The World Presumes Central Bankers Get It. They Don't.

The World Presumes Central Bankers Get It. They Don't.
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It most definitely is a liquidity trap, just not the one they conceive. What lost Japan three decades of economic growth was a gargantuan mistake about its own monetary system, and where its central bank fits into it. Western authorities in our current decade seem hard pressed to follow the Japanese example. The wanton recklessness is borderline criminal.

Go back one year. Europe out of anywhere was booming, or so Mario Draghi had said. After the devastation of 2008 and then the “unexpected” retrenching in 2012, by 2017 European policymakers had finally solved the riddle. A combination of things, mostly laid at the doorstep of their Public Sector Purchase Program (PSPP, or what is commonly called QE), the tumblers finally clicked into place and the doorway was at last open to full, complete recovery.

It was too late to stave off the Italian populists or their British counterparts’ Brexit, but at least the European establishment would show who each really were. The Continent had been rescued right from the brink of political dissolution just in time.

Only, that’s not at all what happened. Over the past year, the ECB has been putting on a circus, and yesterday was the center ring act. If there was a boom, it has now vanished entirely. Whereas the ECB’s President Draghi was, by far, its chief proponent, not even he believes in it any longer.

European monetary policy in 2019 was supposed to be smooth and happy. The central bank would terminate its PSPP (which it has) and then begin raising its corridor of money market interest rates. All this time, ever since 2014, they have been stuck at ridiculously absurd settings. The last changes in them, undertaken in March 2016, set the deposit rate floor at -40 bps, the interest paid on Main Refinancing Operations (MRO) zero, and the ECB’s Marginal Lending Facility at 25 bps.

These are now anticipated to continue where they are all the way through the end of this year. That’s just the beginning, though, as there is practically no one left who believes a liftoff in 2020 happens, either.

The whole booming exit has been scrapped. In its place, absolutely more of the same.

In announcing their recent decisions policymakers quietly issued them based on considerably downgraded forecasts. Last March, the official econometric models had foreseen 2.4% real GDP growth in 2019, continuing Europe’s “boom” (even if at 2.4%, that’s not a boom). Right now, central bankers hope the aggregate economy is able to manage 1.1% this year. Less than half the growth already, and 2019 is just getting started.

What happened? Is still happening? At his press conference, ringmaster Draghi unleashed his full show:

“While there are signs that some of the idiosyncratic domestic factors dampening growth are starting to fade, the weakening in economic data points to a sizeable moderation in the pace of the economic expansion that will extend into the current year.”

They really are politicians, aren’t they? Never give a straight answer even though the modern central bank has been placed into a special category of transparency. Instead, I’ll translate his European fedspeak: we tried to get everyone to believe that there was a massive economic boom underway, only it began to run into significant unanticipated difficulties undermining the very idea of a boom, which we then tried to get everyone to ignore by calling them “transitory” and “idiosyncratic”; we were wrong on all counts.

To counteract what isn’t temporary or idiosyncratic, the ECB will begin auctioning off more “liquidity.” Officials including Draghi yesterday unveiled their plan for Targeted Longer-Term Refinancing Operations, or T-LTRO. European banks will be able to borrow up to 30% of their stock of eligible loans at current rates. The idea is sort of like a rate-lock, to allow banks to lock in the current “accommodative” financing conditions.

Because, you see, banks are afraid of higher interest rates. What else could it be?

But 2019’s T-LTRO isn’t the ECB’s first, nor will it be the second. This is actually T-LTRO III! Number Two was launched in 2016 which banks took up about €700 billion in financing. The very first dates back almost five years, to June 2014.

If you keep repeating “stimulus” so that, before you know it, half a decade has flown by and you are still launching and relaunching the same policies, you aren’t doing it right. It cannot be stimulus, you have instead wandered right into Japan’s trap.

The concept of a liquidity trap used to be a very studied approach. Relating to the Great Depression, it was near universally accepted as a factor, much of it having to do with the human structure of nominal interest rates: the dreaded zero lower bound (ZLB).

