The latest Fed confab at Jackson Hole is demonstrating that central bankers were so keen to avoid taking much blame for the global financial crisis that they also failed to learn critical lessons from it. That lapse in turn is directly related to the present emerging markets upheaval that has the potential to morph into something worse.
In case you managed to miss it, the prospect of the end of QE is leading investors to rearrange their portfolios in a fundamental way. One of the most widely-followed sayings among traders is “Don’t fight the Fed.” Having the central bank that runs the world’s reserve currency on the verge of ending its extraordinary bond market interventions and indicating that it expects later to enter a conventional tightening cycle is a fundamental change in stance. This shift is particularly important for risky investments, such as those in emerging economies, since the Fed’s super accommodative posture fueled a global carry trade. As Ambrose Evans-Pritchard wrote last week:
India’s rupee and Turkey’s lira both crashed to record lows on Thursday following the US Federal Reserve releasing minutes which signalled a wind-down of quantitative easing as soon as next month….
A string of countries have been burning foreign reserves to defend exchange rates, with holdings down 8pc in Ecuador, 6pc in Kazakhstan and Kuwait, and 5.5pc in Indonesia in July alone. Turkey’s reserves have dropped 15pc this year…
It was Fed tightening and a rising dollar that set off Latin America’s crisis in the early 1980s and East Asia’s crisis in the mid-1990s. Both episodes were contained, though not easily.
Emerging markets have stronger shock absorbers today and largely borrow in their own currencies, making them less vulnerable to a dollar squeeze. However, they now make up half the world economy and are big enough to set off a crisis in the West.
Fears of Fed tightening have pushed borrowing costs worldwide to levels that could threaten global recovery. Yields on 10-year bonds jumped 47 basis points to 12.29pc in Brazil on Thursday, 33 points to 9.72pc in Turkey, and 12 points to 8.4pc in South Africa…
Hans Redeker from Morgan Stanley said a “negative feedback loop” is taking hold as emerging markets are forced to impose austerity and sell reserves to shore up their currencies, the exact opposite of what happened over the past decade as they built up a vast war chest of US and European bonds.
The effect of the reserve build-up by China and others was to compress global bond yields, leading to property bubbles and equity booms in the West. The reversal of this process could be painful.
“China sold $20bn of US Treasuries in June and others are doing the same thing. We think this is driving up US yields, and German yields are rising even faster,” said Mr Redeker. “This has major implications for the world. The US may be strong to enough to withstand higher rates, but we are not sure about Europe. Our worry is that a sell-off in reserves may push rates to levels that are unjustified for the global economy as a whole, if it has not happened already.”
So given that developing economies have become canaries in the coal mine as far as the Fed’s taper is concerned, their central bankers are calling on the Fed to show a bit of mercy, say by going a bit easier on them and/or coordinating with other central banks. Not surprisingly, it appears that the most these petitioners will get are some comforting words. From the Financial Times today:
The world’s top policy makers must be more aggressive in handling the unfolding emerging markets crisis, the finance minister of Africa’s largest economy has warned, calling for greater action on global capital flows and currency volatility.
Pravin Gordhan, South Africa’s finance minister, told the Financial Times in an interview that there is an “inability to find coherent and cohesive responses across the globe to ensure that we reduce the volatility in currencies in particular, but also in sentiment…
“There’s no doubt that the multilateral institutions that participate in, and often work for, and with, the G20 need to desperately try to come up with new answers and do some heterodox thinking to find a new framework which will enable us to embrace the current environment, create less volatility,” he said…
Mr Gordhan added that while it was understood that “you cannot manage all of these phenomena in a fine-tuned way”, policy makers needed to “come up with better answers” to reduce volatility and create a more predictable environment.
But policy makers at Jackson Hole did not have many answers for Mr Gordhan. “As much as we may like to find it, there is no master stroke that will insulate countries from financial spillovers,” said Terrence Checki, the head of international affairs for the New York Fed.
In a paper presented to the Jackson Hole conference, Hélène Rey of the London Business School concluded that central banks would struggle to adapt their policies to avoid spillovers to other countries, because it would conflict with their domestic goals.
In fairness, Christine LaGarde did say the IMF was ready to help, but the python-like embrace of an IMF rescue is not likely to be the sort of assistance the beleaguered central bankers were seeking.
