Lessons for Central Banks. Secular Stagnation and Fiscal Multipliers
“And then the harder they come, the harder they fall, one and all”
—Jimmy Cliff
We have analyzed many key elements of the failure of the central bank trap.
Let us summarize a few:
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Creating bubbles that need to be maintained afterward to avoid a financial crisis
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Trying to solve a problem of debt with more debt
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Assuming investment and growth are weak because of a demand problem, not a structural issue
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Generating collateral damages in emerging markets and commodities
In the recent times, we have witnessed another, and worrying, side effect. The reaction from voters against the establishment becomes more aggressive as citizens do perceive that all those massive stimuli do not get to them.
We have also mentioned a few actions that have worked.
But the main economies’ central banks need to take measures to address their rapidly declining credibility.
Let us start with a few recommendations.
Won’t Get Fooled Again
One of the main mistakes of central banks is to provide extremely detailed forecasts that are met rarely or never.
In chapter 3, where we discussed the hockey stick mistake, we showed that the discrepancy between the estimated impact of monetary policy and reality has sometimes been 100 percent.
Central bankers have plenty of excuses to justify these mistakes, but the reality is that investors, companies, and families do not believe in these estimates anymore.
Furthermore, as we have seen with opinion polls, it reaches a point where the impact is actually the opposite of what is expected.
So, the first solution is for central banks to provide stricter guidance with more complex sensitivities.
Bernanke’s famous quote that monetary policy is 98 percent communication and 2 percent action is true. When there is credibility. If the market and economic agents see the central banks lose credibility, it will not matter. Neither the action nor the communication will work.
Guidance should not be about macroeconomic aggregates like GDP or rate of unemployment, let alone inflation. It should be about what money is actually all about, short-term credit, and benefits for SMEs, and this guidance should be monitored on a monthly basis.
Consistency and credibility in guidance is essential.
Scrap big headlines about GDP and employment. Those are second derivatives, at best, of monetary policy.
By trying to show that the policy is only about main street instead of helping the transition for financial entities, central banks have destroyed their credibility.
Central banks will regain credibility when they show the benefits of monetary policy by focusing the main headlines on the transmission mechanism of its actions.
Citizens can understand the short-term benefits of improved lending to SMEs or, the most important headline of them all, the actions taken to strengthen banks without hurting the real economy.
But, most importantly, central banks must avoid providing messages to “appease” financial markets.
If a central bank is to succeed in delivering a credible message to main street, it cannot just give empty talk of main street.
The average citizen is not stupid. They know that central banks end up catering to Wall Street by the market reaction.
Let us face it. Saying that buying bonds creates employment is like saying that if we all dance together, it will rain.
Central bank managers that might read this book will likely say that all the things that I mentioned are in the extremely detailed reports they make. And they will be missing the point.
One can make a 100-page report stating numerous factors about monetary policy, but they are denying the fact that estimates have been the driving force of the message to society, and central banks have lost their credibility by missing their own projections over and over. I come back to Paul Romer’s excellent piece.1
I know it is not the intention of the staff or management of central banks to lose credibility and make mistakes in predictions, the same way as it is not an analyst’s intention to overestimate earnings. But failing to understand that in the process, they are losing credibility, and that this is something exceptionally dangerous for central banks, is a big risk.
The entire status of a currency as global reserve depends on the credibility of its economic policies and its central bank.
As such, it is imperative that forecasting is focused exclusively on the elements in which central banks’ staff have a clear evidence of correlation and causation.
It is imperative that central banks use sensitivities in their analysis.
It is also essential that guidance is clear and the basic assumptions behind that guidance are provided upfront and in detail. There is a reason why the average citizens dismiss central banks as alchemists. There isn’t only two factors that affect the real economy. Interest rates and money supply are simply just two elements, but there are many more. Ignoring aging, overcapacity, tax burden, and so many other factors is dangerous because it puts the attention on the central bank as a failure, and governments sit back happily blaming monetary policy for their inaction.
There is a strong improvement and credibility in the words of some of the central banks recently—they are being less simplistic and focusing more on structural aspects—but I cannot stress enough the importance of managing communication and guidance in a much more realistic way, and being realistic is also recognizing risks in financial assets.
Denying bubbles tops the list of central banks’ “problems.” How can an average investor or citizen trust in the biggest experts in finance and economics if they are unable to recognize, sometimes even justify, evident exuberance in financial markets?
The entire communication and guidance policy of central banks needs to change. Focus on those points where causation is real, not on justifying the reason why it does not happen afterward. Forget alchemist messages.
