the mid-January.  Earlier  they had dropped  below 2 percent for the first time since October, indicating less appetite for investing in capital formation, which is essential for the longer term growth. It is true that the US is in the sixth year of a recovery that has seen her unemployment fall from 10 per cent in 2009 to 5 per cent in December 2015. But as I wrote before  it is the impacts of the US weak capital formation that has artificially boosted the recent declines in the unemployment rate.   I wrote; 

“The appearance of a gradual decline in the US economy's slack is attributable to a greater use of contingent labour and contingent capital, due to the prevailing global uncertainty.”  

The global uncertainty and ultra-loose monetary policies have hampered capital formation and encouraged businesses to follow strategies of incremental reductions in costs that are not accompanied by investment in new technology. Instead of investment businesses have resorted to capital-saving strategies, or have bought back their shares. I have suggested that due to high uncertainty businesses are reluctant to invest in irreversible capital, arguing that businesses

“would try to meet any increased demand by employing contingent workers.  (...) In such conditions, businesses may lease equipment instead of purchasing, or may upgrade an existing production line with used equipment,” 

I went on to argue that this increased reliance on contingent labour and capital appears to be the key reason for a rapid decline in the U.S. unemployment rate, which in turn was used by the Fed to justify its interest rate increase in December.

In his speech of January 14^th, James Bullard President and CEO of FRB-St. Louis has argued that oil price movements are an important component of headline inflation in the U.S. Of course this is true, but a significant part of the decline in oil prices is due to the slowing of global growth not only in China, but also in the United States and Japan. In fact, it is quite probable that the U.S. annualised growth rate may have dropped, to less than 2 per cent in the fourth quarter of 2015. In November 4^th Fed Chair Janet Yellen told a House of Representatives committee that if the economy were to deteriorate in a significant way, "Potentially anything - including negative interest rates - would be on the table.” The possibility of a negative interest rates has also been raised by some other central banks including Bank of Canada.

The ECB has been the first major central bank to set interest rates below zero in June 2014, and in its December move it slightly went lower to  minus 0.3 percent. Sweden, Denmark and Switzerland have also moved their policy rates below zero. In Japan, despite the fact that Bank of Japan Governor Mr. Kuroda has stated that he saw no need to implement negative deposit rates, one could argue that the BOJ's massive asset-buying program, dubbed "quantitative and qualitative easing" (QQE) is tantamount to a declaration of negative interest rate. It is not yet clear a negative interest rate policy would be effective, and one could legitimately argue that this policy is the other side of the coin in the recent currency wars.

Sooner or later central banks must or will realize that they are ill-equipped to deal with the current global economic malaise. The coordination failure of fiscal and trade policies on the global level for the urgently needed structural reforms to deal with unsustainable debts, insolvent banks,  break-down of  healthy transmission mechanisms  is exacerbating the imbalances, worsening inequality, increasing poverty and may lead to disastrous conflicts.      

Fed's December Rate Hikes and Its Aftermath!

Against a backdrop of heightened risk and uncertainty in the global financial markets Federal Reserve is widely expected to make a game-changing interest-rate hike on December 16th, what would be the impact?

 According to a Wall Street Journal survey, 97% of business and academic economists expect the increase is inevitable, as some 80% of respondents believe the Fed's credibility would be damaged if it doesn't finally act. Earlier this month, in her congressional appearance, the Chair Janet Yellen testified that the U.S. economy “is doing well and that is the reason that it is a live option for us in our December meeting to discuss…whether or not it’s appropriate to raise rates.”

It is interesting that Fed’s October minutes stated that:

 “The U.S. financial system appeared to have weathered the turbulence in global financial markets without any sign of systemic stress. Most participants saw the downside risks arising from economic and financial developments abroad as having diminished and judged the risks to the outlook for domestic economic activity and the labor market to be nearly balanced.” 

 As an aside, one must say that such  claims appear ill-considered and surprising particularly since they remain unchallenged by the media and experts. It must be quite clear that they cannot be factually correct, as nobody can claim to have a model that can realistically measure all the possible risks and their directions. This is not a Black Swan argument. We know that the macro models are not very well specified, simply because there have not been enough observations that would allow for control of the impacts of various QEs, zero- and-negative interest rates, global shocks and behavioral and policy changes – just to name a few (and assuming that we have a right theoretical model- which is a big assumption). Furthermore, we  do not know what are the distribution shape of various arguments in our risk functions and so on.  A more careful statement would have read: “most participants ‘felt’ or ‘hoped for’ …”, which of course would be a psychological statement.

