Lurching Between Hope and Despair; Is a Chinese Hard Landing Inevitable?

China is  still grappling with spreading financial imbalances and trepidations arising from its distortionary  overextended export-led industrial structure that could result in severe socio-political challenges. Back in the July last year, this forum predicted  the continuous weakness in China’s stock markets and interpreted it as a leading sign of the troubles ahead for the China's real economy. We wrote the Chinese stock market crash : 

is providing leading signals about the direction of China’s economy and its medium term outlook. (...) The Chinese economy is badly distorted by following a lopsided export-led-growth model for far too long.

 A week later China’s stock market dropped by another 8 per cent, and  by January 14^th  this year, Shanghai index had dropped more than 20 per cent from its December high, which led George Soros to argue:

"The Chinese left it too long to address the changeover in the growth model that they have to adopt from — investment and export-led to domestic-led. So a hard landing is practically unavoidable," 

Obviously concerned about the fragile state of the economy, Chinese President Xi Jinping in his recent keynote speech in the G20 summit in Hangzhou  stated:

China’s reform has entered the deep water zone where tough challenges must be met. We have the resolve to make painful self-adjustments and tackle problems that have built up over many years, particularly underlying issues and entrenched interests and carry reform through to the end. We will continue to carry out supply-side structural reform, resolve major problems in economic development and improve the performance of the supply system by optimizing factors allocation and adjusting industrial structure. With these efforts, we can energize the market and achieve coordinated development. We will continue to explore new institutional mechanism, break through the resistance of vested interests, exercise law-based governance and better leverage both the decisive role of the market in resource allocation and the role of the government.

China's outdated and inefficient export-led model is the main source of its overcapacity, which is devouring a massive amount of the newly generated credit without an adequate pay-off. In fact, the bulk of the country's investment is undertaken by the local governments that have been the main source of a sharp surge in credit growth,  endorsed by the central authorities. The government has impelled provinces to issue massive volumes of new bonds, apparently to replace the more costly bank debt but in actuality has generated a marked increase in the public investment. As a result over the past 24 months China's domestic credit has expanded more than the corresponding amount in 2008-9, which was created to stimulate growth after the global financial crisis. However due to the 'adverse selection' problem, the newly generated credit has lost three-fourth of its effectiveness in generating growth. Meaning, to generate one yuan of additional GDP it now takes nearly four yuan of new borrowing relative to a slightly higher than one yuan of credit that was required before the financial crisis. 

 Mr Xi has acknowledged that economic reform is "crucial to maintaining medium-high rate of growth under the new normal", and that "China will take sure and firm steps in advancing reform and will not slow down its pace". However, reforms have been painfully slow, more specifically with regard to China's most pressing challenges i.e., state-owned enterprises (SOEs) that are burdened with excess capacity, and  the alarming level of debts. China's central government manages 111 companies. In addition, around 25,000 SOEs are managed by the local governments. Since the 1990s, SOEs have been consolidated through closures and mergers but this downsizing came to a halt in 2007-2008 when the government rolled out a stimulus programme to cushion the effects of the global financial crisis and finance went into factory constructions and equipment without the demand to meet this supply. Many of these enterprises are restrained by a massive debt burden, as an  estimated 40 per cent of new debt is used to service the existing loans, and a large number of firms' debt services are more than their earnings before tax.

Despit the fact that the reform of SOE is of high priority for the Chinese government, there has been little progress in gaining efficiency, reducing overcapacity and utilizing technological advances in these entities. In September 2015, China released  the long-delayed guidelines for reforming these firms that included introducing "mixed ownership" by bringing in private investment.  The main aims of guidelines are to improve the prospects for domestic growth and enhance the export competitiveness of its largest firms known as yangqi, that are inflicted by low productivity, weak balance sheet, and serious corruption.  However, "decisive results" are expected by 2020!

In a futile attempt to resuscitate the export-led model, Mr. Xi acknowledging the fact that  in today's globalized economy "countries are closely linked in their development and they all rise and fall together," and stressing the point that  "no country could seek development on its own."  However, global  expansionary policies have become ineffective and cannot generate demand for China's export-oriented industries. Mr. Xi argued:

The world economy is now in profound adjustments and moving along a twisted path to recovery. It stands at a crucial juncture where new growth drivers are taking the place of old ones. The dynamism provided by the last round of scientific and industrial revolution is waning while new impetus for growth is still in the making. Currently, protectionism is rising; global trade and investment are sluggish; the multilateral trading regime faces bottlenecks in development, and the emergence of various regional trade arrangements have led to fragmentation of rules.

As we have argued in this forum before, the new impetus for growth, stemming from  smart materials, internet of things, cloud computing,  Big Data , Nanotechnology and so on is huge. However, what hampers the growth is financial imbalances and the associated uncertainty that restrict private capital formation.   Based on the recent data it appears that China’s economy has grown close to  6.7 per cent  in the first half of 2016, mainly due to a sharp increase in credit. In August, China's total fixed-asset investment  grew 8.1 per cent  from the year before,  a rebound from July’s 3.9 per cent. Yet, growth was concentrated in investment by the SOEs, which grew 21.4 per cent in the first eight months of the year, offsetting a decelerating growth in the private  investment to  2.1 percent, over the same period. Thanks to credit growth and an ensuing speculatively-driven housing boom together with increased fiscal spending of 12.7 per cent China's factory output and retail sales grew faster than expected in August. However reflecting an expected sharp decline in private-sector fixed-asset investment, continued deleveraging and fragile global demand; the prospects for the upcoming quarters are now getting gloomier.