Draghi has changed communication policy by constantly referring to structural reforms, downside risks, and fundamental elements. This, in turn, has been one of the reasons—apart from poor earnings—why European stock markets have not been as insanely overoptimistic in their reaction as others. But there are relevant elements of improvement, particularly in sovereign debt. Showing governments the risk of adding more debt if interest rises is completely absent from big headlines, and it is an enormous factor of instability.
The ECB, for example, should present the impact of a 1 percent rise in rates on interest payment and government deficits and make it abundantly clear to voters ahead of promises of more spending and the inevitable end of QE.
Credibility-enhancing communication is a critical factor. It will help citizens understand the actions and, more importantly, help avoid an enraged crowd of voters from thinking that they are being swindled and robbed leading them to vote for radical defenders of magical solutions.
The purpose of a central bank is to help mitigate the impact of the process of solving imbalances on the economy, not to perpetuate those imbalances.
No Romance Without Finance
There is a way of avoiding—or at least minimizing—the accumulation of risk in financial assets. No, it is not ending central banks or going back to the gold standard or similar, which, in the current world of massive debt, would be impossible to implement, because even if one country did it, the others in the currency reserve system would likely fail to follow suit.
Expanding without control the balance sheet of the central bank. We are told every day by many that it has no negative consequences because there is no inflation ... except, there is. Massive inflation in financial assets. Furthermore, inflation expectations were already rising fast in 2016, and the BoJ, the ECB, and many other central banks continued expanding their balance sheet as if nothing happened.
Monetization of debt and hiding bonds under the central bank carpet is exactly the same as any other form of excessive risk-taking. And the bubble in bonds is simply spectacular.
In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
The reality of how money is created today differs from the description found in some economics textbooks:
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Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
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In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money “multiplied up” into more loans and deposits.
Although commercial banks create money through lending, they cannot do so freely without limit.2
Herein lies the solution.
On one side, central banks should monitor money supply and credit growth relative to the real GDP. If money supply exceeds five-year historical real GDP growth, it would be a first signal of excess. But it needs to be more complex. Money supply and credit growth must also be analyzed in their quality. A proper analysis of the sectors and areas where the accumulation of credit occurs and the price increases in such asset or sector should be adequately monitored as well, not to justify abnormal rises in prices as a “new paradigm” but as a measure of risk.
In fact, central banks should have a cascade of red and green lights when analyzing the increase in money supply.
First, price signals in bonds and risky assets versus its fundamentals.
Central banks can monitor the improvement in debt repayment ability and there is plenty of data coming from rating agencies.
When lending rises, yields fall, and there is a simultaneous underlying trend of worsening solvency and liquidity, the central bank must take action to avoid a bubble.
Lowering interest rates can only be a measure that helps the economy if there is an undoubted discrepancy between the real risk and the market. For example, one can argue that the euro crisis created a disproportionate risk based on concerns that the single currency would break up. This is an anomaly, or at least it can cause panic. The solution might entail lowering interest rates but at the end of the day is just a matter of confidence. In that case, Mario Draghi did more for Europe’s stability saying the famous words, “We will do whatever it takes and it will be enough,”3 than purchasing €80 billion a month of government bonds while building a trillion in excess liquidity.
Additionally, central banks should analyze investment and credit growth trends using larger historical periods in order to avoid making estimates of excess or lack of investment looking at a period of time that was clearly an anomaly. If central banks look at investment to savings in a 20-year period instead of the past five years, their analysis of “too much” or “too little” savings varies enormously.
Therefore, the main characteristic of a prudent monetary policy should be to change the objective. Price stability is important, but inflation for inflation’s sake should not be.
To avoid money supply growing more than real GDP greatly reduces the risk of bubbles. Monitoring real causation between interest rates and investment does the same. Lowering interest rates for the sake of it is a recipe for bubbles.
Table 10.1 Schematic representation of risk in negative rates
Source: BNP.
The central bank should understand that if a company’s decision to undertake an investment did not happen at 1 percent rates, it will not happen at 0.5 percent either.
In fact, governments and central banks should understand that if a company’s investment is not viable at 1 percent and it becomes viable at 0.5 percent, it is not just a massively dangerous investment, but a guarantee of failure.
The law of diminishing returns with interest-rate cuts is pretty evident after more than 600 of them. Believing that negative real interest rates would change that negative spiral is delusional. See Table 10.1.
Negative real interest rates, as we mentioned before, encourage short-term risky lending in liquid financial assets and discourage long-term real economy lending.