The fact is that the current emerging markets upheaval demonstrates that the economics policy elite has been unwilling to look at the real roots of the crisis and come up with workable remedies. And Gordon’s remarks give a clue as to why this hasn’t occurred: that it would require “heterodox thinking” which really means “heretical thinking”. Not only would policymakers and the public need to identify the bad policies and decisions that produced the crisis (naming names!) but also abandon some deeply held beliefs.
Not surprisingly, Carmen Reinhart’s and Ken Rogoff’s idea that high government debt levels were bad for growth was touted widely because it justified what amounted to policy prejudices. Yet another finding they published around that time, that high levels of international capital flows are correlated with more frequents and more severe financial crises, got nowhere near the same level of attention.
Similarly, Claudio Borio and Piti Disyatat of the Bank of International Settlements published a paper in 2010, “Global imbalances and the financial crisis: Link or no link?” that argued, persuasively, that overly high international capital flows were a direct cause of the financial crisis, and those resulted from “excessive financial elasticity”, which one might also call too little regulation. Borio has the misfortune to be the Cassandra of financial crises; he joined William White in trying to warn Alan Greenspan and other central bankers in 2003 of a global housing bubble and was brushed off. His 2010 paper with Disyatat was written defensively and for professional economists and thus is not layperson-friendly. Andrew Dittmer’s translation helps explain why: the paper also savages Bernanke’s self-serving “global savings glut” explanation of the crisis. From Dittmer’s summary:
The global financial crisis led to widespread dislocations and misery. However, another set of victims, hitherto overlooked, were central banking authorities and professors of economics who had staked their names on the thesis that the current configuration of the global financial system (which they had helped to engineer) was generally wonderful. These unfortunate souls were forced to come up with an explanation for the crisis on short notice, and it had to be an explanation in which they themselves played no role.
Ben Bernanke et al. rose brilliantly to the challenge. They remembered that many Asian countries had stocked up on foreign currency reserves in the hopes of never again being at the mercy of the IMF (26, note). Obviously, trying to resist the IMF was wrong and deserved criticism. Moreover, saying bad things about the Chinese would inevitably be welcomed in foreign policy circles eager to talk about the coming “bipolar confrontation” between America and China.
This “savings glut” theory argued that savings by Asian (and Middle Eastern) countries had washed like a tidal wave onto US financial markets, effectively forcing US money managers to invest imprudently in the course of their attempts to cope. For instance, these “excess savings” were widely assumed to have reduced long-term interest rates, thereby making credit cheaper.
There were some obvious problems with the global imbalances theory. Before the crisis exploded, many of the same economists had pointed to the same imbalances as a happy coincidence of needs, leading to better results for all (23). According to the sort of economic theory that was used in these explanations, if “global imbalances” were causing long-term interest rates to fall, that was simply a natural market outcome that should be contributing to equilibrium (23)…
Despite the consensus of these eminent authorities, we have decided to take a second look at the theory. Unfortunately, we have found further problems.
The idea of “national savings” or “current account surplus” refers to the total amount of exports sold minus the total amount of imports sold (more or less). The “excess savings” theory holds that this excess had to have been financed somehow, and so presumably by countries in surplus, like China.
However, for the US in 2010, the total amount of financial flows into the US was at least 60 times the current account deficit (9), counting only securities transactions. If this number were correct, then inflows would be 61 times the current account deficit, and outflows would be 60 times the current account deficit. The current account deficit is a drop in the bucket. Why would anyone assume it had anything to do with the picture at all?
Moreover, if the “savings glut” theory was correct, we would expect there to be certain historical correlations between the following variables: (a) current account deficits of the US, (b) US and world long-term interest rates, (c) value of the US dollar, (d) the global savings rate, (e) world GDP. There aren’t (4-6, see graphs).
You would also expect credit crises to occur mainly in countries with current account deficits. They don’t (6).
Suppose we look at a more reasonable variables: gross capital flows (13-14). What do we learn about the causes of the crisis?
Financial flows exploded from 1998 to 2007, expanding by a factor of four RELATIVE to world GDP (13), and then fell by 75% in 2008 (15). The most important source of financial flows was Europe, dwarfing the contributions of Asia and the Middle East (15). The bulk of inflows originated in the private sector (15).
