Central Bankers' Weekend at Bernie's! Will the Shanghai's Ceasefire in Currency War hold?

Monetary authorities around the world are busily introducing ineffective policies that they hope would create growth. As a result the state of the global economy increasingly looks like approaching the instant when Wile E Coyote runs off a cliff, but keeps spinning his legs, unaware that an impending hard landing is practically unavoidable.  Actually, the unresponsive world economy can be represented by yet another illustrative allegory, the movie Weekend at Bernie's, where two financial professionals (a metaphor for the central bankers), who have discovered a large insurance fraud scam in their company (a metaphor for Too Big to Fail, QEs, or negative interest rates, etc.), are invited to a party at their boss’s beach house over Labor Day. Only when they get there, they discover that their boss Bernie (the global economy) is dead from what looks like a drug-overdose (the massive $225 trillion of debt, and $600 trillion of toxic assets.)  Instead of doing the right thing the two executives decide it better to pretend he’s still alive so they can keep partying! 

Like the young executives in Weekend at Bernie's central bankers around the world have been increasingly using unconventional policies to prop up the global economy, expecting to convince investors that their policies are working and hoping nobody would notice all the Bernie's vital signs have been extinguished, i.e., the transmission mechanism of monetary policy is shattered . The world’s largest four central banks bought assets worth $1.2 trillion in 2015, similar to the amounts purchased post-Lehman and during the 2013 euro-area crisis, with a very little impact on growth. Meanwhile, they are futilely waiting for cheaper oil impacts come to rescue and give a boost to the world economy.  The fact that growth has not yet accelerated after the collapse of oil prices is blamed on the lag structure of impacts and not on the prevailing global uncertainty about the outlook that has weighed seriously on financial markets.

Negative Interest Rates, and market Volatility 

Both the Bank of Japan and the European Central Bank cut rates further into negative territory this year, and both saw their currencies strengthen. This is largely because markets has started to realize that these prop ups are not able to revitalize the economy. Particularly, when in the words of Governor Carney in his G20 speech in Shanghai

 “Volatility has spilled over into corporate bond markets with US high-yield spreads at levels last seen during the euro-area crisis. The default rate implied by the US high-yield CDX index is more than double its long-run average. And sterling and US dollar investment grade corporate bond spreads are more than 75bp higher over the past year. "

That volatility has not disappeared, it will show up soon with Brexit referendum and in the meanwhile, after the latest Fed’s move, is morphed into more of exchange rate volatility.  

Business Fixed Investment, and Intensive Margin

While, the FOMC statement in March  reported that economic activity has been expanding at a moderate pace despite the global economic and financial developments of recent months, it also noted that business fixed investment and net exports have been soft. Undeniably, the strong US job gains in the absence of strong fixed investment, contrary to Fed’s reading, cannot point to additional strengthening of the labor market. As we have repeatedly argued in the past the strong job gains have been mostly emanating from a greater business focus on intensive margin due to the prevailing uncertainty. An intensive margin implies that instead of investing on latest technology firms hire more labour and utilize their existing equipment capacity more intensely. The substitution of transitory labour intensive tactics ( such as introduction of extra production shifts for part-time workers) instead of committing to irreversible longer-term fixed-capital investment has been the main reason for increased use of contingent employment and weak wage growth.

   

By the mid-March, the experience of five consecutive weekly gain for various stock indexes including the Dow, S&P and Nasdaq created the impression that the recent weakness in markets is over.  Recall that the weakness has been observed since the Fed’s December interest rate rise.  Many market analysts were excited that an estimated loss of more than 6 trillion dollars since early January has been recovered, and  reported that their earlier  concerns about slowing global growth is now waning and the outlook for commodity prices has improved.  Nobody, mentioned any fundamental factors. Some attributed the recovery to a rather sharp rise in oil prices and expectations of higher US growth, despite the global slowdown.

High Debt, Banks' Non-performing Loans, and Shanghai's Accord

Yet these factors pale in significance when viewed against global debt, including the U.S. gross national debt  that according  to some estimates would reach a level of $24 trillion by 2020, or just over 100% of gross domestic product, which can surge to $27 trillion if Mr. Trump’s tax cuts are implemented, assuming, of course, that the global economy withstands the shock to international trade stemming from his anti-trade rhetoric. Similarly European sovereign and private debts are quite high while banks’ non-performing loans are disturbingly rising. These are fundamental factors which would not allow a return to a smooth normal growth path – even if policymakers are content with a slow growth trajectory. Wile E Coyote has now reached the edge of debt and QEs cliff.