If central banks monitor these variables properly and forget about aggregate data and objectives where monetary policy offers no causation, the risks we have outlined throughout this book would be mitigated significantly.
A close monitor of quality and accumulation of credit by asset and sector.
A more robust analysis of valuation of risky assets and bonds.
A better understanding of the transmission mechanism, recognizing structural issues outside of cost and availability of credit (overcapacity, real demand).
When understanding the role of a central bank, it should be both to help break unnecessary panics and to attack unjustified euphoria. The latter is as dangerous as the former.
Break All The Rules?
Credit growth is important if it is productive debt. Therefore, regulation of the financial system must be simpler and more focused on quality than on perverse incentives.
Excess regulation is as bad as no regulation. It leads to the same perverse incentives. Excessive imbalances.
The central bank should try to avoid trusting credit growth as the only metric without understanding what it is comprised of.
Regulation needs to be simple and effective.
Most of the excess in regulation we have seen in the past years comes from trying to protect the system from the last crisis, not the next one.
Regulators all over the world are generating millions of pages of rules to avoid 2008, not the current flow of imbalances.
The main reason why regulation tends to fail is because governments and regulators confuse quantity—lots of reports and filings—with quality.
The other fundamental reason is that regulation tends to incentivize excess risk—taking in assets that are perceived as low-risk by the same regulators—and that is where the next crisis will come from.
Take the EU, where the founding papers and the entire banking regulation were based on the principle that government bonds had zero risk. In the rules they hid the time bomb.
Producing hundreds of pages of new rules every week just does not work.
Monitoring accumulation and quality of loans does.
For example, the EU will always have more trouble getting out of crises and seeing their banks solve their imbalances because loans are valued at a combination of market value and mark-to-model.
What does this mean? That banks may account assets in their books at a much higher valuation than what the market would pay for those assets under the justification that it is a very short-term metric and that they have done extensive research to prove that the book value of those assets is much higher than what market transactions would dictate.
No wonder that European banks have been, at the end of 2016, slower and less effective at dealing with the crisis.
No wonder, either, that European banks trade at a massive discount in price to book value relative to their U.S. counterparts. Very few believe the “book value.”
Yes, having constant mark-to-market, as U.S. banks do, may create short-term pain when markets fall, but it also helps the entities to be in touch with reality, to avoid accumulating nonperforming loans and refinancing them forever, and to take more aggressive actions to return the bailout.
No wonder that the United States recovered the money lent to banks from the TARP with interests, while in Europe most of the bailouts have simply been lost money.
At the end of the day, markets have a healing effect, and the closer that regulation is to the reality of markets and supply and demand, the better.4
European politicians just do not understand that banks cannot reduce debt and expand credit everywhere at the same time.
Yet that is exactly what governments demand of the banking sector. More credit, but mass deleveraging.
Europe creates more than 200 pages of new regulation per week.5
This process of constant regulatory changes does not strengthen the financial sector balance sheets; it weakens them—because constant revisions sabotage the divestment and recapitalization process and introduce uncertainty, which scares demand, and valuations of the loan portfolios continue to erode, deepening the recession.
The European financial crisis was not a crisis of deregulation or of private banks—in 2006 fifty percent of European financial institutions were semistate-owned or controlled by politicians. There have been thousands of pages of regulations published every year since the creation of the EU and the European Banking Association (EBA). Regulation and supervision in Europe is, and always has been, enormous.
This was a crisis of an economic model too dependent on commercial banks and a very intervened system.
Excessive, complex, and bureaucratic regulation has prolonged the agony of the industry for many years, instead of facilitating market conditions for the capital increases and asset sales needed.
Despite the detailed and complex regulation of the eurozone, between 2008 and 2011 Europe spent €4.5 trillion (37 percent of the GDP of the EU) in aid to financial institutions, many of them public and highly supervised.
More regulation will not solve the problem.
Europe’s banks suffer what is called an “endogeneity problem.”6 Inward-looking. It is precisely excessive intervention that prevents a quick and surgical solution to financial sector difficulties.
As I said before, regulation must be effective and simple. In Europe, it is not. In the United States, it worsened.
The Eurogroup’s resolution in 2013 about bank recapitalization—trying to avoid further bailouts with public funds—is an example of such endogenous problem. It was hailed as a success of the bail-in model,7 but was far from it. First, because it did not close the door to unilateral state intervention, and second, because it did not facilitate the creation of prompt capitalization mechanisms in banks nor broke the mark-to-model perverse incentive.