Once market rates began to rise in the aftermath of WWII with the return of postwar global prosperity, the ZLB and the idea of a liquidity trap fell out of the Economics textbook. In its place was written an activist central bank which, first, would never allow any economy to ever come close to a position where this might apply. By virtue of having studiously overstudied the thirties (Ben Bernanke), no one would ever reach the ZLB again.

Except, the Japanese did. At the time Japan’s economy wasn’t a pariah, it was the world’s second largest, a true dynamo that during the eighties everyone was keen to reproduce and copy. There were many who spent a lot of time figuring out how far ahead of the United States the Japanese might get by the 21st century.

Leading Japan’s dominance was a very active and well-versed (in Western econometrics dogma) central bank, the Bank of Japan (BoJ). It was shaped into the mold of everything that Economics had demanded of it.

Rather than challenge the US for global economic supremacy, by the end of the nineties the economy was a total disaster. Everything the BoJ tried had failed, which was considered considerable, nothing could pull Japan out of its economic stall. By 1999, ZIRP.

The trouble, some Economists began to surmise, incorrectly mistaking low rates for excess liquidity, was the ZLB. The Japanese had fallen into the liquidity trap. Among them was Paul Krugman. As an MIT professor in 1998, Dr. Krugman wrote:

“To the extent that modern macroeconomists think about liquidity traps at all (the on-line database EconLit lists only twenty-one papers with that phrase in title, subject, or abstract since 1975), their view is basically that a liquidity trap cannot happen, did not happen, and will not happen again. But it has happened, and to the world's second-largest economy. Over the past several years, Japanese money market rates have been consistently below 1 percent, and the Bank of Japan plausibly claims that it can do no more; yet the Japanese economy, which has been stagnant since 1991, is sliding deeper into recession.”

This amounts to “pushing on a string.” Since, in this view, the system becomes oversaturated with liquidity the central bank has been rendered almost powerless. What good is more of that which is in oversupply?

Thus, what’s required is a combination of unconventional monetary policies alongside reckless fiscal engineering and deficit-fueled waste. Anything that gets “aggregate demand” up since it won’t go up on its own (don’t ask Economists why).

The monetary way out of the trap, according to the thesis, is to punch through the ZLB by smashing all expectations. Once you’ve gone down that far nominally, what you need to happen is for real interest rates to drop still further. If you can’t get nominal rates below zero, there is no such constraint on real rates.


Inflation expectations. The real interest rate is a nominal yield corrected for inflation. Except, inflation in the case of bond and money markets isn’t what everyone sees today or what is printed on the latest CPI. Rather, the real interest rate is the difference between expected nominal rates and expected future inflation. If you can get people believe consumer prices are really going to accelerate, the lower the real rate.

Even if the nominal rate is already at zero, greater inflation expectations would mean a more negative real one. To orthodox Economists, this is highly accommodative.  

The problem here is that investors already know the score. In the economic situation like a liquidity trap the only way a central bank can raise inflation expectations is to, quoting Krugman in 1998, “credibly promise to be irresponsible.” In other words, monetary policy is going to be full throttle even when the economy starts to recover. They are going to promise to keep it up long after the need for it has diminished.

This was the genesis of QE. The Japanese first unleashed it in March 2001. It didn’t work.

Twelve years and nine types of QE’s later, the Bank of Japan would try again. In April 2013, they finally went crazy exactly how it was proposed back in ‘98. QQE was BoJ finally embracing “credibly promise to be irresponsible.” Dr. Krugman was hugely enthused, writing days after its announcement, “And that’s why I’m bullish on the Japanese experiment, even though current monetary policy has little effect.” Inflation expectations through the roof, negative real rates at every tenor!

Six years later, BoJ officials are talking about expanding QQE for a fourth time (QE 10.4). There is no sign of sustained inflation in Japan, and its economy is nearing, maybe having already achieved, yet another recessionary condition.

