The Central Banks' Monetary Policy Is Backfiring (w/ Simon White)
SIMON WHITE: My name is Simon White. I'm co-founder of Variant Perception which is a macro-economic research company. Our aim is to look for leading economic relationships so that we can find actionable trading ideas. Really what we're trying to get away from is a Guru approach to economic research so we're very data driven, and we're agnostic. We try and come up with a repeatable and resilient processes so that our clients can understand the process and so therefore, it's something they can understand for themselves and also, at the end of the day trust. The current monetary policy is failing for a number of reasons. We've been in this situation since the Great Financial Crisis. We've had so-called unconventional monetary policy, and we've had lower and lower rates. We've had zero rates, we've had negative rates, and we've also had large scale asset programs, quantitative easing. They really haven't worked and the reason is, is the fundamental issue here is the private sector is desire to run a saving surplus. The private sector since the Great Financial Crisis has been running a saving surplus. Now, there may be a number of reasons for that, I'd say foremost, might be the fact that the financial crisis was so severe, it basically created such an effect on these companies. They're still licking their wounds and still trying to rebuild their balance sheets. Monetary policy is really there to try and if you like, persuade these companies to try and reduce their savings surpluses, and that is what it's not been able to do. You take lower rates, that's basically not worked for three main reasons, I would say. The first of all, is what's called the income substitution effect. The closer you get to the zero bound, when you have a sector that desires to save, that means that they have to essentially save more and more to maintain the same level of income. It starts becoming counterproductive. The second thing is the wealth effect, you're seeing greater wealth concentration across the world. Again, you can speculate some of the reasons. You might say that, for instance, you look at the tech companies takes fewer and fewer people to create a lot more capital than it used to. You could also blame monetary policy itself, QE, for the rise in wealth inequality. That means the pervasive impact of lowering rates is much less effective than it once was. The third reason, and this is the one that's obviously invoked quite a lot today, is negative rate. They, if anything, are deflationary. The main reason is, is because of the impact they have on banks. Banks under a conventional monetary policy are the, if you like, the transmission mechanism. They are the things that you supposed to transmit monetary policy. But when you have negative rates because banks are loathed to cut rates to negative on retail depositors, their net interest margins are getting squeezed, and they're getting squeezed further and further. That means ultimately they have lower profits, they have less retained earnings. Then that means that ultimately they can lend less so the whole thing starts to become counterproductive. In fact, there was a good piece of research from the University of Bath recently and they looked at 7,500 banks across 30 OECD countries, banks have been impacted by a negative interest rates policy and over the period of negative interest rates, on average, their net interest margins fell by 16% and the return on assets fell by 3%. It's clear that these policies not only aren't working, they're becoming counterproductive. You take QE, the only main policy that we've seen since the Great Financial Crisis, now, that's also been ineffectual in trying to persuade the private sector to reduce its saving surplus. All it's really done is caused the private sector to change the composition of its savings. The central bank buys government debt, it bids up government debt. The private sector basically exchanges one savings vehicle, which is government debt for another savings vehicle, which is reserves. The overall level of savings remains the same, but the composition changes. As I mentioned earlier, you have the political toxicity effect from QE because it's probably adding to a huge amount of wealth inequality. It's quite clear from these reasons that monetary policy, current monetary policy isn't working. That leads us down the path of if current policy isn't working, what are some of the alternatives? Now, the one that's very much involved right now is MMT, everyone's talking about that, stands for modern monetary theory. It's as old as the hills really, it's nothing more than good old-fashioned monetary financing. In a nutshell, really, it's just them central bank financing of government deficits, that's all really MMT is. Now, governments can fund themselves in two ways. They can do so through taxation and they can do so through borrowing. Under MMT, the government is supposed to essentially borrow without limits. Don't pay attention to your deficits or your debt or anything like that until you reach full employment. That's the point where you're supposed to stop. Taxation just really takes the place of what conventional monetary policy there before. Taxation is really there to basically simulate or dampen the economy and to redistribute income. The only really overall constraint of MMT is basically what are the productive limits of the economy? You're supposed to stop when the economy is at the level where if you start to produce anymore, it becomes inflationary. That's the big question, does