Global Economy Moved Past Sputtering, and Into Downturn

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The bad economic news has spread, its pace quickening. China reported its worst quarterly growth in decades. Trade is contracting. Germany’s industry is declining at a rate not seen since Europe’s last recession. Even Canada is leading the way forward, meaning downward, reporting retail sales growth that for two months in a row wasn’t growth.

The global economy moved right past sputtering and into downturn. That view has been reinforced this week. IHS Markit reports sobering flash PMI’s across the world. Manufacturing in Japan fell to 50 this month, “ending longest expansionary run for over a decade.” And that’s just where we start.

You could try to blame the Yellow Vests for France’s composite at just 48.7 in January 2019, a 50-month low, but they sure don’t explain Germany’s manufacturing index at 49.9, also the lowest in 50 months. For Europe as a whole, Markit says economic sentiment (both manufacturing and services) is down to a level not seen in five and a half years.

For Mario Draghi, none of this seems to matter. Europe’s central bank is committed to the end of QE and after a short while more raising interest rates. Recalcitrant central bankers in the face of obvious economic weakness, this is a familiar story.

And it has brought about growing criticisms from all quarters. President Donald Trump’s low-simmering feud with Jay Powell of the Federal Reserve is only the most public.

At the end of November, Draghi was met with a chorus of uncertainty when standing before Europe’s “parliament.” He conceded that the European economy had slowed but that it wasn’t a big deal. “Part of this lower momentum is due simply to a normalization of the growth process coming from pretty exceptional years.”

That’s the conceit many people subconsciously pick up on. In the official canon, 2017 was a “pretty exceptional year” and it was if only in the context of the last eleven. Being less bad than awful isn’t really what the phrase implies. Making policy out of this, you are setting yourself to be made the fool.

That was the entire point of so many years of ZIRP and QE, not just in Europe but all over the world. The global economy in all its parts required stimulus, they said, constant accommodation because for some reason it just wouldn’t restart itself in the same way it had every time in the past – except the one time in the thirties.

It raises the question of raising interest rates. After a year maybe two of exceptional growth, meaning less bad, a few rate hikes in certain places, the US or Canada, plus the constant preparation for exits elsewhere, Europe and Japan, the global economy falls apart in a matter of months?

Obviously, we are missing something.

The problem is William McChesney Martin. He was the longest serving head of the Federal Reserve and probably the last one who could be counted as a real banker. They are all PhD Economists nowadays, a truly regrettable development that has seen every central bank trade competence in money for elegance in statistics. Only one of those is worth something in a real-world economy.

Alan Greenspan had his “irrational exuberance”, which people still don’t realize what that was really all about, Bill Martin had his punchbowl. Everyone remembers the cliché without factoring why they do.

In October 1955, Martin traveled to New York City at the height of his reputation to speak at the Waldorf Astoria Hotel before the International Bankers Association of America. It was a particularly auspicious moment in economic history, not just for the United States but all over the world. The Great Depression and the ravages of world war were finally being shed.

“In the absence of war, or serious conflict among our people over political or social aims, the road to a substantially higher standard of living lies ahead of us as clear and as smooth as our modern turnpikes.”

As now, the Federal Reserve had spent years, decades with what it believed had been extraordinary accommodations. The US central bank placed a ceiling on interest rates all throughout the forties and fifties to that point, promising to buy Treasury bonds and notes if their price fell too low. In truth, the Fed never really had to, the ceiling was easily covered by market demand alone.

In the middle fifties, however, the switch from a depression era regime to one like Martin’s vision meant adjusting the interest rate framework. Not only should everyone have tolerated higher rates, they should’ve welcomed them as a sign of progress.

Accustomed to yields on the low side, there was tremendous angst. In struggling to come up with a good analogy, Martin instead offered a late 20th century bubble visual.

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects--if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

It wasn’t until Greenspan that the metaphor really stuck. This is today the very idea that drives Draghi and Powell. It did Kuroda in Japan last year, too, but Japan has already sunk back into the deflationary hell from which it can never seem to escape. The regressively hydrated partiers over there are going to be given even more “punch.”

There are enormous problems with this platitude. To start with, in 1955 central bankers were bankers who dealt with effective money and money supply. A decade later on, they were struggling to define money. One decade more, they came to the amazing conclusion they couldn’t and then the even more startling one that they wouldn’t need to. By 1985, because of this, central banks had turned to exclusively econometrics at the expense of money in policy.

By the time Alan Greenspan took over, his punchbowl was offered to a party at a different hotel on the other end of town which very few actually attended. Everyone was instead over at the wholesale gala imbibing all sorts of exotic concoctions, few that could be classified as punch, and getting hugely excessive for it.

The media and the public were comforted by the news the maestro was watching over an unspecified revelry somewhere in the general vicinity.

We can see this in any number of ways, from the dot-coms to the housing bubble. There are those who still today blame the Fed for taking away the punchbowl from both, especially the latter one; the Fed’s 17 rate hikes 25 bps each from June 2004 to June 2006. After all, Greenspan, finished up by Bernanke, claimed that he was “tightening.”