 Of course, a more than likely severe slowdown of world’s second-largest economy will have global consequences. China with its  biggest banking sector in the world that boasts an asset base of equivalent to 40 per cent of global GDP, its second largest stock market  that worths $6 trillion  and its third largest bond market, at $7.5 trillion is massively contributing to the global growth, and its slowdown would sharply exacerbate  the already fragile growth in a financially imbalanced world.  More specifically, an estimated 0.2 percentage points of the global growth would be wiped out as a result of direct impacts of each  one-percentage-point decline in Chinese GDP growth rate.  The indirect impacts  from a decline in international trade,  slowing of global growth, and increased uncertainty could  be  as large as 0.4 percentage points.  Thus, a slowdown of Chinese economy by 3 percentage points, to say 3.7 per cent in the coming quarters, would shave about 1.2 percentage points from the currently tepid global growth, i.e. would generate a global recession, which would be particularly devastating for commodity exporters around the world.

Unfortunately in his speech,  president  Xi did not mention that China’s debt-to-GDP ratio that has surged from 150 per cent to more than 260 per cent over the past decade. This is stemming from an unsustainable credit growth aimed at achieving  unrealistic high export-led growth targets that are based on specious economic models.  According to a statement by China's State Council the country's three government-owned banks i.e., the China Development Bank, the Export-Import Bank of China and the Agricultural Development Bank of China are instructed to expand credit to investment projects. According to Bloomberg these banks have raised a combined 3.4 trillion yuan ($509 billion) through bond sales and low-rate credit from the People’s Bank of China, and according to Economist

In the past year alone, China has spent nearly $200 billion to prop up the stock market; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. 

China's  Annual GDP Growth Rate

Fixed Asset Investment Growth

China's Balance of Trade, $bn.

Clearly, the recent surge in credit growth and fiscal policy cannot be substituted for the normal market forces and soon the country will have to deal with the recessionary market impulses as the impacts of expansionary fiscal  policy vanish and as the authorities would inevitably refrain from credit expansionary policies due to their damaging "adverse selection" consequences, among them for instance  more than doubling of the non-performing loans   over the past two years which now stands at 5.5 per cent  of bank's total lending. China needs to tap into its enormous domestic consumption potentials through market forces. Chinese investments in export-led growth and its speculative investments in real estate market should be diverted into investments in health care, education and other personal services, utilities, transportation and communications. A robust domestically oriented sector would  provide supports for domestic manufacturing and related services. Perhaps the upcoming sharp deceleration would trigger a move toward this rebalancing of the economy.

World's 20 largest Economies -2015 E
Percentage share of total global nominal GDP in US$

Will the Fed raise rates this September? A question of fixed rule and method.

  

'' o ere, quae res nec modum habet neque consilium, ratione modoque tractari non volt, in amore haec sunt mala, bellum, pax rursum : haec si quis tempestatis prope ritu mobilia et caeca fluitantia sorte laboret reddere certa sibi, nihilo plus explicet ac si insanire paret certa ratione modoque."

 ' My master, a thing that admits of neither method nor sense cannot be handled by rule and method. In love inhere these evils—first war, then peace : things almost as fickle as the weather, shifting about by blind chance, and if one were to try to reduce them to fixed rule for himself, he would no more set them right than if he aimed at going mad by fixed rule and method.'  --     Horace, Satires

Global economic growth has been rapidly approaching a stagflation state with the inflationary pressures being concentrated on the asset prices. There are some staggering  $11.4 trillion of global sovereign debt, primarily in Europe and Japan, carrying negative yields, while in the U.S. yields are also getting very low. The market has become quite jittery, as we saw on September 9th, when participants reacted to some hawkish comments from the FOMC members and downloaded their positions causing a half trillion dollars decline in the value of equities.

Fears of an imminent rate rise were eased three days later after  Lael Brainard, a member of the Board of Governors of the Fed, urged “prudence” in removing the central bank’s accommodative policies. Reportedly, market had anxiously expected the usually dovish Ms. Brainard might deliver a hawkish speech recommending a rise in the Fed funds rate, that has been held in a range between 0.25 to 0.5 per cent  since December.

Overall, some FOMC members appear to feel little sense of urgency about raising rates because of the low inflation, while others seem to reckon that with the labor market gap being closed the extremely accommodative policy rate is no longer warranted. The truth is that both groups are looking at irrelevant indicators and the fact that inflation is holding below the Fed’s 2 per cent target or the unemployment rate  is at 4.9 per cent are disconnected from today's globally imbalanced economic conditions that have drastically altered the transmission mechanism of monetary policy in all the major advanced countries.

In her Jackson Hole lecture, Ms. Yellen  referred to the updated estimates from the model developed by Laubach and Williams (2003) that indicate that the real long-run neutral or "equilibrium" short-term interest rate in the United States is currently about 2-1/2 percentage points lower than it was on average in the 1980s and 1990. She also referenced to a papers by Holston, Laubach, and Williams (2016) that find similar declines in equilibrium rates for the euro area, Canada, and the United Kingdom  and attributed  these declines to factors like slower growth in the working-age populations of many countries, smaller productivity gains in the advanced economies, a decreased propensity to spend in the wake of the financial crises around the world since the late 1990s, and perhaps a paucity of attractive capital projects worldwide. As we have argued in the past the  neutral rate is a long-run equilibrium concept that cannot be applied to a short-run disequilibrium situation like today's.

Theoretically the neutral rate should be equal to the rate of growth of potential output, associated with the efficient production possibility frontier, and given the incredible technological advances it is hard to believe that the potential growth rate has declined because of slower growth in working -age population which on the supply side can easily be offset by the advances of robotics and AI technologies, and on the demand side by increased demand for a wide spectrum of new smart goods and services.  All other factors in her list are stemming from a shrinkage in the production possibility frontier due to the global financial imbalances that have generated a prolong and deep uncertainty and has adversely affected the global capital formation.  

Of course, the main reason for her  focusing on the neutral rate as Ms.Yellen has articulated is to answer the following question:

 Would an average federal funds rate of about 3 percent impair the Fed's ability to fight recessions? Based on the FOMC's behavior in past recessions, one might think that such a low interest rate could substantially impair policy effectiveness. 