Given the urgency of the moment, many of us expected that the G20’s February 25th meeting in Shanghai would come up with some fundamental agreement to rebalance the global economy,   would try to readjust  values of   various currencies by employing some version of Purchasing Power Parity, and would restructure  debts. It was hoped that such policies would rescue the banking sector before a full blown financial crisis set in.    Regrettably, once again the International Monetary Fund (IMF) did come up with an entirely inappropriate policy recommendation and instead of arguing for resolving the global financial imbalances, a restructuring of global debts, and an end to currency wars, argued for a coordinated stimulus program!   Fortunately, it was soundly rebuffed by both Germany and the United States.

Nevertheless, the flurry of erratic monetary policy announcements after the Shanghai meeting has led some to conclude that there must have been a secret Plaza type Accord in Shanghai to adjust exchange rates and create some semblance of truce in the currency wars. However, for that  hypothetical accord to be successful the necessary conditions are transparency and completeness, neither of which exist.  In other words the accord must deal with the astronomical global debt, and must provide a framework for the orderly currency readjustments.    All in all, though, judging from the inconsistency of various monetary policies it appears that a putative Shanghai accord, even if exits, would be ineffective and short lived.

  

This is evident from the ECB’s March 10th policy announcement of an array of new unconventional policies.  Mr. Draghi  cut the three official interest rates;   increased the volume of asset purchases; offered more generous terms on targeted longer-term refinancing operations, and introduced a liquidity facility for banks pegged to the quantity of loans on their balance sheet. Given the ineffectiveness of these measures, the only motive that may be detected  for their introduction is a hope for a further depreciation of euro. However, this tactical move in the current currency wars, backfired, as it has been the case for Japan. Both currencies appreciated instead of depreciating. 

Being oblivious to the longer-term damaging impacts of negative interest rates on the financial sector, and their  distortionary impacts on intertemporal preferences,  ECB  reduced euro area deposit rate further down into the negative zone (from -0.3 to -0.4) per cent.  As the chart below shows, it is hard to believe that this move will have any real impact on growth, or will cause a change in the provision of liquidity. The only impact would be on the expected slope of the yield curve of up to ten-year maturity, which now is expected to remain relatively flat for a longer period, exerting more damage to the already fragile banks’ balance sheet.

A flat yield curve removes the banks’ maturity transformation opportunities.  A bank’s ability of intermediation in the credit market, to transform short-term savings into long-term loans, is critically compromised  by the flat slope of the yield curve.  Thus, banks’ profitability is now seriously impaired. Long term rates are low because markets are anticipating a hard landing is inevitable.

In terms of helping the global economy the US Federal Reserves’ policy action on March 16th was not much different.   Ms. Yellen markedly revised the pace at which her bank expects to lift interest rates, justifying the revision by referring to global worries that could adversely impact America’s recovery. This was despite the fact that core inflation in the US, excluding the deflationary impact of lower oil prices, has now ticked up to 2.3 per cent, which is above target for headline inflation of 2 per cent.  Ms. Yellen has halved the number of rate increases that are expected for 2016 to two 25 basis points moves.

However, given our argument with regard to economy’s greater use of intensive margin, the inflation scenario is now much more complicated.   The use of intensive margin indicates a lower growth of the aggregate potential output, as investment for extensive margin is being delayed or abandoned. This would imply a lower non-accelerating inflationary rate of unemployment (NIRU).  A lower potential growth rate determined by an aggregate short-term cost function would cause inflation rate to pulsate in accordance with the on-off use of contingent factors of production. The impact of these bouts of inflation rate on the expected inflation could become a potent source of stagflation.

It is certainly true that the US is now worryingly more exposed to the global volatility.  The alleged surprise of those that consider the Fed’s mandate is to worry about the US inflation and unemployment, or that did not expect a greater Fed's sensitivity to the worldwide repercussions of US monetary policy decisions, is at best disingenuous. It is hard to believe that Fed is not using a structural model in which some forms of covered or uncovered interest rate parity relationships play an important role in determining the value of the US dollar against other currencies.  In other words, global events would impact the Fed’s policy rate setting via this channel, and then reverberate through the balance of trade. As soon as one uses a structural model with some interest parity conditions the sensitivity to global impacts would be a foregone  conclusion. 