For start, let me be clear that in my view the rate increase is necessary, because the low rates have been distorting the economy and have created dangerous imbalances, particularly unsustainable level of debts. However, to raise the policy rate by 25 basis point at this time would not send any useful signal and, for the reasons that I would elaborate later, could be a wrong move. A policy normalization would only make sense when the markets know what the normal level is and how fast is the speed of adjustment toward that level. If the Fed moves 25 basis point this coming Wednesday and then remains inactive in 2016, or even if it undertakes two other moves by the end of the next year to level of 1.25 per cent (assuming that it would be possible) one cannot claim that the policy would be normalized and the harmful impact of imbalances on saving, investment and productivity will be healed. In fact, the October minutes of the FOMC implicitly agrees with the above reasoning.

 The minutes report that participants

“indicated that the expected path of policy, rather than the timing of the initial increase, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of underscoring this view at the time of liftoff. “ 

This point then was later emphasized by Ms. Yellen in her remarks at the Economic Club of Washington, on December 2nd, when she stated:

 “what matters for the economic outlook are the public's expectations concerning the path of the federal funds rate over time: It is those expectations that affect financial conditions and thereby influence spending and investment decisions.”

And yet, the Fed has not provided any clue about the likely path of the policy rate. The FOMC minutes vaguely reported that:

“During their discussion of the likely path for the federal funds rate after the time of the first increase in the target range, participants generally agreed that it would probably be appropriate to remove policy accommodation gradually.” 

However, when one sifts through the qualifiers such as ‘generally agreed’, ‘probably be appropriate’ and ‘gradual’ removal of the policy accommodation, the statement about the path becomes a totally vague statement of intention. Even this level of vagueness has been nuanced even more in the next sentence to render it even somewhat less clear:

 “It was also emphasized that, while participants' most recent economic projections suggested that a gradual increase in the target range for the federal funds rate will likely be appropriate to support progress toward the Committee's dual objectives, monetary policy adjustments ultimately would be dependent on economic and financial developments. These adjustments thus could be either more or less gradual than the Committee currently anticipates”.

 On this point Ms. Yellen   was  at least a bit more forthcoming in her speech  informing the public that:

“In this regard, the Committee anticipates that even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run. Fed should raise the rate when it can be reasonably confident that the pass toward normalization and subsequent rate rises is open – this is not so at the present time.” 

Note that, according to her the target rate would be below the ‘normal’ by some unspecified amount and for some indeterminate time. This clearly shows that the upcoming 25 basis point increase on December 16th does not contain any information about the likely path of normalization. Indeed, in this juncture with the benchmark crude oil price below $36 a barrel, mounting pressures in the U.S. high-yield bonds and the signs of the likely burst of stock price bubbles, what could be the a likely path toward equilibrium interest rate? The answer -- any path would be a possibility.

The Fed’s chair has informed us that:

“With respect to longer-run trends, the staff noted that multiyear averages of short-term real interest rates had been declining not only in the United States, but also in many other large economies for the past quarter-century and stood near zero in most of those economies.” 

Unfortunately , this statement appears somewhat confused, since the equilibrium real rate of interest is a long-term concept, relating to the rate of growth of potential output.  It is hard to believe that the  the potential output growth is  now close to zero in the U.S. and many other large economies. Let’s assume, a la Friedman,   that over the longer term there is no reason for the velocity of money to be unsettled, then the Wicksellian equilibrium real rate of interest would be exactly equal to the rate of growth of potential output. It is noteworthy  that the concepts such as short-term or long-term rates of interests  are usually related to the concept of yield curve. In other words, once we find out the Wicksellian rate of interest we can apply various theories of the term structure of interest rate to specify the yield curve. However, as far as the monetary policy is concerned we only need to find out what the long term equilibrium level of the policy rate is (i.e., Fed funds rate, which of course is at the very short end of the term structure).

 Thus, when Ms. Yellen continues in her remarks to say that

“Moreover, economic theory indicates that the equilibrium level of short-term real interest rates would likely remain low relative to estimates of its level before the financial crisis if trend growth of total factor productivity does not pick up and if demographic projections for slow growth in working-age populations are borne out.” 

She is simply suggesting that the rate of growth of potential output is expected to remain low, because of the low growth rates of total factor productivity and population growth. So assuming a potential growth of about 2% and an inflation target of 2% the Wicksellian equilibrium interest rate would be about 4 per cent. Let’s assume that for a number of special factors the equilibrium rate is 100 basis points lower, i.e., 3 per cent. Thus, the Fed fund must reach 3 per cent for the economy to be considered as normalized. Note that in this regard the equilibrium yield curve must shift upward in a parallel  fashion by 275 basis point, assuming all other things remain the same of course.

Thus, it is hard to believe that an extra 25 basis point move, that would raise the policy rate to 0.5 per cent, will provide any signal about the path of normalisation, particularly when the situation in Europe and China is so precarious and the global equity markets have become more volatile losing about $2.5 trillion in the last two weeks. The more likely scenario is a heightened level of uncertainty and a possible financial crisis when  this season's  holidays are over. Such developments will produce a diametrically opposing path for the policy rate -- towards negative rates.