If we look instead at foreign holdings of US securities (15-16), Europe is still dominant, but China and Japan are a little more prominent due to their large accumulations of foreign exchange reserves (15). Still, the Caribbean financial centers alone account for roughly the same proportion as either China or Japan (16). Other statistics provide a similar picture (17-19).
So what caused the crisis? Clearly, the shadow banking system (mainly based around US and European financial institutions) succeeding in generating huge amounts of leverage and financing all by itself (24, 28). Banks can expand credit independently of their reserve requirements (30) – the central bank’s role is limited to setting short-term interest rates (30). European banks deliberately levered themselves up so they could take advantage of
opportunities to use ABS in strategies (11), many of which were ultimately aimed at looting these same banks for the benefit of bank employees. These activities pushed long-term interest rates down. Short-term rates remained low because the Fed didn’t raise them as long as inflation didn’t appear to be an issue (25, 27).
The Asian countries played a small role as well. They didn’t want US/European-driven asset price inflation to spill over into distortions in their economies, and so they protected themselves by accumulating foreign exchange reserves (26 and 26 note). That was mean of them. If they had allowed more spillover, then the costs of the shadow banking system would have been partly borne by them, and that would have made the credit crisis less severe in the advanced countries (26). As things stand, instead, the advanced countries are suffering, while Asian countries have bounced back strongly (26).
What should we do? Well, we have suggestions for theory and practice. Let’s start with the practical suggestions.
Countries should do a better job of restraining their financial sectors (24). However, that will probably not be enough (24). Countries should also work together to share the burden of consequences of further crises (27). Unfortunately, countries are irrational and political and so are often unwilling to cooperate in ways we consider wise (27).
Now this important paper covers even more ground, but the parts above are most germane for this discussion.
In shorter form, the implication is that too much in the way of international capital movements is destabilizing. Thus restricting capital movements, as in tougher financial regulations or even targeted capital controls, would be desirable. Yet the economics elite (no doubt due at least in part to indoctrination by bankers) believes that allowing international investors to chase returns is a good thing. They seem unable to recognize that hot money by its very nature isn’t reliable as a source of real economy funding and worse, its sudden influx and exodus will distort the pricing of capital for real economy projects.
In the wake of the crisis, central banks and national regulators have done virtually nothing to address this problem. And it appears to have gotten worse. We’ve written often of the dangers of tight coupling, that overly interconnected systems are vulnerable to catastrophic failure. If one node on the grid goes out, the damage propagates through the system faster than officials can intervene. The combination of extensive counterparty exposures and an undercapitalized shadow banking system created just this sort of danger in the runup to the crisis.
While some measures are underway to reduce counterparty exposures, such as moving more activities to exchanges and centralized clearing, they don’t appear to be far-reachign enough to change the architecture of the financial system. We’ve seen some evidence that the interconnectedness has increased, such as investors moving in massive herd-like “risk on, risk off” trades, and concerns that ETFs, which have become a favored trading vehicle for many investors, are a potential source of systemic risk. Yet tellingly, the Jackson Hole participants seem unwilling to recognize that the only way to reduce the risk of international hot money is to change the structure of the grid. For instance, a Reuters write-up of a Jackson Hole paper by one of France’s former central bankers, Pierre Landau, worked through several ideas for alleviating the negative feedback loops of the unwind of what he called “more accommodative monetary conditions than warranted.” Unfortunately, he concluded that it would be well-nigh impossible to get the political support for the needed national coordination. He concluded:
As a result, the outlook for global capital markets is not encouraging, Landau said, warning of a “segmentation” between nations with surplus capital and others that will suffer from a dearth of investment due to a lack of access to capital.
“The most likely scenario is that of progressive fragmentation of the international financial system,” he added
This sort of thinking is why we are likely to have another bout of bad outcomes. More compartmentalization of international capital markets is necessary and desirable, precisely because regulation and legal systems are nation-based. Having capital able to escape proper oversight has repeatedly led to miserable results for everyone but the speculators who were able to cash in their chips before the casino collapsed (or more recently, was bailed out). So we can either have an organized and well-thought out approach to containing cross-border money flows, or we can have it take place as a result of panicked, uncoordinated action and possible or actual institutional failures. It’s looking more certain that because the authorities are unwilling to do the hard intellectual and political work to move to a more robust system, we’ll have a chaotic end game instead.