Then, looking at the experiences of the past nine recessions, Ms. Yellen notes that:

the FOMC cut the federal funds rate by amounts ranging from about 3 percentage points to more than 10 percentage points. On average, the FOMC reduced rates by about 5-1/2 percentage points, which seems to suggest that the FOMC would face a shortfall of about 2-1/2 percentage points for dealing with an average-sized recession. 

However, she finds this simple comparison exaggerates the limitations on policy, since  a large portion of the rate cuts that subsequently occurred during these recessions represented the undoing of the earlier tight stance of monetary policy.  Thus she maintains that:

Of course, this situation could occur again in the future. But if it did, the federal funds rate at the onset of the recession would be well above its normal level, and the FOMC would be able to cut short-term interest rates by substantially more than 3 percentage points. 

So the main reason for the Fed's urge to raise the policy rate would be to push it above the normal level (that is supposed to be very low in the present time), so that in the event of the next recession the FOMC would be having enough room to respond by reducing it. Given that the next recession is almost upon us this introduces a bizarre and volatile policy response.Of course, if the transmission mechanism is broken then declines in the policy rate, no matter by what magnitude, would be ineffective as is witnessed in Japan and eurozone.

In August last year asking the same question about the possibility of Fed raising rates in September 2015 I wrote:

In my estimation Fed cannot risk raising 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!

Had it not been for a marked  increase in  the prevailing uncertainty that has rendered  the decision of the Fed " almost as fickle as the weather, shifting about by blind chance",  as evinced by a lack of consensus among various FOMC's participants I  would have also reached for the very same conclusion again, i.e., the possibility of a September inaction this year.

Ms. Yellen, like Mr. Draghi, in her Jackson Hole lecture  implicitly maintained that the transmission mechanism of monetary policy has been working  well and that Fed's new unconventional policy tools have been effective. She maintained that the reason for the disappointingly slow growth rates has been related to various headwinds the economy faced in recent times. She stated:

In light of the slowness of the economic recovery, some have questioned the effectiveness of asset purchases and extended forward rate guidance. But this criticism fails to consider the unusual headwinds the economy faced after the crisis. Those headwinds included substantial household and business deleveraging, unfavorable demand shocks from abroad, a period of contractionary fiscal policy, and unusually tight credit, especially for housing.

Apart from the the fact that those headwinds should have been and could have been predicted by any decent model,  she did not mention the lack of capital formation, low productivity growth and a greater use of contingent capacity that have arose from the global financial imbalances.  Referencing  a study by Engen,  Laubach, and Reifschneider (2015)  Ms. Yellen argued that the Federal Reserve's forward guidance and asset purchase policies "have put appreciable downward pressure on long-term interest rates and, as a result, helped spur growth in demand for goods and services, lower the unemployment rate, and prevent inflation from falling further below our 2 percent objective." Obviously, if the model underlying the transmission mechanism have been outdated then one cannot rely on the inferences derived from a wrong model.

Nevertheless, many FOMC members, like Mr Kaplan the president  of the Dallas Fed, have acknowledged the fact that the world has become much more interconnected over the past several decades, and  global trade and financial markets  have expanded such that an economic deterioration  in one country can have  greater adverse effects on other economies. In other words, the parameters and the functional forms of economic models with regard to the trade of goods and services, capital flows,  labor market dynamics,  asset allocations  and global investment demand for “safe” assets have changed.  `In Mr Kaplan words:

Because financial markets trade in real time, market strains or other challenges in one market now have the potential to rapidly affect currency, debt and equity markets globally. We certainly saw the effects of this interconnectedness during the 2008–09 financial crisis. More recently, and on a much smaller scale, we saw how turmoil in currencies and local markets in certain countries in early 2016 helped lead to global market volatility and a rapid tightening of overall financial conditions.

Moreover, as we have argued in our previous post it is very hard to maintain the hypothesis that the transmission mechanism is still working

 in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest. 

A rise in interest rate will put upward pressures on the US dollar, reducing the American competitiveness in the global market, when many regions are engaged in currency wars to support their exports. Last year I was proved correct in my call that the Fed will not raise the interest rate in its September meetings. I also was correct in predicting that a December rise will destabilize markets after the new year's holidays. This year the case is even stronger because of the Brexit and because of the presidential election.  As I argued last year:

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.”

In such a conference 3 key issues must be on the agenda (1.) a halt in the currency wars and  a move toward rationalizing  currency relationships based on the law of one price. (2.) A restructuring of the current unsustainable levels of debt  and (3.) a coordinated global fiscal policy to improve the international trade infrastructure .  

Mr. Draghi's Transmission Mechanism of Monetary Policy

The European Central Bank's Governing Council in its September meeting kept the monetary policy unchanged  leaving  the main refinancing rate at zero, the deposit rate at minus 0.4 per cent and asset purchases at 80 billion euros ($90 billion) a month. Following the familiar pattern of revising down the optimist projections by the IMF and other central banks, the ECB also lowered its growth forecast for 2017, to 1.6 per cent from 1.7 per cent and revised down its inflation forecast for 2016, to 1.2 per cent from 1.3 per cent.

In spite of negative interest rates and quantitative easing, eurozone's growth slowed to 0.3 per cent in the second quarter, from 0.5 per cent  in the first quarter, and headline inflation remained unchanged in August at 0.2 per cent, reflecting in part the lagged effects of oil prices. Furthermore, core, or underlying inflation rate that excludes energy, food, alcohol and tobacco was also lower, at 0.8 per cent in August, as compared to 0.9 per cent in the previous month.

ECB Balance Sheet, Total Assets €3,330,487 mn.

Euro Area Headline Inflation Rate

Euro Area Core Inflation Rate

Inflation has been close to zero since the late 2014 and in fact below 1 per cent since the late 2013. In other words, assuming an upward measurement error,  of the kind discussed by Bernanke and Mishkin (1997) and Camba-Mendez (2003),  of say 0.5 per cent, then one may maintain the hypothesis that eurozone has been very close to a deflationary mode over the past few quarters. The region grew by just 1.6 per cent in 2015 with much of the expansion deriving from the ECB's purchase of more than €1 trillion ($1.1 trillion) of securities so far,  which  has diminished bond yields to abnormally low levels.