anyone know when that point is? MMT and QE are very different beasts. QE creates the supply of money but crucially, it doesn't create the demand. It doesn't create the demand for that money. What you end up with is lots of reserves sloshing around the system, but not really having any impact on the real economy. MMT is very different. It creates the supply of money, but it also creates the demand through the government purchases of goods and services. Just because QE is not inflation rate, that doesn't mean to say-- and by that of course I mean it doesn't create consumer inflation, of course, it creates a lot of asset price inflation. Just because QE has not been inflationary, people shouldn't be lulled into a false sense of security that MMT also won't be inflationary. Now, I think MMT will be very inflationary. Why is that? Well, there's three main reasons I would say. First of all, under MMT, they say that deficits don't matter. It's also said that debt, total debt doesn't matter and the government, as I mentioned earlier, is supposed to know when to stop stimulating, at that point when you reach full unemployment-- or full employment, sorry. Taking the last part first, is it possible for anyone to know where that point is? I would argue no, ex ante, to know when an economy is going to hit full employment. Even if you did catch the right moment, it's very difficult. You have a little bit of inflation, but inflation is like toothpaste. Once it's out the tube, it's much harder to put back in. I would also argue that the last person you want trying to make that decision is the government. Central bank independence was all about trying to take this away from governments. Governments have an inherent inflationary bias. Their main aim is to essentially win elections. How do they win elections? They do that by buying votes. They buy votes by essentially spending money on sections of the electorate. How do they pay for that? Well, they'd rather not tax because that might lose them votes on the other side, so they borrow. They have the situation where they tend to borrow seemingly without limit and don't pay attention to the deficits. They're inherently inflationary actors, if you like. I think that's going to be very difficult. When you look at deficits, deficits are supposed to matter of course, but when your deficit is too big, that seems to give some impression that the government's spending too much and you're going to end up hitting inflation. MMT says this doesn't matter but if you look at basically the composition of debt, most countries like the US, for instance, a third of outstanding USTs owned by the foreign sector. The foreign sector will pay attention to the fact that you're running massive budget deficits. Then people might say, "Well, look at Japan." Japan's already down that route. Well, the big difference there is the Fed owns only like 11% of outstanding debts. We're a long way off that point. Even in Japan, the BOJ owns 50% of JJBs. Even then, we're a long way off from the fact where you can say that deficits don't actually matter. Then the final point, I think this is very important is debt, the total debt, or debt to GDP also ultimately matters and you need to find out about this, you look to Reinhart and Rogoff, great book, This Time, It's Different. They looked at financial crises going back to like two centuries and what they discovered is that when your debt to GDP ratio goes above 90%, you tend to get higher interest rates. The response to that from someone who's maybe an MMT supporter might then be well, why would you ever default in your debt if you just owe it to yourself? Like if the central bank is facilitating this borrowing, why would you ever default? Well, the response to that then if you look at the history again in what Reinhart and Rogoff have written, you do get domestic defaults. They do happen. There's been three or four in the last 20 years. You've had Jamaica has done it twice. You've had Estonia in late '90s. You've also had Argentina in 2001. They do happen and also, what they point out in their book is that inflation in the run up to domestic default is much, much higher than the run up to an external default. You have a number of reasons to suggest that what is considered not to matter, does matter. What are some concrete examples? I'd say the 20th century is littered with examples of inflation. A fantastic book that we've recommended to our clients is called Monetary Regimes and Inflation by a guy called Peter Bernholz, who's a professor at the University of Berlin in Switzerland. What he does is he examines all the main high and hyperinflations of the 20th century and try to look for what he considered to be similar characters within them. What he'd noticed was every one of them was preceded by central bank financing of large government deficits. Specifically, what he noticed is when the budget deficit exceeds 40% of government expenditures, and the central bank is monetizing this, in every situation where this happened, it led to a high or hyperinflationary episode. The interesting case today is Japan. Japan is probably furthest along the path of like the major economies that's closest to going down to MMT like policies. An interesting about Japan is everyone thinks they hold it up as a reason for not to worry about MMT because Japan has never had inflation. If you look under the hood, Japan has actually been sailing very close to the inflationary wind. Back in 2012 to 2015, they were running a budget deficit that was over 40% of expenditures, maybe just a smidgen above, but