Global economic growth has clearly borne the brunt of US-China trade war but remains in positive territory. Why then such accommodative central bank policies? In the US, political pressures to avert a recession are rife, with the next Presidential election only a year away. In Europe, not only has the banking sector’s backlog of non-performing loans (dating back to the 2008-2009 financial crisis) not been sufficiently addressed, but low interest expenses are also necessary for highly indebted governments to be able to maintain their social welfare programs.
In effect, low/negative rates mean that policymakers are no longer sanctioned by financial markets for running deficits and not putting their debt house in order. President Trump has for instance been able to increase the US budget deficit to USD 1,000 billion (near 5% of GDP), without even delivering on his infrastructure spending promises. Instead, military expenditures have been lifted and tax breaks granted to higher-income bracket households.
But while cheap money is keeping the economy – and financial markets – humming, it does produce some nasty side-effects. We have previously discussed how social inequalities are widening and the process of creative destruction is being distorted. Now also coming to light, particularly in Europe because of the large fixed income allocation, is the impact on pension schemes. Roughly-speaking, when a worker retires after 45 years of paying into a pension fund, two-thirds of his end capital are attributable to compound interest. As long-held bonds mature and have to be replaced by new issues that yield next to nothing, this compound interest component is fast vanishing – threatening to slash retirement income. In countries like Holland, with such a pension system, this is understandably starting to cause much angst, to the point of questioning whether taxpayer money should be used to prop up pension funds, such that retirement “promises” can be fulfilled.
At first glance, Belgian citizens seem better off with their pension system being one of full distribution – meaning that the contributions of today’s workers are used to pay the pensions of today’s retirees (rather than accumulate capital to fund the pensions of tomorrow’s retirees) – but it is also headed for financial troubles, especially as the cohort of baby boomers moves into retirement.
Either way, persistent unconventional monetary policies are setting the stage for a generational conflict on the pension front. For now, though, our recommendation to investors is unchanged: prefer (asset-backed) equities over bonds – to the extent that the former offer the possibility of protecting purchasing power whilst the latter involve a foreseeable loss of capital. Indeed, with the monetary spigot now again wide open, liquidity will continue to flow to risky assets in a desperate search for yield, quite regardless of valuation. Gold holdings should, however, be maintained – as a hedge against episodes of volatility and also a protection against the longer-term inflationary dangers posed by this monetary “experiment”.
Modern Monetary Theory is (Almost) Here
Source : BCE, Bloomberg
Monetary policy used to be a matter of adjusting interest rates up and down, such that the economy be kept near (growth and inflation) equilibrium – with accidents nonetheless occurring every now and then. That central banks make systematic use of their monetary base to manage the economy (not to mention political expectations) is a new development.
The next stage in this “experiment”, and starting to attract increasing attention, bears the name of Modern Monetary Theory (MMT). In short, this theory endorses unlimited money creation to finance government spending. Large deficits pose no problem, says MMT, since a government cannot be brought to default on debt issued in its own currency. Its partner – the central bank – can always be relied on to print more money.
As the capitalistic system of the past few decades reaches its limits, with “ordinary” workers struggling to cover their basic needs (whose prices, incidentally, are rising much faster than official overall inflation figures indicate), populist parties are gaining traction across the globe – and people even taking to the streets in some countries. Faced with this discontent, as well as the looming pension fund and climate change issues, governments have little answer but to spend more. That said, rather than making radical changes to the tax system, they are preferring to finance this spending via ever larger budget deficits, adding to an already huge debt load. And to this effect, they are “co-opting” the central banks.
The process started in Japan when Prime Minister Abe was elected in 2012 and promptly put very public pressure on the Bank of Japan to ease the monetary stance. Its then-governor left office prematurely, enabling Abe to appoint Kuroda to the job – who has since dutifully pursued a very accommodative policy.
In the US, President Trump is openly and regularly expressing his discontent at how Powell, his very own nominee to head the Federal Reserve, is managing monetary policy. For how long the US central bank will be able to maintain its independence is a legitimate question. Indeed, the latest rate cuts were perhaps not truly necessary from an economic perspective.
Closer to us, Ms Lagarde has just taken over from Draghi as President of the European Central Bank. Like Powell, she is not an economist by training. And her first words in her new function were to urge governments to up their spending… A mantra that even Germany might find difficult to resist, particularly given its present, relatively weak, political and economic situation.