What's Wrong, Such That 'Stimulus' Just Isn't Working?

What's Wrong, Such That 'Stimulus' Just Isn't Working?
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You could practically hear the popping of champagne corks, a uniform echo of celebration for the completion of a long journey.  All across the developed world last month, inflation finally registered 2%, the very threshold that almost every monetary policy regime has come to define as stable prices.  Below that level suggests concern, a high degree of economic risk about the fomenting of deflation and potential for the worst case.  That was where the world had been for years prior to February 2017.

It was an enormous problem for central bankers, if not quite for consumers.  Central banks have explicitly targeted 2% inflation, including in Japan since the start of QQE in 2013, meaning they promise to use all their collective and individual tools in order to achieve that level in a sustained fashion; not just for a single month or several months here and there.  In the United States, the PCE Deflator had not registered 2% since April 2012, a record of futility that stretches very nearly 5 years (and in all likelihood was finally breached in February, though that particular statistic isn’t yet released). In Europe, the HICP rate for the EU had been below 2% continuously for 48 months dating back to January 2013.

These were, and remain, considerable problems for monetary policy.  It’s not as if the central banks in these locations were idle during those many years; far from it.  It was within that very timeframe where both the Fed and ECB experimented with by far the largest monetary programs in history.  We can add the Bank of Japan into that mix, as well, where the Q’s in QQE are threatening to mean quadrillion.  Despite all of that, outside of a temporary burst in Japan in 2014, related far more to the tax hike than QQE, inflation bears absolutely no resemblance to balance sheet expansion.  None.

Oil prices, by virtue of nothing more than being up off the bottom, have accomplished what no central bank ever could and in the one area where money and monetary policy are supposed to matter the utmost.  At around $52 to $54 a barrel during February, oil prices were sharply higher than in the year ago period where they sat at their lowest point in a very, very long time.  Unless the price of crude continues to rise, however, the developed world’s flirtation with 2% will be embarrassingly (for policymakers, not consumers) brief all over again. 

With either WTI or Brent lower in March than February, and to significant degree, the bloom is already off the monetary policy rose.  The first figures for March inflation from Germany have already crested and are starting back lower (deceleration).  The rate of 2.2% hailed in February is replaced by a much sharper than anticipated drop in the latest update, just 1.5%.  Overall European inflation will surely be less than 2% in March given Germany’s disappointment to the mainstream (as of this writing Eurostat’s HICP estimates have not been released yet).

Germany’s consumer prices were not expected to slow so sharply because by and large econometric models still assume that QE works. The Financial Times yesterday wrote, “German inflation has fallen dramatically, easing pressure on Mario Draghi, European Central Bank president, to rein in ultra loose monetary policy in the eurozone.”  The article does not note nor apparently take into account the obvious grand contradiction contained just in that one sentence. After four years of “ultra loose” it is oil alone that delivers, and then takes away, 2% inflation.  The term has clearly lost all meaning in this context.

And in Europe, unlike the US, the ECB is through its constituent NCB’s still buying bonds as well as all sorts of other things. It affords us yet another opportunity to test monetary assumptions by way of something like a control group.  On that side of the Atlantic, QE is on; over here, QE is not only off but has been off for more than two years with the Federal Reserve now three times into “raising rates.”  

Despite those seemingly drastic monetary policy differences, what will be proved by inflation in both places is that monetary policies don’t matter at all.  Again, it is oil prices that provide all the marginal direction for HICP in the EU and its member nations as well as the PCE Deflator here, or the CPI versions in Europe and the United States as well as Japan.  QE is a total and complete failure everywhere, more so because inflation and inflation expectations were the primary channels through which it was believed the numerable instances of them would work. If it can’t move the needle even marginally on inflation then it can’t be money printing no matter how many times it might be uncritically described that way in the mainstream.

The interjection of oil prices instead demonstrates the real global impetus when it comes to both money and economy. Crude is the hyper-intersection between them, where money meets physical fundamentals.  In the oil price crash over the past few years, both money and fundamentals have been squarely on the same side, aligned perfectly against central banks and their misguided expectations and interpretations. In short, it is the “dollar” that rules, not central bankers.

This is no surprise at all, though it will come as one.  Despite that oil prices are up sharply from last year, they remain down even more so from the peak.  It is a trend that we find commonly in the global economy dating back to 2007.  It falls off, comes back only part way, only to fall off, “unexpectedly”, all over again.  The downturns have each been preceded by “dollar” events, easily thwarting whatever monetary policies have been constructed in response to them. 