Of course, Fed must be acutely aware that all over the world there are now over $7 trillion worth of bonds with negative yields. In other words both governments and banks are now being paid to borrow from the various central banks in the euro area, Japan, Sweden, Denmark, and Suisse.   This would elevate the already unsustainable   level of global debt. A hard landing is becoming even more devastating and painful, when banks are now more vulnerable, more exposed, and larger.   

On the Arrival of 70's Stagflation: It's like deja-vu, all over again!

The US Labor Department data on February 19th, showed core Consumer Price Index, which excludes the more volatile food and energy components, increased 0.3 percent in January, the biggest gain since August 2011. The annual core CPI advanced 2.2 percent, compared to the market expectations of 2.1 per cent, the largest rise since June 2012 and exceeded the 1.9 percent average annualized increase over the last 10 years.

This trend would get the Federal Reserve closer to its 2 percent target on the PCE inflation and together with a tightening labor market, provides some impetus for additional rate hikes. According to the minutes of Federal Reserve's January 26-27 policy meeting, policymakers still expected to raise rates and even discussed whether a hike was warranted in that month, but after a lengthy discussion on global risks they said tighter financial conditions may be "roughly equivalent" to further hikes!

It appears, that the U.S. economy is headed for stagflation. Clearly, Fed’s signals with regard to a need for early and modest action toward "normalizing" policy with the ultimate goal of staying ahead of the inflation curve is proving unhelpful and is adding to the current extraordinary uncertainty.  In brief, as we have argued before in this forum, businesses’ capacity planning horizon has shortened in recent times and this is one of the key contributing  causes of the emerging stagflation .

Firms' survival strategy is now determined by their optimization along their short-term cost functions, and this is evident from the lack of investment in capital formation. The reluctance to commit capital to irreversible fixed investment and waiting for uncertainty to abate, stemming from the prevailing global imbalances and their impacts on credits that are rooted in extraordinary amount of global debt overhangs, rising non-performing loans, slowdown in China, and oil price shocks are causing a decline in the potential GDP growth.

Firms caught in these circumstances have resorted  to contingency capital and labour planning to meet any conjectural increases in demand, and this is corroborated by a rise in part-time work and the stagnating wages. These effects are artificially reducing the official unemployment rate. It should be noted that these effects are exacerbating the Not-in-Labor-Force population problem, which based on BLS estimate is 12-times the number of “officially unemployed”, and is  expected to steadily rise.

The use of contingent workforce is increasingly widespread and rising particularly during these uncertain times. Firms use this short-term optimization tactic because it will provide extra flexibility and cut labour costs sharply, by eliminating the need to pay contractual fixed wages, benefits, sick days and vacation days, or overtime. Moreover, it isn’t necessary to withhold taxes, pension plan contributions, or employment insurance premiums and so on, and  payroll, benefits administration, and HR costs are also reduced.

 Although to our  knowledge, the literature on job search has not yet investigated the impact of a greater use of contingent workforce on regular-jobs’ search costs, it stands to reason  to expect that these costs must have risen markedly for the unemployed in particular. This is why many unemployed workers are deciding to provide their services through a temporary agency, or work as intermittent workers, “casual” workers, and other types of works without a standard employer-employee relationship, which are all referred to in the U.S. as “contingent workers”, and are playing a significant role in the stagnation part of the stagflation.

As well, all the needed ingredients are in place to create the inflation part of the stagflation, and in this regard Fed’s policies have become inconsequential from a stabilization policy perspective. Since a hypothetical rise in interest rate would intensify the stagnating part of the stagflation, and on the other hand a reducing interest rate would add to its inflationary part and simultaneously  would aggravate the prevailing macroeconomics’ imbalances.

The underlying reasons for the fact that inflation had remained weak in recent quarters have been articulated quite well by the Fed’s recent release;

“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” 

In other words, because of the mathematics of calculating the annual inflation rate, those parts of the inflation weakness arising from impacts of lower oil price and lower import prices stemming from the US dollar appreciation, which are transitory and normally should be expected to disappear after a year would linger for a while, because of the fact that oil price declines have been staggered and have not occurred all at the same time, and thus  their adverse impacts on annual inflation rate may be enduring for more than one year. Nonetheless, sooner or later, they will disappear.

However, there is no danger of creating memories in the data, arising from the persistence of inflation weakness. Meaning inflation expectations would remain anchored. Obviously then, the inflationary pressures would be reinforced by the above mentioned  lower rate of potential GDP growth rate that would reduce the impact of the notional output gap (measured against the theoretical longer-term cost functions) .