While acknowledging that the current negative interest rate introduces challenges for the policy makers, Mr. Draghi suggested that:

Right now the transmission mechanism is really working very well. It's never worked better.

It is very hard to validate this assertion in a market which agents,  in the optimization of their objective  functions, are able to take account of the possible policy actions.  In fact, the transmission mechanism has been disrupted at various critical connections precisely because of this ability and this is why the forecasting models that  central banks are using  are persistently overpredicting the economy's growth rates and why investors are reluctant to invest.

The  ECB’s ability to stimulate aggregate demand by lowering interest rates and devaluing euro has been seriously undermined by the disruption in the transmission mechanism as bond holders prefer to hold on to their bonds despite the fact that an estimated 28 per cent of Eurozone bonds' yields are lower than the deposit rate and  52 per cent of its government bonds  are yielding negative returns. The comparable figures  for German bonds are  66 per cent  and about 85 percent.  Of course, part of the excess demand for bonds stems from the QE's rules that restrict the ECB purchases to  only one third of most bond issues and any bonds yielding less than minus 0.4 per cent.   The rules also restricts the scale of purchases in each country to the size of its economy in the eurozone. For instance in Germany this amounts to  a monthly purchase  of about  €10bn of government debt. Nevertheless, because of excess demand for the German government deb their prices have increased  and more than half  of the country's bonds are now yielding less than the  minus 0.4 per cent which excludes them from the QE.

Mr Draghi maintained that for the time being, the ECB's downward revisions are not substantial enough to warrant a change in policy, and despite the distortionary impacts of the negative interest rates and QE,  he asserted that these policies have been "very effective", since:

While in the previous time we had observed fragmentation and very subdued credit developments, now we can say fragmentation is over and credit is growing constantly.

Of course, credit may be growing constantly, but because of the adverse selection problem this growing credit is not channeled into most productive ventures that could expand the economy's efficient production frontier. As theory envisages the high-risk borrowers are flooding the supply side  of the bond markets while the high quality borrowers are leaving the market because of the increased risk. As a result of getting into this slippery slope  some are now  suggesting the possibility  that ECB, like Bank of Japan, may be forced to purchase stocks. Mr. Draghi  expressed his determination to provide more stimulus if needed and reported that the  bank has asked staff members  to re-evaluate the design of the QE program,  which may hint  to the possibility of a widening of the program to include equities in order to circumvent  the bond shortages.

One has to ponder on the equity-based QE policy's extreme distortionary risks -- e.g.,  how the ECB would  choose among the winners and losers in various sectors and in various countries or would the bank be able to purchase  the promising startups' stocks with high  productivity prospects when the market information is plagued with high levels of noise in this climate of global uncertainty, or would the ECB be focusing on stock purchase  of the Too-Big-To-Fail corporations with low productivity prospects?  The number of such questions would be incredibly large. In any event, eurozone growth is expected to flatline over the next several years like those of many other advanced economies.

 In fact, the ineffectiveness of the ECB's non-conventional policies is already evinced by a recent ECB working paper    that suggests  that in recent years inflation expectations in the eurozone have shown some signs of de-anchoring,  implying  a loss of ECB's credibility due to the lack of information content in its inflation forecasts that has caused the professional forecasters to ignore the bank's inflation targets in their inflation expectations formation. The authors write:

Continuous analysis of de-anchoring risks is crucial in monetary policy, especially in the current low inflation environment. Monetary policy credibility is built gradually over the years, but we cannot rule out the possibility that it may deteriorate quite rapidly. 

When analysing anchoring of inflation expectations, we also need to examine when the inflation target is expected to be reached. Risks of de-anchoring are potentially increasing, if the time when the target will be reached has been postponed in economic agents’ expectations. 

As we have argued in the past, the slowdown of growth and policy ineffectiveness are global phenomena stemming from the current global financial imbalances, currency wars, and a fragile banking system, that are being exacerbated by the QEs and other unconventional policies. The fact that German and French business sentiment fell unexpectedly in August, especially among manufacturers, is another sign of the ECB's loss of credibility to deal with this global predicament.  Even the ECB's resort  to the currency war  has resulted in an upward pressure on euro due to generating a current account surplus that cannot be offset by outflow of the scarce capital from the region, due to the fragility of its banking system.

Euro Area Productivity

As the above chart indicates, the eurozone productivity growth  has slowed markedly over the post-recession period. The ever-so-slight  positive slope in the trend productivity of the recent years  has been basically concentrated in countries like France and Italy which have experienced a rise in their unemployment rates, indicating that the recent unemployeds in these countries have been mostly among the least productive labourers.  

In contrast, productivity growth has been stagnating in Germany,  a fully-employed economy with balanced public finances and a surging current account surplus of 9 percent of GDP.  Registering 1.8 per cent annual growth rate  in the first half of this year, German economy is running almost one percentage point above its potential and is attracting  inflow of funds from the low productivity countries. German GDP growth in the second quarter was tepid 0.4 per cent, down from a 0.7 per cent  in the first quarter and its business investment exhibiting the same wait-and-see pattern as the rest of the advanced economies.

Despite this anaemic productivity growth Mr. Draghi's advice to Germany, an export-reliant country, is that it must increase its unit labour cost by allowing wages to increase. He suggested that:

Countries who have fiscal space should use it. Germany has fiscal space.

But in today's circumstances  Germany's fiscal space has to be used to increase the productivity of eurozone's pripheries, otherwise it will be adding to imbalances.  However, this would imply a centrally planned model which would be destined to failure.

German Productivity

French Productivity

Italian Productivity

German Unemployment rate

French Unemployment Rate

Italian Unemployment Rate

In August 2015 we argued here in this forum that:

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.