The Organization for Economic Co-operation and Development (OECD) estimated that global trade hit a new record high last year.  By their figures, total trade added up to just more than $22.8 trillion, $4.6 trillion above than the “cyclical” peak recorded for 2008. But that raw comparison is highly misleading, as are any number of other related and unrelated economic statistics.  “Record high” tells us absolutely nothing, just as briefly hitting a 2% inflation target is an empty result. 

Total world trade since 2013, meaning the three years of 2014, 2015, and 2016, was up just 8.5% (total, not per year) though at that record high level.  In 2007 alone, despite that year falling under the initial conditions for what would become a globally synchronized Great “Recession”, trade grew by almost 8%.  Had that event actually been a recession, global trade growing in full recovery at its uninterrupted baseline rate would have been around $32 trillion in 2016, not less than $23 trillion.  It’s an enormous difference, and begins to explain why oil prices and not central bank balance sheet expansion is setting inflation rates. 

By some counts, the economic retrenchment was worse than a broken growth trajectory.  The WTO estimates that merchandise exports contracted by more than 10% between 2011 and 2015, with a good deal of that decline due to commodity prices – again the “dollar” and its textbook deflationary condition.  As the Wall Street Journal reported yesterday:

“Annual movement of capital across borders -- in the form of stock and bond purchases, foreign direct investment and lending -- fell more than two-thirds, to $3.3 trillion in 2015 from $11.9 trillion in 2007, according to McKinsey & Co. Overseas bank lending, particularly from Europe, has been hard hit. The stock of cross-border loans held at banks around the world contracted 21%, from $35.5 trillion in 2008 to $28.2 trillion in the third quarter of 2016, according to the Bank for International Settlements.”

The global economic “miracles” of the late 1990’s and middle 2000’s were all built on cross-border lending and monetary flow.  Their absence is the dominant economic setting, before 2007 nowhere but up and now no other direction than down.  The eurodollar system is poorly understood if so often ignored, but it is essential as a completely parallel global banking system where at root is the monetary capacity provided by offshore virtual currency.  There are no dollars there, no physical Federal Reserve Notes or certificates of any other kind, and there surely isn’t any gold or hard money equivalent.

There are only bank balance sheet perceptions, which is why calling it a currency is in some ways a mistake.  It is merely a system of agreed upon standards and protocols whereby one form of bank liability is accepted in monetary fashion by another bank (usually in trade of liabilities).  So long as whatever new kinds and formats of liabilities these banks could cook up were generally accepted among most if not all banks, that, too, became “money”, largely “dollars.” 

It has been the background “field” behind everything, the credit-based system that to the mainstream doesn’t exist.  Money in the conventional sense is what central banks do.  Yet, here we are all over again with unequivocal evidence that they don’t. 

This point doesn’t register because Economics is not a science; it is instead a closed ideology. The world economically spun far off its axis and now threatens more than just further economic deficiency.  The political and social instability now building and breaking out is the body politic realizing the symptoms of what Economists refuse to. And because of that, these opinion-makers are attempting to form an intellectual defensive line on Adam Smith and David Ricardo.

It was those two men who did the most to establish trade as the basis for social advance, particularly Ricardo.  With it being settled doctrine for two centuries, free trade according to Economists must be observed on all occasions; meaning conversely anything that gets in the way of free trade being an economic drag or worse.  When Ross Perot, for example, famously debated Al Gore just days before Congress voted on NAFTA in November 1993, Vice President Gore smeared Perot with Smoot-Hawley, the 1930 Tariff Act that supposedly aided the downward force of the already considerable Great Depression.  The message was thus established, and over the years reinforced: stand against “free trade” and be tarred with the histrionics of 1930’s comparisons.

Again, it is an ideology rather than a science, for you can’t even argue that the last three or four decades fell outside the realm of free trade to begin with. The word itself, trade, defines an exchange.  The trade over especially the past few decades with and from the United States has been anything but the exchange of goods theorized in Ricardo’s definitions.  It has become instead where overseas economies, particularly China, send us goods and this country sends back some form of eurodollar liability (which includes the global offshore storage of US Treasury securities and other government obligations like agency paper). 

It was none other than Ben Bernanke who in 2005 publicized this grand deviation, calculating for his audience in St. Louis:

“The table confirms the sharp increase in the U.S. current account deficit, about $410 billion between 1996 and 2003. (Data from the first three quarters of 2004 imply that the current account deficit rose last year by an additional $140 billion at an annual rate.) In principle, the current account positions of the world’s nations should sum to zero (although, in practice, data collection problems lead to a large statistical discrepancy, shown in the last row of table 1). The $410 billion increase in the U.S. current account deficit between 1996 and 2003 must therefore have been matched by a shift toward surplus of equal magnitude in other countries.”