 This stagflation could be exacerbated by the appreciation of the US dollar real effective exchange rate, which has been showing a trend, owing to a kind of currency wars, and a relatively safer haven quality of the US vis-à-vis other countries that entice the  inflow of capital. The February 17th data on the producer price inflation registering a 0.1 percent increase appear to suggest that this process is already started.

Will Banks survive this Minsky Moment?

The global financial imbalances have pushed the banking sector off the cliff edge. On February 11th after yet another volatile day in stock markets, bank stocks crushed amid a selloff that has erased more than $4 trillion from global equities this year -- another Minsky Moment is almost upon us. The global distress embraced industry's titans such as Goldman Sachs, Morgan Stanley, Société Générale, Deutsche Bank, Barclays and Credit Suisse among others. Shares of Goldman Sachs and Morgan Stanley, the two American equity-trading giants, dropped by close to 10% below their tangible book value, a theoretical gauge of how much of their worth they could salvage if liquidated.

American financial stocks are down by 19%. French and German banks like Société Générale and Deutsche Bank saw their shares fall by more than 10%, while Italian banks shares have plunged by 31% and those of Greek by an alarming 60%. The European banking shares have lost around 27 percent so far this year. The index of major banking shares in the UK at one point hit its lowest levels since the depths of the recession. Asian banks were also afflicted, for instance Japanese banks’ shares have dropped by 36% this year. The readers of this blog may recall that this outcome were consistently warned against in this forum. Indeed, in July 2015 we wrote:

While $107 billion dollar Greek debt to European banking sector appears manageable, even a rather modest money multiplier inflate that amount to a quite frightening level. In fact, since the inception of the euro in 2001, the German, French, and Dutch banks bought a huge amount of Greek, Portuguese, Spanish and Italian sovereign debts by leveraging their equity capital—this was European version of the US subprime mortgage fiasco. Thus, the balance sheets of these banks, levered up in some cases by forty to one or more, is in a very fragile state. The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.

We are witnessing another financial contagion, where initial deterioration in banks’ balance sheet resulting from a number of adverse shocks such as the oil market predicaments, China's slowdown, and currency wars are rapidly spreading and the risk quality of financial sector’s loans is plunging into a dark abyss. While market anxieties, reflected in increased intra-euro area spreads and higher term premia, were appearing somewhat abated by ECBs policies; it is now clear that its unconventional monetary policies are ineffective and incapable of correcting the fundamental fragilities.

The risk of low market liquidity has reappeared again with a vengeance. Confidence among large banks with respect to their ability to make markets must be collapsing. ECB like a number of other central banks had hoped that its asset purchase program would eventually support nominal growth and as a result banks’ profitability would be improving. It was assumed that by a simulated shrinkage of banks’ balance sheets and some regulatory improvements in various capital and leverage ratios the lingering post-Big-Recession challenges would be behind us.



However, as the above chart demonstrates shares in institutions from Goldman Sachs to Deutsche Bank have endured a serious slide. Central banks may be able to discount the fact that, as shown by Reinhart and Rogoff, at least in the United States, the ex post probability of being in a financial crisis era has been about 13 percent of the time since the country’s independence – i.e., once about every 8 years. However, they cannot deny that the recent intensification of banking stress as net interest margins are being disappeared under the low interest rate environment and flattening yield curves, has created a severe systemic risk. It is quite clear that the legacy of sovereign debt crisis is still haunting and stock of non-performing loans are on the rise proceeding from the plight of the oil and related services sectors, as well as the expected poor performance of companies that are adversely affected by the slowdown in China, or those that have invested heavily on luxury London real estates which hedge funds are beginning to short.

 For much of the last few years various central banks have been performing an extensive set of “stress testing” their balance sheets against a chain of purportedly worst-case economic scenarios, in order to identify which banks do not have sufficient capital to meet the hypothetical shocks, gauging the amount of recapitalisation the banks require. However, policy makers are well aware that no bank can survive these tests when confidence in the banking system has been shattered. As well, nobody knows how the structural parameters of the underlying models for these tests have changed in response to unconventional policies such as negative interest rates. In other words the results of these tests are at best unreliable. The same can be said of calculations that, for instance, show European banks are holding €700m worth of capital more than they were at the time of the last crisis and have disposed of their riskiest assets. These would be misleading if there is a crisis of cofience. Banks’ financial strength is under a question mark and the probabilities of large banks reporting large losses  are not trivial.