 Yet as I have argued before  there is a need to normalize the market and remedy the distortive impacts of the zero interest rate policies. To do this the authorities need to realize that we are living in the proverbial global village and we need a coordinated global effort to correct this mess. This is a positive-sum game for every region, so there is a realistic chance of success in any such negotiation. The only group that may suffer the cosequences would be those large financial entities that have lent imprudently and contributed to the creation of the current imbalances

Is the Fed's estimate of longer-run normal rate of unemployment consistent with the US capital formation?

After more than six years of near zero interest rates, the U.S. Federal Reserve is pondering on the merits of a move towards policy normalization. Despite the turmoil in China’s economy, the ongoing uncertainties in Europe, tumbling commodities and volatile stock markets authorities express confidence that the American economy is getting close to equilibrium, and a rise in interest rate is warranted by the end of this year.

This urge to raise the benchmark federal fund rate started earlier this year when Fed deleted a forward guidance signal from its communique in order to indicate its intention for a mid-year rise in interest rates. The FOMC that had been saying it would be “patient” before the commencement of a tightening phase wiped out that qualifier in March, but indicated that it was looking for “further improvements in the labor market” before an increase in interest rates would be appropriate.

The FOMC had given some signals about its long-term goal following its meeting in January 2012, when issued a statement informing the market participants that the Committee judges that inflation at the rate of 2 percent (Based on the price index for personal consumption expenditures, PCE) is most consistent over the longer run with its mandate. By the end of 2012, the Committee signaled that low rates would be appropriate “at least as long as the unemployment rate remains above” a threshold of 6.5 percent, again reassuring the markets that this guidance was consistent with low rates persisting at least until mid-2015. Finally, in the FOMC's June 2015 Summary of Economic Projections, its estimates of the longer-run normal rate of unemployment had a central tendency of 5.0 to 5.2 percent, and in August, the unemployment rate fell to 5.1 %.

In his recent Jackson Hole speech Stanley Fischer, the Fed Vice Chairman, stated:

Although the economy has continued to recover and the labor market is approaching our maximum employment objective, inflation has been persistently below 2 percent.
(…)
Of course, ongoing economic slack is one reason core inflation has been low. Although the economy has made great progress, we started seven years ago from an unemployment rate of 10 percent, which guaranteed a lengthy period of high unemployment. Even so, with inflation expectations apparently stable, we would have expected the gradual reduction of slack to be associated with less downward price pressure.
(…)
In making our monetary policy decisions, we are interested more in where the U.S. economy is heading than in knowing whence it has come. That is why we need to consider the overall state of the U.S. economy as well as the influence of foreign economies on the U.S. economy as we reach our judgment on whether and how to change monetary policy.
(…)
With inflation low, we can probably remove accommodation at a gradual pace. Yet, because monetary policy influences real activity with a substantial lag, we should not wait until inflation is back to 2 percent to begin tightening. Should we judge at some point in time that the economy is threatening to overheat, we will have to move appropriately rapidly to deal with that threat.

In this note I argue that the Fed's estimate of longer-run normal rate of unemployment is not consistent with the US investment in capital formation,  The appearance of a  gradual decline in the US economy's slack is attributable to a greater use of contingent labour and contingent capital, due to the prevailing global uncertainty.  The economy is being distorted by the zero-interest rate policy  and  is not getting closer to its   long-term equilibrium. The use of contingent production factors  has generated a quasi-closing of the gap in reference to a quasi-potential output growth, which corresponds to Klein (1960) and Berndt and Morrison (1981) definitions of capacity. This is why this quasi-closing of the gap has not exerted an upward pressure on the US inflation rate. The exploration of these issues would help us to understand where the US economy is headed for?


Following the financial crisis, the Fed lowered its benchmark federal-funds rate to near zero in December 2008, communicating its assessment that exceptionally low interest rates would be appropriate “for some time,” and then for “an extended period.” In August 2011, the “forward guidance” language was modified to calm market anxieties by signaling a date before which an increase in the federal funds rate was unlikely. As the economy’s performance was disappointing, that date was moved forward several times thereafter, settling eventually at the mid-2015.

Those economists who still believe in the legislative power of market warned from the start that these kinds of interventionist policies will only distort the economy. Long period of ultra-loose monetary policy has triggered global mispricing in financial and goods and services markets, discouraging capital formation and adversely impacting the potential output, Larry Summers’ secular downward trend was basically Central-bank-made stagnation policy which has prevented the equilibrating market forces to do their jobs. As the classical theory suggests the very low or negative “natural rate of interest” reflects the very low or negative expected growth in potential output, and this is the main driver of the increased demand for the safety of U.S. Treasury securities, which would raise longer-term interest rates.