Any honest and unbiased reading of the global monetary climate at that time, however, shows the opposite to have taken place. If anything, the global monetary system went into overdrive during that very period. Phillip Turner, a longtime monetary policy analyst formerly from the BIS, wrote in a paper published in November 2017 in which he stated:

“…the substantial increase in the Federal funds rate from mid-2004, reinforced by higher policy rates elsewhere, did not prevent further increases in risk-taking in the financial markets during this period. One international comparison is particularly telling about the ineffectiveness of monetary policy as a financial stability tool. The Bank of England’s tight monetary policy from late-2001 until mid-2005 did not prevent financial excesses from building up in the United Kingdom. The Bank of Canada, in contrast, reduced its policy rate in line with Fed policy; Canada avoided the crisis because of the tighter regulation of banks and fatter profit margins from a less contestable domestic banking market. The prime culprit for the GFC was the failure (of both regulators and markets) to recognise the new dangers created by financial innovation.”

Those “new dangers” Turner now writes about were the “proliferation of products” Alan Greenspan himself once lamented in June 2000 decrying the state of affairs where any central bank on the planet would be unable to define let alone measure money. The “rate hikes” of the middle 2000’s were theater, not effective policy.

Despite doing almost everything in his name, they have all forgotten Friedman. In 1997, Milton had warned:

“As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates.”

That is what was happening in the fifties and it was unequivocally a good thing. Prosperity brings with it an abundance of benefits, among them expanded choices for monetary opportunity. Why invest in cash or safe, liquid instruments when the whole world is your oyster? You don’t; yields on safety rise not to take away the punchbowl but to reflect this incredibly favorable condition.

What if interest rates instead fail to rise as they have over the last eleven years? Their determination is therefore obvious and unequivocal. There is no opportunity and therefore there can’t have been recovery. Mario Draghi can try to claim 2017 was a “pretty exceptional year” for the public but if he really believes that then he really is the fool.  

We know this from our own experience, a fact we can establish though we may have forgotten what real economic growth looks like. It does not in any way resemble an economy struggling when short rates hit 2%.

In the latter 1990’s, for example, around the time when Friedman was perfectly describing his interest rate fallacy the Federal Reserve’s target for the federal funds rate in the United States never fell below 4.75%. Most of the time it was around 5.50% or even above.

Was the innovative “new” economy of the nineties especially inhibited by what today seem like repressive interest rates? Of course not. The two actually go together, even though Alan Greenspan really, really bought into the whole punchbowl-chaperone charade. In fact, he was the one who turned the proper way of thinking about them upside down, this idea that low rates are somehow “stimulus.”

But more than that, he irreconcilably removed money from monetary policy and therefore any reasonable basis for his punchbowl mythology. Economists had come to really believe in their astrology; that if they could convince you that low rates were good and high rates were bad you would act contrary to all established financial and monetary experience.

It worked! - at least as far as the public and mainstream media are concerned. Even today, after 23 or 24 QE’s the Bank of Japan’s policies are still reflexively characterized as “ultraloose.” I don’t believe the word “loose” applies regardless of how anyone might want to qualify it.

Central banks raised rates in the middle 2000’s; the eurodollar system completely ignored them and even accelerated in its final stages. Central banks then panicked and lowered rates even all the way to zero as the eurodollar’s avarice imploded in on itself; the implosion continued wholly unmoved by so much powerful “stimulus”, zero or not.

Central banks are not central.

Persistently low interest rates tell us everything, including that, because Friedman was exactly right. As I wrote yesterday, “It isn’t that the economy can’t manage slightly higher rates, rather the economy at low rates is prone to falling back again long before policy rates can get very far.” An economic system represented by stubbornly low interest rates is a weak, fragile one. Even its best years aren’t very good.

It falls backward again not because a central bank adds a hundred basis points or two to its policy target over the course of several years, it retreats because it is weak and fragile and therefore is susceptible to any number of untreated monetary maladies that pop up at almost regular intervals. Eurodollar #4, not fed funds 250 bps.

The fact that yields and rates have stayed low all this time means money is already tight to begin with (in the real economy); that’s the whole problem Friedman described. Central banks raising rates to try and tighten don’t realize from where it is they are actually starting, and therefore they can never understand why they won’t, can’t get very far along. Sure enough, with rates still historically low, policy pauses as well hints of cuts are now commonplace.

The fool Draghi is the lone exception, but for how long?

No matter, because convention attributes the weakness to monetary policies and central banks dating back to the whole punchbowl thing. It is almost fitting in a way, tragically so, because so much of Economics is predicated on just these kinds of shallow shorthand banalities developed from a fifties level of monetary interpretation. You aren’t meant to actually think about all the details of the party beyond the punchbowl, you are just supposed to uncritically accept and parrot the description – especially the chaperone.

Central bankers used a minor improvement in 2017 to set up expectations for an economy about to soar. Bond markets said all along it was far more likely to sour, the legacy of now more than a decade featuring consistently low interest rates. Now that the global economy is souring, again, Milton Friedman should be given the last word on the subject:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

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

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