He makes here a philosophical mistake of dogma. By assuming the tenets of orthodox economics where the US current account discrepancy “must therefore have been matched by a shift toward surplus of equal magnitude in other countries”, he then hypothesized a “global savings glut” to finance it all. In his view, it was a form of vendor credit deposited on account largely with US banks in the form of US government debt.  That would then nicely relate to Alan Greenspan’s “conundrum.”

Ironically, that isn’t far from the truth, but with one important exception – those dollars, really “dollars”, financing the one-way merchandise flow were not foreign savings because those nations, too, were borrowing heavily at the same time.  The difference was actually quite simple, where central banks in each of those countries, particularly the PBOC, was interrupting the flow of eurodollars onshore in order to provide idiosyncratic monetary and currency policies (whether the currency was pegged or floating, as in the case of China which featured both).  It was largely the official sector that recycled some of that eurodollar flow, often mistakenly called “hot money”, back here into holdings of US government debt.   

What happens if that flow is interrupted at its source? 

We know without a doubt that it had been, and not just via official inflation figures that fail to respond to any monetary policies.  The banks themselves report nothing but declines in capacity if not outright balance sheet contraction.  The quarterly financial filings confirm the shrinking in hard number fashion.  From JP Morgan to Morgan Stanley, Credit Suisse to Deutsche Bank, HSBC and beyond, the global supply of capacity has dwindled.  Thus, the words credit-based become everything; if you realize what that means, the global depression is the expected result; if you don’t, you spend a decade thinking you are “printing money” and being surprised when you can’t find a single trace of it anywhere (apart from stocks, of course, where prices now completely divorced from earnings continue only to anticipate at some far off date that it will all just work). 

In economic terms, if the system is as I describe above, where the flow and the ease of distribution of “dollars” are the central point forming the basis of not Ricardian free trade but eurodollar-driven global commerce, an interruption in eurodollars would necessarily lead to an interruption in trade everywhere.  There would be no other alternative except where some other form of international money might take its place.  With central banks stuck in 1950’s era assumptions about money, that just wasn’t going to happen.  It’s a distinction that solves all these supposed riddles.

I wrote a few days ago:

“It was only (seemingly) stable so long as both parts worked – rapid monetary growth had to finance consumption in the DM end markets as well as construction and investment in the EM production capacities. Taking away first the finance of consumption left the entire global system unable to function – and economists to calculate the resulting lack of recovery as the low R* they set today.”

That is what is so frustrating now, where after ten years of resisting, claiming that the Great “Recession” was a recession and therefore QE’s were appropriate demand side responses to ensure the cyclical recovery, Economists, including central bankers, have finally surrendered on that point.  The low R*, denoting their idea of a natural rate of interest, is actually the econometric way of being forced into accepting one half of reality.

“R* is just the plugline or balancing factor that attempts to make sense of why neither ultra-low interest rates after the dot-com recession nor QE in the aftermath of the Great “Recession” worked as they 'should' have. For policymakers, policy rates went low and lower but since no great recovery resulted, especially from the QE’s, it is merely asserted that R* must have been that much lower still...If “real” policy rates had been pushed down to -10%, the still lack of recovery would have left Fed officials claiming R* surely was -10.01%.”

An Economist would look at those results and come to the conclusion that there must be something wrong with the economy making it impervious to so much “stimulus.” A reasonable, open minded person would instead suggest there was something wrong with monetary policy. 

We are at the point now in economics similar to where quantum physics was in the early 1960’s.  What is now called the Higgs field was theorized because without it all the math, theories, and observations just couldn’t equalize or coalesce into a consistent whole theorem (the Standard Model).  Though it was highly controversial to try and introduce a brand new fundamental component to the universe where none was thought existing before, all the calculations and logic kept pointing in that one direction even though first the Higgs field and then the particle that was later theorized to carry it, the Higgs boson, was neither observed nor confirmed.

It all changed, of course, in 2012 when the Large Hadron Collider at CERN finally established the existence of the Higgs boson using high enough energy collisions so as to induce its unthinkably brief appearance. By then, however, the Higgs had already been widely accepted as reality, leaving only the confirmation left to be done. 

The Panic of 2008 and its aftermath are similar in so many ways to such physics experiments.  It was a high energy monetary event with enough overall “force” to break apart what before had seemed to be a monolithic and smooth monetary system, where the central bank sat at its center.  In those “collisions” we found instead proof of the strange new world of wholesale money, dominated by “shadow” conduits and participants, the new monetary particles, so to speak, of the financial world as it actually existed apart from conventional theory.  The aftermath of it has been but the further proof and establishment of the eurodollar as the missing piece, both in function as well as theory.

How do we reconcile, for one example, HSBC’s balance sheet with European, American, and Japanese inflation drawn by oil rather than “money printing” and the growing backlash against globalization (not free trade)?  There is only one common element.  

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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