Of course, globalization implies that these distortions are also globalized, thus in the absence of a global coordinated policy domestic monetary policy cannot mitigate this predicament. Global economic dynamics are contaminated by distorted global linkages through commodities, trade and finance. The overriding risk of uncoordinated policy is to the downside — a risk that would be aggravated by a groping normalization policy.

What is the evidence?

The unemployment rate, which peaked at 10 percent in October 2009, has fallen quite rapidly. For many analysts this has been the evidence that labour markets are getting closer to equilibrium. However, economic theory suggests that a balanced growth requires a contribution from all production factors in the production process -- particularly from tangible fixed capital. As the following chart shows the US investment has been quite weak in the post-recession era.

How can the labour markets move to equilibrium with such a weak capital formation? It is quite clear that this fragile capital formation is due to the prolonged period in which businesses have postponed investment as a result of the prevailing global uncertainties which have been exacerbated by the authorities suppression of equilibrating market dynamics . Investment spending has grown more slowly than usual for a business-cycle expansion and this is the main reason for the observed decline of the US productivity. 

The global uncertainty and ultra-loose monetary policies have encouraged businesses to follow strategies of incremental reductions in costs that are not accompanied by investment in new technology. This has undermined the longer-term growth of potential output, which appears to have caused a distorted and artificial decline in real interest rate, by which authorities hope to encourage entrepreneurs to assume more risk. The economic theory suggests that lack of capital formation would cause a shrinkage in production possibilities frontier, resulting in a decline in labour productivity growth as we have observed in the US (see the following chart).

The fact that U.S. businesses are hesitant to invest is also evident from the labour market data. It is clear, both from theory and empirical data that when uncertainty is on the rise businesses would be reluctant to invest in irreversible capital. They would try to meet an increased demand by employing contingent workers, this appears to be a key reason for a rapid decline in the unemployment rate. In such conditions, businesses may lease equipment instead of purchasing, or may upgrade an existing production line with used equipment. This increased reliance on contingent labour and capital is frequently the reason why firms report difficulties in finding labour.

In a slow growth environment, workers prefer to work through contingent labour agencies instead of accepting temporary jobs directly offered by firms, simply because by doing so they would enhance their working relationships with those agencies, whose repeated offering of temporary jobs to trusted workers could be regarded as reasonable substitutes for permanent jobs. This is also why participation rate has declined (roughly 3 percentage points since the end of the recession, a steep drop by historical standards), why the number of people per job openings has dropped and why the labour share of income has remained so low (see charts below). It is of note in this regard that a broader measure of unemployment that includes part-time workers, plus people who have recently left the labor force but would like to be working, was 10.4 percent in July, well above the official unemployment rate of 5.3 percent.

If economy is to move to a normal phase, and potential output together with labour markets are to be at their long-term sustainable equilibria, then strategic investment must be restored to a normal level adequate for a balanced growth.

It is stunning that how little attention is being paid to the postponement of private investment projects, and a general lack of entrepreneurial risk taking in today's investment climate. As I have argued before:

I am not of course a fan of current zero interest rate policies, and I believe these policies have distorted not only the US and European economies, but also the global economy. The Fed indeed has created a catch 22 situation; as higher rates are needed badly, but any action towards raising rates would be extremely destabilizing.

The only solution at this time is a coordinated global rebalancing of financial structure and eliminating all moral hazards of guaranteeing too-big-to-fail financial institutions.

Macroprudential Follies and Monetary Policy

In a recent article in Project Syndicate Barry Eichengreen appears to criticize the former Fed Chair Alan Greenspan, for expressing doubt that policymakers can reliably identify bubbles, and are generally uneasy about managing asset prices. He writes:

To be sure, central bankers cannot know for sure when asset prices have reached unsustainable heights. But they cannot know for sure when inflation is about to take off, either. Monetary policy is an art, not a science; it is the art of taking one’s best guess. And, as the 2008-2009 crisis demonstrated, merely cleaning up after the bubbles burst is very costly and inefficient.

Eichengreen’s argument, is in fact, part of a post-global-financial-crisis discourse on macroprudential policy. Many  interventionists argue for financial regulation that would be  specifically  designed  to mitigate systemic risks to the financial system as a whole. According to macroprudential regulation’s proponents, monetary policy historically has failed as policy changes have resulted in blunt outcomes i.e., the monetary policy actions in either directions have resulted in a broad sweeping measure for the whole economy that does not properly address the issues specifically feeding financial instability. Thus, they argue that the recent financial crisis was created by a supervisory gap, as various sectors of the financial system often fall under the responsibility of different authorities, making it difficult to conduct a thorough analysis of systemic risk. As a result of these debates, in recent years, a number of new institutions have been popped out to preserve financial stability such as the European Systemic Risk Board in the EU and the Financial Stability Oversight Council in the US.