crucially, it was above. At that point, they weren't really monetizing many of these expenditures. Then the monetization started to rise later on in the decade, but the budget deficit ratio, the ratio of expenditures start to fall again. Although it looked like they got away with it, if you look under the surface, they were actually sailing very close to the inflationary wind. That's why I think Japan is going to be the place to watch. It's going to be like the canary in the coal mine to see if and when MMT policies go too far. I think you can have a situation where, obviously, if everybody's trying to do the same policies, and that will obviously mute the impact. I think it'll probably happen in stages. This is very difficult to speculate in this stuff so longer term. I certainly think Japan's at the front of the queue. I think there, you will find them pushing the situation further than other countries but it's clearly the path that places like Eurozone and America are wanting to take. They want to go down that path. I think what will happen is it'll be a progressive series of currency collapse, but I also think that when someone has seen what happens to Japan, there may obviously be a reaction to that. There might be some rolling back. The thing is, what do you then do? If you've already hit the limits of conventional monetary policy, you're going back to fiscal policy or central bank enabled fiscal policy, what's the alternative after that? It might just be a case of they try and rein it in a little bit more but clearly, the risk is that the problem is with MMT, is that the people in charge of that policy are not the ones that are the best able to know when to not to push that policy too far. That's why you can end up with these inflationary episodes. I think it's something that happens, say you go from the disinflationary episode which causes the behavior of the central actors, central banks, governments to become more inflationary. You take Japan as an example. I think that the ultimate endgame in Japan is very high inflation, as I say, the way that the policies that they're doing but how do you get there? The way I think about it is like the road to hyperinflation is paved with deflation. What will probably happen is that we have a very deflationary episode in Japan, one that's extremely bad that pushes their currency extremely strongly. The dollar/yen falls a great deal. They have a very, very major slowdown in their economy and that essentially causes them to take a full caution to the wind and ease on a scale that they've never used before. I think you have to see that disinflation and deflation before you get to that inflation, but arguably, we're already there. Even in the whole Western world, we've obviously talked about sector stagnation. Sector stagnation really is harking back to what we're saying earlier. That's that private sector is not willing to draw down a surplus. Japan has been in that situation since the late '80s. They had their crisis in the late '80s, the early '90s. The corporate sector is still running this huge surplus. The fundamental reasons are there, sector stagnation and low inflation. You may not even need to see a severe deflationary episode. Already, the wheels are turning that people realize that this isn't enough. The structural limits of conventional monetary policy have been reached and the central banks are now just throwing their arms up almost in despair. They're saying, "We need help, because we cannot fix the productivity. We cannot fix the structural high unemployment." We're already running along that path. What's the implications to markets for these policies? Well, I think that it's going to turn a lot of things on its head but I see three main structural themes from the shift away from conventional monetary policy towards MMT like policies. Just to make something clear, this isn't going to happen overnight and we're not going to hit full MMT overnight. There's a clear progression towards the policies. The three main structural changes I foresee is the long boom in financial assets versus real assets. I think it will come to an end and real assets will begin to outperform financial assets. I think cross-asset volatility will begin to rise on average, and I think we'll see more frequent bursts higher in volatility and also I see because the tail risks are shifting from lower inflation to higher inflation and that means that the risk of higher short term rates will be higher. That makes leverage a much more of a dangerous game. When it comes to financial assets, why are they going to begin to underperform? Well, you look back to the '70s, '70s is a great poster child for long term high inflation that was pockmarked with double digit inflation and stagnating growth. You look at which assets performed the best, which asset classes performed the best and the worst, best performing assets were commodities, and the worst were equities. In fact, the only asset that actually gave you a positive real return in that decade was commodities. Equities on the other hand became like a shunned asset. Very simplistically speaking, if you think about an equity as an infinite maturity bond, you had the higher rates to deal with inflation, the present value of these things just got absolutely decimated. Nobody wants to hold them. Even though in price terms, the market bottomed in 1974 in equities, PEs didn't actually bottom until the early '80s. They really were not an asset that people wanted to hold collectively speaking. Within equities, there was actually some quite interesting trends. The