And its not like the Japanese have been the model of frugality, either. The national government spent the decade of the nineties building bridges no one uses and paving over the banks of every river, big and small. Extra airports for mid-sized cities. You name it. Japan’s fiscal deficits remain horrific.

Japan, now Europe, is clearly trapped by something. But it isn’t the same liquidity trap. The only benefit for the world of the Japanese having done, still doing, QQE was (is) in providing that proof. Krugman’s got it wrong.

What would look like a liquidity trap but be something very different? In other words, it would exhibit mostly the same symptoms as he was writing about in 1998 and afterward: an economy that seems stuck in deflationary tendencies, the seeming irrelevance of the central bank and the stubborn impotence of its policymakers, and, like a trap, no easily identifiable escape. Only, the cause is nothing whatever Economists can conceive.

Or maybe they can. In the fallout from what became a very sharp global downturn in 2015-16, even for Japan under expanded QQE, Paul Krugman was “interviewed” by none other than Japanese Prime Minister Shinzō Abe at the City University of New York in March 2016. In his opening, the Nobel Laureate acknowledged, “We are all very much wishing, I am a great admirer of the policy moves that have been made by Japan, but they are not good enough, partly because all of the rest of us are in trouble as well.”

This is what 2017 really was. The whole idea of globally synchronized growth wasn’t an economic boom, it was a last-ditch effort or Hail Mary to avoid having to face up to the real truth. Fingers crossed, central bankers hoped that by playing up the BOOM at every opportunity it would be enough to push positive expectations (hysteresis) high enough for what was then fantasy to become reality. Expectations policy nonetheless.

What is the truth? Dr. Krugman in March 2016 came awfully close to explaining it right in front of Japan’s top officials (BoJ Governor Haruhiko Kuroda was in attendance, too).

“[First] is that we are now in the world of pervasive economic weakness. In many ways, we are all Japan now. This complicates policy for everyone including Japan. The second is that the linkages among major economies are strong. They are stronger than much conventional economic discussion suggests, largely I would argue because of capital flows. This is very important to speak about. The third, which may be of particular concern here is, we are seeing the difficulty in achieving goals through even very bold and unconventional monetary policy.” [emphasis added]

Global liquidity in global money. The right kind.

What if central bank liquidity isn’t the kind of liquidity the world actually requires, what banks actually use? They would pump out trillions upon trillions of what is called liquidity, only inert and inoperable. The results of the program(s) are central banks who appear (and are) powerless and helpless and the global economy sunken deep into a trap from which it can never seem to exit. It gets close, now and again, or many say it is close, but then “something” makes it fall back each time.

Like Bill Murray’s Groundhog Day, the same over and over and over; we can never escape the repeating nightmare. That’s Japanification.

I wrote about the ECB’s T-LTRO I at its initial take-up in September 2014:

“Given what has transpired across European credit markets, I get more than the faint sense there was perhaps some T-LTRO optimism in the various bond curve ‘rallies’ (steepening) so far in September. The other side of the actual figure has instead seen bonds, especially bunds, take up their previous flattening once more… If there was a T-LTRO effect in the short term money ends, it wasn’t much and certainly did not last.”

Indeed, European bond curves would go on to collapse even more, a lot more, from there. They’ve never recovered even during 2017 with Mario Draghi, Haruhiko Kuroda, and Janet Yellen doing their boom best. Quite tragically, the mainstream media pronounced these lower yields and curves the accommodative results of Europe’s QE. Every little thing about the current economic predicament is upside down.

The world economy remains in its liquidity trap, the United States, too. The problem, however, isn’t too much of it, there isn’t any. That’s the trap, this stupid fallacy. Low rates don’t indicate abundance. The world presumes central bankers know at least a little about the monetary system. They don’t. Just ask the Japanese.

Overfill your gasoline-powered car with diesel fuel and see how far you get – and how costly it is to repair for such a short trip. You could lament having fallen into a “gas trap” after you do, but you’d be insane. You might be a criminal, too, if, no matter how well-intentioned, you did this repeatedly to someone else’s car. 

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

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