At the same time, central banks are now assuming an important role in this regard, to the extent that in a recent speech, Governor Daniel Tarullo, a member of the Board of Governors of the Fed, has stated: “I feel secure in observing that we are all macroprudentialists now. The imperative of fashioning a regulatory regime that focuses on the financial system as a whole, and not just the well-being of individual firms, is now quite broadly accepted.” Mario Draghi, President of the European Central Bank has also argued that “As you know, the [Single Supervisory Mechanism] Regulation gives the ECB the power to apply stricter macroprudential measures than the national authorities if it deems them necessary. We can also advise on the calibration of instruments. This goes some way towards insuring against an inaction bias at the national level, thus improving the prospects for a more stable euro area financial system.” As well, the Bank of England has been assigned full responsibility for macroprudential policy.

In 2008 chairman of the House Committee on Oversight and Government Reform, Henry A. Waxman of California, asked Mr. Greenspan: “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. Do you feel that your ideology pushed you to make decisions that you wish you had not made?” Mr. Greenspan conceded that:

“Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact. (…) Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

Unfortunately, it appears that this testament has caused an irreparable damage to confidence in the market’s self-equilibrating potentials. Instead authorities have espoused a partial preference for the risk-management and credit-allocation skills of a few central bank officials. The macroprudential regulation has been justified by arguing that Chairman Greenspan’s 1994 hypothesis, put forward in front of House Subcommittee on Telecommunications and Finance, to the effect that “There is nothing involved in federal regulation per se which makes it superior to market regulation,” is proved to be wrong. Also misguided was his argument for removal of the legislative barriers that prohibited the straightforward integration of banking, insurance and securities activities, when he concluded that:

“In virtually every other industry, Congress would not be asked to address issues such as these, which are associated with technological and market developments; the market would force the necessary institutional adjustments. Arguably, this difference reflects the painful experience that has taught us that developments in our banking system can have profound effects on the stability of our whole economy, rather than the limited impact we perceive from difficulties in most other industries.”

In fact, governments across the world begun to introduce macroprudential regulations in the form of more stringent capital requirements, requiring financial institutions to value their assets more conservatively, asking them to hold more liquidity buffers, placing constraints on risk-taking, enforcing more stable funding restrictions and requiring improved provisions to protect against bad and toxic loans. According to Christian Noyer, Governor of Banque de France, there is a consensus over broad outlines of macroprudential regulation that

First, it involves adding a macroeconomic perspective to the supervision of the financial system, which up till now has only really been addressed from a “micro” standpoint. As the crisis has shown, financial stability does not depend solely on the soundness of the individual components that make up the financial system; it also depends on complex interactions and interdependencies between these components.

Implicit, in Noyer‘s argument is the unsubstantiated claim that even those economies that their financial system were composed of sound micro components suffered from financial instability. This is not true. Canada is perhaps the only country that can legitimately claim that its financial sector was robust at micro level, and as it was expected its economy fared quite well during the global financial crisis. In the words of Mark Carney the governor of the Bank of Canada at the time “the core lesson we learned from those difficult years was the importance of coherent, principle-based policy frameworks.” These frameworks discipline policy-makers and enhance credibility. In the words of his predecessor David Dodge:

Canadian financial institutions took a more cautious approach to financial innovation at some cost to their short-term growth and profits relative to more leveraged foreign competitors, relied relatively less on wholesale funding and kept relatively more liquidity. In part, this stemmed from more stringent, coordinated and effective regulation and supervision in Canada, which provided the right incentives to financial institutions. (…)
Our system of principles-based regulation should continue to serve us well, even more so in a context where most national regulators elsewhere will not conform to the detailed, uniform international standards. What is required here in Canada is a high degree of cooperation between regulators and financial institutions to achieve stability goals. In the past, such cooperation in designing principles-based regulation has strengthened the Canadian system. We should not lose that advantage as we move forward.

It is important to note that in principle-based policy frameworks monetary policy would be dealing with the monetary policy goals and would not allow macroprudential considerations to contaminate  the transmission mechanism and distort the economic structure. Mr. Noyer ‘s second characteristic of macroprudential policy is that:

“it is preventive. Its aim is precisely to prevent the formation of financial imbalances, procyclical phenomena or systemic risks by limiting excessive growth in credit and in economic agents’ debt levels, and increasing the shock‑absorbing capacity of financial institutions or structures ex ante.”