equity sectors, they're the best, were the ones that either owned real assets or benefited from real assets, so energies and industrials, they're the best in that decade, they were the best performing sector. At the other end of the scale, you had the banks. The banks really struggled. Banks are nominal machines. They borrow short term, and they lend long term. They are in a very difficult environment in rising rate environment. It makes sense, going forward, banks have benefited from this low rate environment where they're able to provide leverage to boost financial assets. If these things go into reverse, the whole business model of banks is going to be challenged. They're going to find life much more difficult unless they overhaul their business model. Another very important theme here is the traditional portfolio construction. I think that's going to come under immense pressure. You have risk parity, or you have the traditional 60/40, which is risk parity like, they've benefited for years from the negative correlation of stocks and bonds. That's not really the normal state of affairs. Over the last hundred years, 70% of the time, that correlation has been positive. What you notice is that as rates go higher, inflation heads higher, and that's what you gradually expect to see under MMT, that correlation reverts back to positive and that whole concept where you're benefiting from the diversification effects, doesn't exist anymore. That has great changes for the markets too, because the 60/40 thing, that's been a major volatility dampener for the markets along with risk parity. Whenever volatility falls, they essentially have to buy more assets to rebalance. This is self-fulfilling effect. These guys are essentially short vol and they're short stock bond correlation. As these things reverse, you expect all these things to begin to go higher. Really challenging what people's general view of markets have been for the last 30 or 40 years. Banks are going to struggle because of this tail risk essentially shifting, because in the last 30 or 40 years, you could basically rely on the fact that although rates might go higher, the general trend was lower, we just had a series of lower lows. In an environment where the tail risks shift to higher inflation, the risk is always going to be we're going to have bursts higher in shorter term rates. That, I think, makes the bank business model extremely difficult because not only is it difficult for them, as I say, they're borrowing short term assets, essentially, they're borrowing in the shorter term period, and lending longer term. They also provide leverage to other people and if there's less demand for leverage, they're really unable to provide that in the same way that they would like to. The whole last 30 or 40 years, if you like, the dominating times of banking will be very difficult under those circumstances. It's really about not about what instantly happens as they-- I don't think it instantly get higher inflation, or instantly see shorter term rates rise, but the risk profile will change and it will really challenge that business model. These structural changes are very difficult to really get a handle on when they're going to happen because they tend to go through their regime shifts. They don't go smoothly from one version of itself to another version of it, it happens quite suddenly. It happens in the way that Ernest Hemingway talks about how one goes bankrupt, how'd it happened? First, gradually, then suddenly, and the rise to inflation will be like that, too. Inflation doesn't go smoothly from 2% to 4% to 6%, it goes 2% to 4% to 10% to 15%. It's actually a very difficult thing to get a finger on but one thing I would look to, I think, will give you some, at least mild degree of heads up, where we're seeing a beginning of change in this environment would be a rise in monetary velocities. I begin to see that would start to pick up in advance of any of these structural changes. When it comes to gold, obviously, we're seeing interesting moves today. I think that's based on-- rather than we're trying to early factor in MMT like policies, it doesn't really need that. That will obviously help gold I think in the longer term because its role as an inflation hedge, it's certainly something you want to consider having in your portfolio. I think what's boosted it most recently, certainly in the last few months, has been the shift to more negative rates. You can almost see an uncanny relationship between the price of gold and the outstanding amount of negative yielding debt in the world. We've seen that negative yielding debt skyrocket and along with it, the price of gold. I think gold is trying to straddle two things right now, as I say, the negative yielding aspect of things because obviously, relatively speaking, gold now has positive carry. A lot of people who shunned it now are looking at as a serious alternative, a serious way to hold some of their investments but the longer term picture is intact as well because certainly in an MMT world, with these tail risks and inflation being higher than gold and other precious metals, it makes a lot of sense to hold them. Expect to see real assets beginning to outperform financial assets. I expect to see cross asset volatility rising on average, and more frequent bursts higher in volatility. I expect to see the whole 60/40 portfolio risk parity model challenged as it no longer offers diversification benefits. Really, financial markets are like history. It has eras, and we're really going from one era and we're transitioning to the next right now.