Last February we argued here that:

It appears that central banks have forgotten a number of basic macroeconomic facts; 

i. The liquidity demand will become inelastic around the potential output, and potential output itself shrinks when there is no capital formation and plenty of uncertainty. Moreover, reducing the interest rate cannot affect the growth rate of real output when aggregate demand becomes insensitive towards changes in the policy rate. The conventional theory suggests that the impact of increased liquidity should be translated in higher inflation rates. However, this could be the case if and only if the newly created liquidity can enter into the markets, via consumption and investment which is not the case in today’s economic environment. One can argue that in today’s economy either central Banks have lost their ability to create liquidity, or to the extent that they are able to do so firms’ change of behaviour has offset it. In other words the liquidity created by central banks is hoarded by firms. Businesses are not investing, because they do not see a sustained level of increased demand, and negative interest rates cannot force them to invest because they have invented new instruments and innovative tactics in order to hoard liquidity.

ii. If central banks are aiming at a currency war, to increase their market share of exports, they must have forgotten that these wars worsen the already highly toxic trade environment. In fact, this is the classic case of ‘fallacy of composition”

It appears that in his Brussels Economic Forum lecture, on June 2016,  Mr. Draghi was agreeing  with that kind of analysis  and correctly acknowledging that;

There is also emerging evidence that growing below potential for too long can erode that potential through its effect on productivity growth. When uncertainty is high, a “wait-and-see” attitude can cause the most productive firms not to expand as much as they would otherwise. (...) The cost of delay, then, is that labour and productivity suffer, and the output gap closes in the “wrong way” – instead of output rising towards potential, it is potential that falls towards current output.

The same idea of wait-and-see has been supported by John Cryan, the chief executive of Deutsche Bank, in a recent commentary published in Germany's Handelsblatt newspaper stating that:

"companies are holding back due to the ongoing uncertainty with investments and are rarely requesting loans."

This is  a clear sign of a disruption in transmission mechanism. Europe is sliding fast toward a deep recession.

On the discombobulating productivity growth slowdown

 In her  Jackson Hole lecture Ms. Yellen has stated:

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.

As the following chart shows  labour productivity has been growing at a slower pace in recent years. Moreover,  according to the revised estimates by the US Labor Department nonfarm business productivity measured as the goods and services produced by American workers per hour, decreased at a 0.6 per cent seasonally adjusted annual rate in the second quarter. This was the sharpest year-on-year decline over the past three years.

US labor productivity in the nonfarm business sector

This  was also the third consecutive quarter of decline the longest slide in worker productivity since the late 1979. In terms of year-over-year change  labour productivity was down 0.4  per cent in the second quarter, the first annual decline in three years.

It is worth to remind ourselves that productivity is the denominator in the unit labour cost ratio, with the numerator being the real wage, meaning  higher productivity would increase the country's competitiveness by reducing the unit labour cost. When  prodctivity grows at the same pace as the real wage it offset the adverse impact of the latter on  a country's competitiveness in the export markets. Unit labor costs rose at a 4.3 per cent annual rate, a 2.6 per cent rise from a year ago, reflecting  in part a 1.1 per cent rise in real  hourly wage per hour in the second quarter.

The strong productivity growth exhibited in the chart in the late 1990s has been attributed to the investment surge in the information technology that resulted in a marked reduction of the unit labour cost, which  boosted the GDP growth.

The productivity slowdown of recent years, as we have persistently argued in this forum, emanates from the effects of the global financial imbalances and high levels of global indebtedness  that have caused high level of uncertainty, whereby  businesses  postpone their irreversible capital expenditures and shift to an intensive margin mode of production. As a result of weak investment the economy's production frontier has not expanded and thus productivity growth has shrunk. This is a global phenomenon , which has been affecting international trade, encouraging currency wars and  spreading  poverty. Lower production frontier and rising unit labour costs have also diminished corporate profits and has aggravated  the financial imbalances.

As we have argued in the past  a lower productivity arising from a prolonged shift towards intensive margin mode of production would lower the economy’s potential growth. Many central banks around the world have already lowered their expectations for future growth and interest rates, without acknowledging the high level of debts and a fragile financial system as the main culprit. The consequential  uncertainty acting as a barrier to capital formation has created a vicious circle towards a rapidly approaching stagflation.

We believe the  alternative hypothesis put forward to explain the  productivity slowdown cannot be maintained with a sufficient confidence. For instance, it is hard to believe that in spite of  the recent advances in high tech communication, smart materials,  Internet of Things, large scale sensor network applications,  Big Data, cloud computing, supply chains  so on and so forth a  secular trend  toward a more modest efficiency gains, as compared to past advances, has been emerged.

It is also difficult to maintain the hypothesis of errors in measurement of productivity when the global economy is clearly slowing down, and businesses are delaying their capital expenditure plans. In the US fixed nonresidential investment, which is comprises about twenty per cent the economy --  has declined for the past three quarters  and new orders for nondefense capital goods excluding aircraf has declined on a year-over-year basis almost continuously for the past year and a half.

The situation is not materially different in Europe and Asia. In fact, investments have exhibited the same pattern of decline as aggregate demand since the 2015. The situation has deteriorated fast since the early 2016. During the second quarter, total investments declined 3.4 percent from the year earlier, and subtracted 1.68 percentage points from the GDP growth.

As the following chart shows the total factor productivity, TFP, that captures the efficiency with which labor and capital are combined to generate output ,  over the past four quarters ending in the second quarter of 2016, has fell at a rate of minus 0.7 per cent while Utilization-adjusted Total Factor Productivity has fell at rate of minus 0.32 per cent. This is another  clear indication of a shift towards intensive margin mode of production. We have in the past examined other evidence in favour of uncertainty hypothesis deriving from financial imbalances and will not repeat the argument here again. Suffice to remind readers that a greater use of contingent labour in the current capacity planning by businesses has resulted in wages falling behind productivity growth.