The argument again assumes a number of untenable implicit assumptions; namely that authorities possess reliable measures of excess or systemic risk, the macroprudential policy makers are themselves experts in detecting and interpreting economic signals, the lag structure of the policy impacts are known and stable, and the policy actions can be precisely calibrated so that they will be efficacious in damping excesses while not unnecessarily reducing well-underwritten credit flows in the economy. In this regard the Bank of Spain’s assessment of the Spanish macroprudential experience shows that virtually none of these conditions are satisfied. That assessment reads:

Dynamic provisioning is not the macro-prudential panacea, since the lending cycle is too complicated to be dealt with using only loan loss provision policies. Indeed the Spanish experience shows that even well targeted and calibrated instruments cannot cope perfectly with the narrow objective for which they are designed, among other things because the required size to fully achieve its goals would have inhibited and distorted financial and banking activity.

 Of course, no proof exists to show that government regulators are more able than private investors at predicting which individual investments are justified and which are folly. The cost of macroprudential regulation in the name of financial stability has been a confused monetary policy that has caused a delay in return to equilibrium, increased uncertainty and a slower economic growth.

In a world that agents can innovate to take advantage of arbitrage opportunities, there would be no reasons for believing that macroprudential policies can have any impact on financial stability. In fact, if regulations were of any use the old Soviet Union would have been a success story, or today’s China’s financial markets would be the most stable in the world. The arbitrage possibilities generated by these regulations leads to financial innovations that would work against those policies annulling their impact. The evidence does in fact already present itself in the form of a shift of financial activities toward less regulated shadow banking system.

Moreover, to assume that macroprudential policies are of any impact must be based on the postulate that economic system can be represented by a stable model and that authorities have already discovered that model. Otherwise, in a fast changing world, in which parameters of taste and technology are responding to new scientific and digital advances at an ever increasing speed no financial authorities have any clue about the nature of an evolving transmission mechanism, the lag structure and the specification of an adequate model.

As Paul Kupiec has argued macroprudential policies will not have a significant impact and thus will not succeed. In fact, his study co-authored with Yan Lee of the Federal Deposit Insurance Corp. and Claire Rosenfeld has found that increasing a bank's minimum capital requirements by 1% will decrease bank lending growth by a paltry six one-hundredths of a percent. As he reported in the Wall Street Journal: There is not much evidence that these policies prevent financial bubbles. But there is great risk in allowing a small group of unelected technocrats to determine the allocation of credit in the U.S. economy.

Furthermore as many analysts have noted the propaganda surrounding macro-prudential regulation or supervision creates a false sense of security and stability. A central bank that is now playing too large a role in the economy in order to stabilize successfully the industrial, construction, and the other goods and services sectors, as well as the labour market, will have more difficulty communicating its monetary policy stance. It’s hard to believe that central banks models and expertise are adequate for executing various goals when the issues in each one of these sectors are complex and are impacted by various technological and competitive factors. The lines between discretion and rules for two sets of monetary and macroprudential would criss-cross and creates a very confusing lag structure for any signal extracting model.

There is no reason to believe that the principal- agent problem is not applicable in this case. In other words, it can be hypothesized that central banks as agents may not be supportive of market mechanism to stabilise independently. A regulated environment maximises the returns to agents in this framework as it entails more secure job prospects because of the needs for intense monitoring of capital and liquidity ratios, continuous inspection of the impact of various restrictions on banking practices, and conduct of periodic stress tests. The increased uncertainty will cause a surge in speculative activity in capital-asset markets which would exasperate the situation and boost the need for macroprudential regulation perpetuating the favourable job prospects of the agents.

Will the Fed raise rates in September?

 In my estimation Fed can not risk rising rates in such  critical times and therefore it won't. A rising rate at current market conditions one month before October, that historically is associated with a stock market correction, could be the psychological trigger that would disturb the current fragile local equilibrium, pushing the US and the whole global system along a path towards instability and a full-fledged financial crisis exhibiting a collapse of investment, debt deflation, and thus leading to insolvent debtors and a weaker banking system – that would be 1937 all over again!

I am not of course a fan of current zero interest rate policies, and I believe these policies have distorted not only the US and European economies, but also the global economy.   The Fed indeed has created a catch 22 situation; as higher rates are needed badly, but any action towards raising rates would be extremely destabilizing. This is why I have been calling for an emergency global finance conference similar to the Brussels conference that took place   between the 24th of September and the 8th of October 1920.  That international conference was called

“with a view to  studying the financial crisis and looking for the means of remedying it and mitigating the dangerous  consequences arising from it.”

Such a sharp focus on financial crisis is needed for any new conference that would be dealing with the current situation in order to find a sustainable long-term solution.  In other words, none of the unrelated questions such as geopolitical crisis, human rights or environmental concerns need to be discussed in this conference, and its sole purpose should be a search for restructuring of global finance.  To arrive to an accurate assessment the Brussels conference secretariat asked the participant countries, and their financial institutions to submit latest data on currency, public finance, international trade, inflation and so on, which is an obvious prerequisite.