The crisis is not just concentrated on the banking sector, negative and very low interest rates are overturning the financial business models of pension funds and insurance companies that must constantly struggle to immunize their long-term liabilities (retirement, long-term disability, nursing home or other long-term care). They do this by financing at a comparable investment horizon with a sufficient yield, so that there would be no interest mismatch or duration conflict. However, now more than US$7 trillion in government bonds (mostly from Europe and Japan)  comes with negative yield, which have caused something of an existential crisis in the global life insurance industry. European regulators have warned that some major insurers may have to be bailed out if the crisis continues, where payout yields continue to outstrip returns in sovereign bonds.

 In the coming weeks we are going to witness more debilitating shocks from the emerging markets, including Saudi Arabia, Venezuela, Turkey, and Brazil. Italian and Greek banks are still fragile. The National Bank of Greece is down 94% this year. In just six weeks, this share has lost almost all of its market value. For many insolvency is just around the corner owing to low oil prices and policy extravaganza. The banking system is in dire need of recapitalization but it is not clear how can this be done? The new "bail-in" rules in Europe mean that senior bondholders and depositors with balances above the guarantee of €100,000 will have to help pay for it, which adds to stress. Of course, North American, and Asian countries will also contribute to various adverse shocks, as the global imbalances and risky balance sheets are interlinked and ubiquitous.

In these circumstances, Italy’s high level of non-performing loans is particularly troubling. Apologists argue that if Italy’s recovery can be sustained they should eventually start to come down, but this is a big if. The fact that over half of the riskiest loans of the country out of €200 billion are covered by special provisions is not particularly helpful. The “bailed in” rules, which have become fully operative for many European countries this year, can trigger a new wave of bankruptcies. As a sign of this many faceted domino effect, it is of note that Goldman Sachs and JP Morgan are now faced with large stakes in Italian oil services company Saipem following their completion of a €3.5 bn (£2.7 bn) share issue with prices that have been falling precipitously.

 The prospect that central banks in Europe and Japan will delve even lower into negative rate territory, and the likelihood that Federal Reserve abandoning its move to normalization are creating further uncertainty and contributing to a more volatile market. It is mind bugling that until now none of the US presidential candidates in the both parties’ presidential debates have not shown even a remote interest on discussing this ominous conditions. Meanwhile, European finance ministers who will meet at the end of February in Shanghai in China have decided to call on the Group of 20 biggest world economies to boost global economic growth. They still do not realize that the culprit is a broken financial structure and as Japan experience has demonstrated no amount of infrastructural investment by itself can create growth.

As we have argued before this crisis is aggravated by global illiquidity arising from sever distortion of credit markets and its incapacitating impacts on supply of bank credit. This illiquidity cannot be expunged unless and until a drastic global restructuring of the enormous global debt overhang is underway. In other words, a comprehensive global strategy is urgently needed which must encompass necessarily a readjustment in valuation of foreign exchange rates based on their purchasing power parity. Furthermore, a drastic overhaul of the operational environment is needed to stop the smothering effects of arbitrarily created rules and regulations that are creating distortionary arbitrage opportunities, moral hazards and adverse selection problems. In this respect, the so-called idiosyncratic tailored approaches would be the most perilous strategy, as no agency can claim to have an in-depth grasp of the various dimensions of the current global imbalances.

What is truly needed is a set of clear principle-based rules that would allow the market mechanisms to do their critical functions of price discovery and determine the efficient allocation of resources. The most important market principle in this approach is the resolution of the Too-Big-to-Fail. TBTF problem. However, a reintroducing of Glass-Steagall separations of businesses without other fundamental restructuring would only exacerbate the impacts of distortions. The main concern is not that banks may lose market share. As, undoubtedly, the “shadow banking” environment is also being affected by the scarcity of liquidity and will be contributing to the severity of the ongoing financial crisis. Other purported policy options such as various macroprudential regulations, “the swap push out rule”, “ring fence” banking activity, and “Volcker rule”, that are supposed to limit or ban TBTF firms’ are also inappropriate in the absence of a comprehensive structural overhaul of the system.

What will trigger the next global bust?