Total Factor Productivity Rate (Four quarter per cent change in natural log) Source: FRBSF

Another evidence for greater use of contingent labor is the fact that in  addition to the officially reported 7.8 million people currently out of work, there are 8 million individuals in involuntary part-time jobs. Furthermore, there are the 2 million of long-term unemployed and another 2 million of virtually unemployable persons that their only hope for finding a job is through demand for contingent labour.

Getting some of these 16 million people back on the payrolls will require a major capital formation so as  generate a favourable shift in the aggregate labor demand which has been lacking. As well, the slowing international trade need to be boosted. It is of note that in the first six months of this year, the U.S. trade deficit was running at an annual rate of $712 billion. That negative trade balance accounts for 4 percent of the economy, and it is currently taking half a percentage point off the growth of the domestic demand. For aggregate demand to grow at a healthy pace the global financial markets need to return to equilibrium, excessive global debts have to be restructured, and currency wars must be ended.

From Jackson Hole with Neutral Rate, Inflation Expectations, and Inflation Targets

 With interest rates around the world at close to zero or negative and another recession looming on the horizon central banks, having exhausted their firing powers with the so-called unconventional policies, appear rather anxious about the efficacy of their tools. This is why the Chair of the Federal Reserve, Janet Yellen, spent much of her speech at central bankers meeting in the mountain resort of Jackson Hole, Wyoming   trying to explore  the  effectiveness of Fed's expanded monetary policy toolkit.

Overall, it appears that Fed still thinks or hopes  that changes in nominal variables stemming from the conventional and unconventional policy tools such as changes in the Fed funds rate or Quantitative Easing will exert a lasting and  long-term impact on the real variables such as the real GDP growth rate in these financially  abnormal times. Ignoring the fact that the effectiveness of monetary policy tools has been seriously diminished in recent times at various advanced countries and abstracting from the distortionary effects of the unconventional tools on the economy, Ms. Yellen  primary message at Jackson Hole was that:

I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns.

There were hardly any new information about the exiting tools  or their effects on the transmission mechanism of monetary policy in the speech. However, the Chair mentioned that  future monetary policymakers might choose to explore some additional tools that have been employed by other central banks,  such as  the possibility of purchasing a broader range of assets,  raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting. She added  "adopting these policies would require a very careful weighing of costs and benefits and, in some cases, could require legislation".

Among these various alternative policies only the idea of targeting for a higher inflation rate will be materially different, and extremely harmful, the rest like  price-level or nominal GDP targeting are basically red herrings.  The idea of opting for a higher inflation target was recently floated by the president of the San Francisco Fed, John Williams, who has argued in the post-financial crisis world the significant decline in the natural rate of interest over the past quarter-century to historically low levels pose significant challenges for the conduct of monetary policy, defining the concept of the medium-term value of the natural  as the real interest rate that balances monetary policy so that it is neither accommodating nor contractionary in terms of growth and inflation in an economy at full strength.

Despite its shortcomings in describing the Wicksellian  concept of Natural Rate of Interest  Williams' concept as an equilibrium interest rate can be thought of as the rate of interest corresponding to a configuration of interest rate, output growth rate, inflation rate, employment and exchange  rate in a model in which goods and services, labour  and money&credit markets all are in equilibrium and in the currency market the covered interest rate parity condition is satisfied.  In  other words, this is the interest rate that prevails in an  economy operating  at its  production efficiency frontier. Williams believes this natural rate has declined and writes:

The new challenge for central banks is how to deliver stable inflation in a low r-star world. This conundrum shares some characteristics and common roots with the theory of secular stagnation; in both scenarios, interest rates, growth, and inflation are persistently low (Summers 2015).

This is also a belief shared by Ms. Yellen, who citing  Lubik and Matthes (2015), Laubach and Williams (2016), and Johanssen and Mertens (2016) states "there is empirical evidence to support the conclusion that the neutral rate is currently not far from zero". This is indeed a remarkable inference, since it implies that  in spite of the existence of a relatively large output gap,  the interaction of the economy's aggregate demand and the long-term aggregate supply function on the space spanned by the   real interest rate and real output variables has shifted down to a close-to-zero interest rate. It should be noted, however, that this inference  appears to have been drawn from a conjecture, as she writes:

 we know that the neutral rate must have been well below its historical norm in recent years, because with the actual real interest having been as low as it has been lately, the economy would have otherwise expanded much more than has been the case. 

This conjecture would be flawed if the potential output growth rate has been slowing down due to a lack of capital formation stemming from the prevailing uncertainty. As we have argued before there is strong evidence that in such circumstances businesses in their capacity planning would be refraining from investing in irreversible capital expenditures, and this is the main cause of lower growth rate at the lower actual real interest in the recent times.

In fact, based on the following chart from Holston, Laubach, and Williams (2016) one can infer that the Wicksellian natural rates  in the US, UK and euro area  over the period 1980-2007 have been close to 3, 2.5 and 2 per cent respectively and the apparent decline  since 2008 is basically an art effect  stemming from a drastic structural change in financial markets in recent years. In other words, the fluctuation around the above mentioned estimated natural rates are caused by various cyclical factors. Moreover, given that natural rate is an equilibrium concept it does not stand to reason to argue that it demonstrates such an extreme volatility over short spans of time.

Estimated inflation-adjusted natural rates of interestSource: Holston, Laubach, and Williams (2016); data are four- quarter moving averages

As we have argued in the past, the concept of neutral rate is a long-run phenomenon associated with potential output at equilibrium. When the economy has been  in a prolonged state of disequilibrium and uncertainty as a result of which  businesses have revised and delayed their capital expenditure plans then the concept of  a lower neutral rate  would be vacuous. In such circumstances the potential growth rate would be lower due to the fact that production efficiency frontier is shrinking, and businesses are not investing toward minimizing their long-run minimum average cost. The stimulative monetary policy becomes ineffective because it cannot stimulate investment and capital formation. The distortionary impacts of flawed policies create bizarre relationships, for instance lower interest rates will encourage more savings because of consumers anxiety about the viability of their pension plans. On the investment side corporation decide to buyback their own share instead of investing and many decide to operate under intensive margin.