       

Like the current crisis, as Gustav Cassel, the great Swedish economist, argued the main responsibility for the 1920s financial crisis was the policy actions by various countries, which could only be remedied by an internationally coordinated return to stable currencies.  It is of note that, such a return in Cassel’s framework was not predicated on a return to the gold standards. He also strongly dismissed the possibility of arbitrarily fixing exchange rates and instead advocated a global exchange rate regime based on the theory of Purchasing Power Parity PPP, which would have linked fluctuating exchange rates to the prices paid for a common basket of goods and services in the regions that participated in international trade, such that the same price level would have been maintained for that common basket in every region.

     

Although Cassel correctly diagnosed the dangers of deflationary policies for the future prospects of economic growth and social stability, he warned that:

“As the internal value of a currency exclusively depends upon its purchasing power over commodities, a stabilization of this value can clearly only be attained by an adequate restriction of the supply of means of payment. The character of this restriction depends, of course, on the character of the means of payment used in the country. If they are supplied by the State as a paper money issued by the Government directly or indirectly for covering their expenses, the stabilization of the monetary standard clearly requires the stopping of further arbitrary creation of such money. This is so obvious that it is not necessary to waste many words on it”.

   Unfortunately under today’s “currency wars” conditions, with the slowdown in China, and Europe’s debt crisis, as well huge debt build up by consumers and states the normalization of monetary supply in any single country, as an isolated and uncoordinated action, would be a recipe for disaster.  

UK Competitiveness Outlook is Gloomy!

In its first budget, the new Government of Prime Minister David Cameron has eased markedly its intended austerity measures that had been pencilled in by the previous Coalition. However, the new relatively less intense tightening is still financed by welfare cuts, net tax increases and three years of higher government borrowing. Chancellor Osborn has delayed the expected return to a budget surplus by a year to 2019-20, sugar coating this delay by promising a slightly bigger surplus in the medium term. Chancellor’s introduction, from April next year, of a £7.20 an hour National Living Wage, rising to £9 an hour by 2020 outshone the opposition’s election pledge for an £8/hour minimum wage by 2020.

Does this budget change the trajectory of the British economy towards a more dynamic and competitive path? To explore this question let’s have a look at the current state of the economy. The UK independent Office for Budget Responsibility, OBR’s estimate of the margin of spare capacity in the economy is 0.6 per cent of potential output in 2015-16 and OBR expects this ‘output gap’ to close in 2018-19. However, these estimates may be hiding the fact that because of businesses’ utilization of contingent capacity the gap has been underestimated. This is because in planning for capacity during uncertain times businesses usually postpone their irreversible component of investment and utilize intensive margin production processes. As a result of this focus on short-term capacity corresponding to existing cost structure the longer-term capacity signals will be hidden. This reading is validated by the Bank of England’s August Inflation Report that reports:

Companies using their existing capital and labour more intensively will increase measured productivity but there is a limit to how far companies can do this without putting excessive upward pressure on their costs. Survey measures suggest that, having increased since 2013, capacity utilisation picked up a little in 2015 Q2, and is close to or perhaps slightly above past average levels.

Consistent with Ben Bernanke’s option price of waiting it would be quite rational for businesses to postpone their strategic investment plans at times of currency wars and global volatility, and focus instead on their contingent capacity limits. Thus, business surveys instead of picking up reports of capacity utilization rates relative to the long term capacity associated with the firm’s minimum long-term average costs would detect signals of capacity tightening due to delays in implementation of irreversible phases of investment. This observation can also be validated by indicators such as investment profile and productivity growth. Note that productivity growth — defined as the rate of change of output minus rate of change of hour worked — will rise when investors invest to expand the production possibility frontier which usually would  reduce their cost structure through adoption of new innovative technologies. The fact that growth in the UK productivity has been subdued in the past eight years is a clear indication that British investors are still quite hesitant to invest strategically to enhance competitiveness.

The chart below, based on the OECD data, shows the widening gap in capital formation between the UK and the United states, particularly since the recent big recession which can explain why productivity growth in Britain has been so low.

As the following chart shows, ONB predicts that investment as a share of GDP, which was hovering around 11% in recent quarters will increase to about 13% by 2018. However, the latest data show that business investment growth slowed in the second half of 2014, thus in a backdrop of heightened uncertainty the ONB predication may prove rather optimistic. Nevertheless, even if its prediction comes to pass the amount of investment would not be sufficient to remedy the loss of competitiveness of British industries, which are in need of a drastic restructuring in response to the imperatives of the new technological advances such as in internet of things, mobility, 3-D technologies, and smart raw materials, to name a few.