After the first of its eight regularly scheduled meetings for 2016 at the end of January the Fed’s FOMC declared that the U.S. economy lost momentum at the end of 2015. "Economic growth slowed late last year," its statement read, noting that the job market had improved. The positive information about the job market was intended to soften the blow of a disappointing growth. We have seen a similar pattern in the recent press releases of other central banks. It is of note that the February release of the U.S. employment data showed that the January unemployment rate was validating the Fed's median forecast for the long-run sustainable level of unemployment — or "full employment" at 4.9 per cent. But, does unemployment rate measure labor market strength?

As it has been argued before in this forum, the employment growth in the present conditions does not provide any useful information with regard to the vigour of economy, simply because it does not control for the greater reliance of the markets on the contingent labour. In other words, due to the prevailing uncertainty firms are shying away from investment and are aiming to utilize various tactical labour-intensive responses in order to satisfy the increased demand that they do not perceive to be sustainable over the medium to longer run. Thus, they rely on part-time workers to operate with existing machinery and equipment, introduce more overtime if necessary and lease used equipment – in short they are utilizing tactical contingent factors of production instead of investing strategically in productivity enhancing technology. By the same token the January rise in participation rate and wage rate are not reliable indicators of the labour market strength at this juncture.

All in all, the sense of panic in the global markets that has been observed since the start of the year, and was predicted in this blog last year, is well-founded. The world is getting much closer to another painful bust, not because of the slowdown in China and its $10 trillion economy, or the fact that the current so-called “recovery” has lasted for 28 quarters (as compared to the average post WW II of less than 20 quarters) or the current fragility of European and Japanese economies, but because of the global economic fundamentals that are afflicted alarmingly by the destructive effects of very low interest rates, exacerbated by other unconventional monetary policies, including QEs .

An increasing number of countries and regions are having negative rates; including Switzerland (-0.75%), Denmark (-0.65%), Sweden (-0.35%), ECB (-0.3%) and  Japan (-0.1%). Others, including the U.S. and Canada have talked about the possibility of moving toward adopting negative rates if the situation warrants. After fueling the expectations of interest rate hikes, in her latest communiqué Bank of England has shown a dovish inclination, with all nine members of the Monetary Policy Committee voting to keep rates on hold. While the U.K. markets now expect the Bank Rate, at 0.5 per cent for more than six years, to remain fixed until well into 2018. The February 4th Bank of England's quarterly Inflation Report, suggested markets expect a notional rate of 1.1 per cent by the start of 2019, while in November it reported that the market expected 1.1 per cent at the end of 2016, 1.7 per cent by the end of 2017 and 2.3 per cent by the end of 2018. Thus, one cannot rule out a negative interest rate in the UK by the mid-2017. The Bank of Japan that surprised markets by adopting negative interest rates at the end of January 2016, a move aimed at boosting a stumbling economic recovery and warding off deflation has maintained that it would cut rates further into negative territory if it needed to push borrowing costs even lower. It said the policy would continue as long as needed to achieve an inflation target of 2%.

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”.

In his Marjolin lecture, organised by the Deutsche Bundesbank, Frankfurt, on February 4th 2016, Mario Draghi, President of the ECB, touched upon some of the challenges faced by central banks. Perhaps somewhat optimistically he asserted that “Today, more than 60 years [after its inception,] monetary integration in the euro area is both complete and secure.” Be it as it may, he then divided the challenges into two categories; those “that are common to all central banks in advanced economies, which are linked to a global low inflation environment (read ‘ linked to a global anemic growth’)” and those “ that are special to [ECB] in the euro area”. As for the common challenges to all central banks in advanced economies, he formulated the most fundamental question as “can our price stability mandates still be delivered?” This, of course, is a sanitized way to express the concern about ever-increasing probability of the upcoming bust. He went on to say:

And in several of those economies, long-term inflation expectations, based on market prices, remain below our numerical definitions of price stability. That has led some to question whether it makes sense for central banks to pursue expansionary policies to meet their inflation objectives. Are they fighting a futile battle against forces beyond their control?

In other words, translated into a general equilibrium framework, Draghi's explanation may be reformulated to suggest that the economic growth rates in several advanced economies have remained below their equilibrium level, and this has led some to question the effectiveness of monetary policy to close their output gaps. Mr. Draghi then explored three causes of “too low inflation”, or what others have called secular stagnation.

I. The structural factors that cannot be addressed through domestic monetary stimulus. As a result, 2% inflation target is no longer realistic. Somewhat surprisingly, the conclusion from this line of argument according to ECB is that “Central banks should adjust their objectives downwards accordingly”.