The idea that the natural or the neutral rate has declined is of course the dual form of the argument concerning the  progressive ineffectiveness of unconventional tools such as QEs or forward guidance. On her June 6th speech in Philadelphia Ms. Yellen, has referred to this ineffectiveness as less stimulative,  reporting:

The current stance of monetary policy is stimulative, although perhaps not as stimulative as might appear at first glance, 

which she has explained it in terms of a decline in the neutral rate. Similarly, Mr. Williams attributes this ineffectiveness to the "less room" conventional monetary policy has  "to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. He states:

Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star era. There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low.

In other words, Mr. Williams  argues that higher inflation rate would provide the monetary authority with a wider interest rate margin to be used as the policy instrument to fight the upcoming recession. Of course, if inflation rate target is arbitrarily raised to say 4 per cent the monetary policy would not automatically become effective in stimulating investment and exports. After all, we have experienced periods of stagflation and currency wars when monetary policy was ineffective.   Furthermore, his argument ignores the fact that what matters is the information content of prices, and this content diminishes at higher inflation rates due to the increased inflation variability. As Okun (1971) has shown variability of inflation rises with the inflation rate, and therefore the information content that allows the two sides of the market to plan and to execute their consumption and production decisions will deteriorate. The result would be lower growth rates.

Total debt securities, by residence and sector of issuer,
Amounts outstanding at end-September 2015, in trillions of US dollars

AU = Australia; CA = Canada, CN = China; DE = Germany; ES = Spain, FR= France; GB = United Kingdom; IE = Ireland, IT = Italy; JP = Japan; KR = Korea; KY = Cayman Islands; NL = Netherlands; US = United States. 

Sources: National data; BIS debt securities statistics.

Trimmed Mean One-year PCE Inflation Rate,

Source Federal Reserve Bank of Dallas

Relying on a partial equilibrium analysis based on the conventional expectations-augmented, or a New Keynesian, Phillips curve in which actual inflation trends depend largely on inflation expectations, and considering the fact that for two decades inflation  has been relatively  stable, Ms. Yellen has argued that:

The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

However, considering the fact that the expected inflation rate usually constitutes the intercept of a  Phillips curve  with the inflation axis in the space spanned by inflation rate and the GDP growth rates it would be natural for this supply side relationship to generate lower expected inflation in response to a persisting output gap. The main reason why inflation expectations and actual inflation were closely connected prior to the mid-1990s was the relative consistency of such shifts that was enhanced by the relative stability of the potential output growth. Wheres according to a study by the  Fed economist Jeremy Nalewaik

Movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations,

The reason for this break up is of course  the greater variability of the gap measure due to the utilization of the contingent  capacity that makes the Phillips curve shift  rather erratically.  At the same time the  aforementioned erratic fluctuation  of  the capacity growth rate caused again by the utilization of the contingent capacity results in the erratic behaviour of the actual inflation rate.

Thus, the key to the effectiveness of monetary policy is economy's return to the efficient production frontier, through a healthy capital formation, which would result  in higher growth of productivity. Unfortunately Ms. Yellen just in passing and almost as an after thought referred to the question of productivity growth in her Jackson Hole lecture :

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.

We will be dealing with this issue in our next post.

Can Deploying Helicopter Money Win the Currency Wars? Qua deinde fugam ?!

In response to the global financial crash of 2008, monetary authorities in the US, Eurozone, UK, Japan and China have implemented  QE plans to purchase massive quantity of bonds to jump start their economies. However, the programmes soon morphed into full-fledged currency wars.

 Following the February Shanghai G20 meeting,  monetary authorities, under the US auspices decided  not to  pursue exchange rate depreciation in a beggar-thy-neighbor approach. For a while it appeared that there was a halt in the currency wars.  However, with the global slowdown in the first half of 2016 and the Fed's delays in implementing its normalization policy, the market came to the view that the Fed is welcoming a weaker US dollar.

On August 4th, the British pound depreciated further after   Governor Carney  announced  that to mitigate the adverse effects of the Brexit referendum Bank of England would expand its bond purchase substantially  and buy not just more government bonds, but also corporate bonds.  A few days earlier, on July 29th, the Bank of Japan that  has been purchasing about 80 to 120 trillion yen (close to $1 trillion) of government bonds each year,  announced that it  would increase the scale of a program to buy exchange-traded stock funds to ¥6 trillion a year from ¥3.3 trillion, and it doubled the size of a dollar-denominated lending program aimed at Japanese companies operating overseas to $12 billion. However, the yen jumped 1.8 percent to 103.37 per dollar. We may recall that  on May 22nd, while denying that he is targeting exchange rate value of yen,  the bank’s governor, Haruhiko Kuroda, had said :

"If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates."

 It would be interesting to ask if the Japanese policy review in September will result in the resumption  of currency wars and will the helicopter money help UK and Japan to improve their economic outlook amidst of the current global slowdown?

Japanese Yen -US Dollar Exchange  Rate

British Pound - US Dollar Exchange Rate

In UK, the Bank of England, introduced its programme  under the banner of "exceptional package of measures" amidst of the current global slowdown. This move was taken by many as the signal that the Bank will do what is required for "monetary and financial stability".  The package included:

* a cut in the UK policy rate from 0.5% to 0.25%,
* a quasi-forward-looking guidance that interest rates could go lower (to near zero) by the year end, and
* a plan to buy £60bn worth of government bonds, extending the existing quantitative easing (QE) programme to £435bn in total, and £10bn of corporate bonds over an 18-month programme set to start mid-September in a bid “to impart broad economic stimulus”. Targeted companies would be those conducting “genuine business in the UK”, and not banks, building societies or insurers.