Moreover, the Bank of England’s Agents’ Summary, depicted in the following chart, indicates only moderate investment growth and it is not clear as to whether the new investment would be aiming at expanding the production frontier and increased competitiveness or will still be focused on a tactical reversible investment, such as repair and marginal upgrading of the existing technology along pursuing a path of intensive margin production process.

As already mentioned such moderate investment growth would not be sufficient for the needed restructuring and the crucially necessary enhancement of British competitiveness. The chancellor’s strategy to rejuvenate manufacturing and exports by new trade deals cannot succeed in the absence of investment that would be geared toward enhancing competitiveness. His fast-track visa system for wealthy Chinese investors would be ineffective, if the new investments just move towards real estate instead of new technology. In order to halt the persistent decline of the UK export market share, depicted in the following chart, a significant rise in investment would be prerequisite.

A participation in the current currency war, even when British pound has appreciated 20% on a trade-weighted basis since March 2013, would not be an option. As it would either worsen the public sector net borrowing (depicted in the chart below), or further reduce the effectiveness of monetary policy, and exacerbating household high level of debt (the next chart below). Of course, one needs to be reminded that that the Bank of England has maintained the stock of purchased assets financed by the issuance of central bank reserves at £375 billion, and will reinvest the £16.9 billion of cash flows associated with the redemption of the September 2015 gilt held in the Asset Purchase Facility. At the same time the Government’s spending is expected to be £83.3 billion higher in total over the current Parliament relative to the previous Coalition budget. Thus, more easing will add to the distorting imbalances.

Alpha, Beta, and Beyond -- A comment on "smart beta'

 

In a recent Project Syndicate article Dr. Roubini argues:

 [M]y economic research firm has a quantitative model, updated every three months, that ranks 174 countries on more than 200 economic, financial, political, and other factors to derive a measure or score of these countries’ medium-term attractiveness to investors. This approach provides strong signals concerning which countries will perform poorly or experience crises and which will achieve superior economic and financial results. 
Weeding out the bad and the ugly based on these scores, and thus picking more of the good apples, has been shown to provide higher returns with lower risk than actively managed alpha or passive beta funds. And, as the rankings change over time to reflect countries’ improving or worsening fundamentals, the equity markets that “smart beta” investors choose change accordingly.

The claim goes beyond the pale, and is absolutely stunning. It is hard to imagine that alphas and betas are not time varying parameters. In fact, studies by Blume; Hawawini, Michel, and Corhay; Levy and others have shown that stock betas can change drastically over two succeeding periods, and some have argued that linear estimators of beta are unrealistic estimates. Thus, one wonders, about the validity of any “smart” (or “enhanced”) beta strategy that can at any specific period pick up the true betas. It has always been a puzzle to many as to how some serious people look at betas and alphas as ex ante criteria for portfolio selection. Is it not reasonable to believe that the intrinsic value of any stock is derived from the firms’ competitiveness characteristics and the market fundamentals for the underlying goods or services that are represented by various stocks? 

Based on the ex post data any econometric technique  can always identify some alphas and betas that appear to have superior characteristics supported by an array of statistical measures attesting to the explanatory power of the regression.  Such models may capture part of the impacts of the real market fundamentals, say a rightward shift of demand curve for the underlying goods and services, or a shift of the cost structure of the firm producing those goods and services, and so on. The data may also contain some memory, due to various lags that can be captured be the estimated equations. However, if a portfolio manager shows you a selection of stats (and there are hundreds of those; R-squared, P-tests, LM, DW, BP, F to name a few) that appear to suggest some superior predictive information content, then one really needs to ask why the investment manager is prepared to share such a valuable information for a small fee, instead of attempting to corner the market!

This is neither a rehash of efficient market hypothesis, nor an argument derived from the possibility of black-swans. It is a subtle recognition of the nature of risk and uncertainty in its Knightian framework. In other words, the expected return from a portfolio is not the same as the expected return from casting of a number of fair dice. The distribution outcomes from casting of a die can be detected by a repetitive casting process and thus the volatility of returns can be formulated as a Knightian risk. However, this is not the case for the expected return of a stock, because each return would be derived from a specific demand-supply configuration for the underlying stock’s goods and services and the position of the short-run average cost of the company producing them at a particular time. This does not lend itself to a repeated sampling. Moreover, we are seldom in an idealistic case of perfect competition, in reality various strategic pricing and capacity decisions together with logistical constraints would also play important roles. Thus, the underlying distributions of the expected betas are unknown –Knightian uncertainty. Can one resort to time series analysis of say cointegration type? Simply because of the unavailability of long enough data (i.e., degrees of freedom restraint), difficulties in detecting of the order of integration and a host of other technical issues that are well known to practitioners that option too would be impractical.

Read more at https://www.project-syndicate.org/profile/551891a0bc1f570d68f3eac8#6VwyDPZ00gQdq8WH.99