It would have been nice if some references were offered for the reader to enable one to explore the logic of this conclusion. A more rational conclusion would be since monetary policy is ineffective to generate growth (and inflation) there is a need for other policies. In any event, Mr. Draghi, refers to Friedman's edict that “inflation is always, ultimately, a monetary phenomenon” and “It could thus always be controlled in the medium-term by a committed monetary authority”. However, this edict is based on two crucial assumptions that are violated in this uncertain times (a) the edict assumes that the level velocity of money remains fixed and (b) the level of potential output also remains unchanged over medium term. However, when due to uncertainty firms operate below their efficient production frontier and use contingent factors of production one cannot assume that the Fisher or Friedman quantity theory of money can still deliver the edict, as both velocity and potential output subside in response to the option price of waiting for uncertainty.

II. The positive global supply shocks eliminates the need for central banks reaction, as they can simply redefine the medium-term horizon and wait for inflation to hit the target.

Mr. Draghi correctly notes that “a succession of supply shocks, such as the steep falls in oil prices we have experienced recently can cause a downward adjustment of inflation expectations if central banks do nothing."  This is because  a positive supply shock would reduce the cost of production and exert downward pressures on inflation. Thus, a policy response in the form of lowering of interest rate and the resulting exchange rate depreciation would stimulate the aggregate demand, causing inflation to get back toward its target level and allowing the interest rate to return to its natural Wicksellian level, as well the exchange rate would return to its equilibrium PPP levels gradually.

However, Mr. Draghi discounts the argument that “central banks fighting disinflation are inhibited by the lower bound on interest rates”.

We now have plenty of evidence that, if we have the will to meet our objective, we have the instruments. As the ECB and others have demonstrated, the lower bound for policy rates, wherever it might be, is not at zero. And we have also shown how non-standard tools can be used to deliver monetary stimulus even without altering much the overnight rate, and produce equivalent effects. For example, the non-standard measures the ECB has taken since summer 2014 have produced a pass-through equivalent to a 100 basis point rate cut in “normal” conditions.

On this issue, of course, the jury is still out and it would be too soon to celebrate under a “mission accomplished” banner. These are not normal times when central banks credibility would allow them to stabilize a volatile situation, particularly when the volatility is caused by their own action. The fact that QEs have become successively less effective is a clear sign of the restraining impacts of a lower bound. Another sign is the slope of term structure of interest rates. The slope changes when longer-term interest rates do not respond to changes in the policy rate. The central banks’ balance sheets have become far too inflated for them to act as credible provider of contingent funds in central counterparty clearing mechanisms in these abnormal times. This adds to uncertainty and inhibits capital formation, which are direct consequences of the lower bound. The purging of the central banks QE-contaminated balance sheets would not be that easy, and their longer-term adverse impacts on finance are gradually but surely appearing on the medium-term horizon. In particular, the devastating impacts of these policies would exert themselves during the upcoming bust sometime over the next two years. Of course, a bust can be triggered much sooner for instance by a geopolitical shock, rising unrest by the unemployed European youth, or a natural disaster.

III. Central banks do more harm than good. “In particular, expansionary monetary policies at home lead to the accumulation of excessive foreign currency debt or asset price bubbles abroad, especially in emerging markets. And when these financial imbalances eventually unwind, it weakens global growth and only adds to global disinflation”. These imbalances are, of course, part of the concerns in this blog too. In addition to distortions created in emerging markets we are also worried about the sectoral distortions of these policies on domestic economies. Low interest rates are fueling housing bubbles, and hampering the investment in productivity growth.

In response to these concerns Mr. Draghi asks:

what would be the alternative? Would it help emerging markets if advanced economy central banks failed on their mandates? Would that be more likely to contribute to global growth? Clearly, the answer is no. The stability of large economies is vital to their trading partners and to the global economy, and diverting monetary policy away from that aim when our economies are still fragile would not be in their interest.

The problem is that there is no evidence that these policies have been contributing to stability or to a sustainable global growth. The systemic risk has been elevated stemming from a false sense of security, manufactured by central banks, that has given rise to moral hazards and adverse selection risk. However, the markets are not stupid and recent volatility is a clear indicator of such anxieties. The markets are waiting for a trigger to signal makets' bust and this time around no QEs will be capable of providing any help. We have suggested a way out of this predicament in our previous posts, based on Gustav Cassel recommendations of 1937 Brussels conference. That would be the alternative policy.

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.