As a consequence bond yields have plummeted in the UK, for instance  the yield on its  longest-dated bond, the 2068 maturity, has declined from 2% on the day of the referendum to 1.06% on August 11, but any marked impact on GDP is highly doubtful. In the belief that the QE policy will lower interest rates and encourage investment and consumption of interest sensitive durable goods, thus boosting the GDP growth, the Bank has been buying bonds (gilt) at auctions in the market since 2009.

We have of course discussed in the past the dangers of negative interest rates, the adverse impacts of lower rates on savers and borrowers at such high level of debts, anemic productivity growth, widening  of current account deficit and lack of capital formation;  and thus will not dwell any further on these issues here. Suffice to remind readers that a year ago we had predicted the lower British economy's  growth, which we attributed  to these fundamental factors particularly a lack of productivity enhancing investment. We now notice that  the Bank has revised down   its growth forecasts  for 2017 from the 2.3%, expected in May, to 0.8%, in its recent announcement.

Bank of England's holdings of bonds (gilt), Source: Bank of England

Although, the British pound has been depreciating since the mid-2014 and the Brexit has given a boost to its decline, the bank's declared the new package's main aim was to mitigate the prevailing uncertainty. In the words of Governor Mark Carney:

"By acting early and comprehensively, the (Bank) can reduce uncertainty, bolster confidence, blunt the slowdown and support the necessary adjustments in the UK economy,"

The Governor, however, acknowledged that when rates are so close to zero the effectiveness of any further cuts on the economy would be diminished, thus restraining the impacts of interest rate cuts and quantitative easing.

UK's Labour Productivity, (pre-crisis peak=100)

UK Manufacturing Input Price Inflation, Annual Rate, Source: ONS

UK Unemployment Rate (Age 16 and over), SA

The Governor's warning was an important one, to the effect that a week later on August 10th when the bank tried to purchase its targeted £1.17bn of bonds it could not find enough sellers for a shortfall of £52m. This excess demand for bonds raised their prices and thus lowered their returns. In fact, yields on UK government bonds on 3 and 4 year turned negative  (to minus 0.017 and minus 0.015 percent respectively).

Despite the fact that the £52m excess demand for bonds was relatively a small sum, and the fact that the Bank assured the market  that it will make up the shortfall in the second half of its six-month purchase programme, the signal indicated that investors, seeing the low British  productivity growth and the current global output gap, were trying to hold on to their relatively safe higher-return bonds, particularly when interest rates are expected to fall in this uncertain times.

In short, savers  increasingly worrying about their future earnings are trying to save more.This implies that the  future shortfall in supply may need to be eliminated by the Bank's direct purchase of government bonds -- i.e, by helicopter money.

The new Chancellor of the Exchequer Philip Hammond may be using helicopter money to both prop up consumer demand and finance government's infrastructural projects. He  has abandoned plan to deliver a budget surplus by 2020 and has said "We have the option of a fiscal response,"  and he will be using the autumn statement,“to keep the economy on track.”

However in uncertain times  helicopter money is a dangerous  tool, particularly when the monetary authority's credibility is under  a heavy scrutiny.    Given that the Bank will be directly financing the infrastructural projects of the governing party, which depending on various electoral strategies are usually concentrated in certain constituencies under a political agenda, it will politicize the Bank -- which is supposed to be  an apolitical entity. The politicization could, most probably, destabilize  the economy, because it destroys the price discovery mechanism  of the market,  generating the risk of stagflation in the current challenging circumstances.

UK's Current Balances ( four-quarters cumulative) as a percentage of GDP

In Japan,  with its aging demography, and a population that  has been declining since 2008, the Bank of Japan's stimulative bond purchasing policies  has been totally  ineffective in generating growth. Moreover the adverse effects of  negative interest rates have already distorted the Japanese financial market. For instance, as a result of lack  of interest on a sale of 10-year Japanese government bond  its yield  has raised to 0.053 percent`from a negative  0.13 percent.

The distorted financial market in an  economy with a declining population, where Japan's fertility rate at 1.6 children is well below its replacement level of 2.1, can prolong the prevailing uncertainty. The situation is exacerbated by the fact that more than a third of the population is older than 60, with a high marginal propensity to save.

Although Japan’s economy  appears to have reached full employment at the unemployment rate of 3.1 per cent in June, there are indications that, like in the US and Europe, businesses are adopting intensive-margin production strategies and postponing  irreversible capital formation.  This is why Japan’s economy has been fluctuating between expansions and contractions in recent quarters, has a stagnating wage growth and  its businesses are hoarding cash that has reached the staggering level of US$3.4 trillion.

In these conditions,  exacerbated by the adverse effects of  the global slowdown the Japanese policy makers are trying to introduce a coordinated policy move with the Bank of Japan almost doubling its purchases of exchange traded funds (which include real-estate investment trusts, corporate bonds, commercial paper and stocks) and the Japanese  government introducing a fiscal stimulus package at a total value of ¥28 trillion ($273 billion) over several years,  that includes ¥7.5 trillion in new spending to jump-start the country's sluggish economy.

The intensified uncertainty, emanating from the negative interest rate policy and the Bank of Japan's announcement of an upcoming assessment of the effectiveness of its current stimulus policies in September has triggered a further appreciation of yen and a sell-off in the Tokyo stock market, as well as the worst sell-off in government bonds in more than three years, that has already impacted other countries bond markets.


Japan's economy grew by an annualized 0.2 percent in the second quarter (0.2 percent on a quarter-on-quarter basis),  well below the 0.7 percent increase markets had expected and a marked slowdown from a revised 2.0 percent increase in January-March. Household consumption, constituting about 60 percent of GDP, rose 0.2 percent, slowing from a 0.7 percent increase in the previous quarter, and  capital expenditure declined 0.4 percent after a 0.7 percent drop in the first quarter.

The September policy review may be a prelude to Japan's deployment of helicopter money in the currency wars, particularly  if the Fed continues to delay its policy normalization.

Japan's GDP Growth Rate, Quarterly- Seasonally Adjusted

Japanese  Government 30-Year Bond Yield