The reader will not be surprised to know that, three years later, one of the main Italian banks had to be bailed out again with public funds.
By carrying out endless regulatory reviews, more than 26 in the past years, the Eurogroup creates uncertainty and banks cannot clean their balance sheets fast enough.
That cleanup cannot happen while governments borrow more, as banks in Europe accumulate up to 45 percent of countries’ sovereign debt. Therefore, the “vicious circle” of financial-sovereign risk soars.
The prices of assets and loan portfolios deteriorate while the economic situation worsens by the constant tax increases and reductions in disposable income, creating a snowball effect.
Financial repression worsens the situation of the financial sector.
To prevent this deterioration, Europe introduces new volumes of hundreds of pages of regulation, again delaying any solution for the banks.
It has been more than eight years since European banks should have reduced debt aggressively. According to the ECB, by 2016 there has been only 35 percent deleveraging.
Banks need private capital and confidence to deleverage. The constant run-to-stand-still regulation overkill led to lower confidence and virtual impossibility to raise capital as shareholders fled the sector.8
In fact, emphasizing the risks to shareholders, bondholders, and depositors, but without solid recapitalization and liquidity mechanisms, is likely to generate even more public bailouts, because there might not be enough private money when needed, creating the perverse effect of accelerating what the agreement seeks to avoid. This is exactly what happened in Italy and Portugal in 2016.
There is not enough money between shareholders, bondholders, and the more than 100,000 euro deposits to cover the losses if a large bank experiences difficulties.
European countries each want to have their own financial sector “bound and controlled” but also with access to the purse of other eurozone members. This is what makes direct recapitalization such a moral hazard.
European banks have been an essential weapon for governments to artificially expand weak economies, placing the finance sector at risk without thinking of the consequences—a disturbing ignorance of what the core capital of a bank is and how quickly it fades out if economic and market conditions are not positive.
The European financial sector is dangerously dependent on the strength of government debt. Few banks of the EU would survive a haircut on sovereign bonds, and the impact on businesses and citizens would be enormous. However, public debt continues to grow in almost all member countries because growth, consumption, and investment are torpedoed with financial repression.
Allowing growth and opening doors to investment and capital is the solution of all these communicating vessels that converge in the financial sector. Attracting capital and creating a favorable investment environment, with increased disposable income and economic growth, will recapitalize the banks—their assets would regain value, companies and families would be able to repay their debts, and the whole system would heal rapidly.
However, with financial repression and predatory regulation and intervention, politicians can agree on whatever they want in another committee, because the hole of the economy and state debt grows, and with them the difficulties for banks, in a downward spiral.
Banks had an undeniable responsibility in the crisis, but we cannot ignore governments’ support of the excessive and artificial credit expansion of the period 2001 to 2011. They are two sides of the same coin. The solution to a decade of excess is not going to come in a few years.
Let’s Stick Together
Central banks and governments form a unique alliance.
There is undeniable power in the fact that monetary policy is governed by independent members, but despite the constant reminders of the alleged central bank independence, the public and markets perceive an uncomfortable—and growing—link between central banks and governments.
Gone are the days when the governor of the central bank took uncomfortable decisions against the demands of reckless governments. The actions of BoJ are undeniably linked to the government and aimed at perpetuating imbalances until implosion.
The Federal Reserve has defended its independence numerous times, but questions were made in different times about surprising decisions. If unemployment and inflation were the main targets, how come the Federal Reserve decided to postpone the decision to raise interest rates by a meager quarter of a percent until elections had passed in 2016?
When central bank decisions are less technical and the discourse changes, it creates a negative perception in citizens and too many perverse incentives in markets.
Central banks pay too much attention to financial assets and risks that they have created with excess confidence that there will be no consequences to artificial monetary expansion.
Governments forget structural reforms and supply-side measures and rely solely on monetary policy to disguise the imbalances until the next election, when the problem will be passed on to somebody else.
Governments need to realize that the long-term impact of forgetting supply-side measures and betting the entire house on low rates, devaluation, and spending means more taxes and less growth in the future.
As such, central banks need to add another layer to their policy.
Conditionality.
Governments cannot simply ask for more expansionary policies and sit back. Monetary policy must be conditioned to the implementation of fiscal reforms aimed at promoting stability, growth, and productivity.
Conditionality is not a penalty. It is about avoiding the accumulation of perverse incentives everywhere, starting—of course—with financial markets.
Central banks’ conditionality to implementation of structural reforms is an essential tool to stop in its tracks any trading policy aimed at buying more when news is bad because monetary policy will be extended.
This factor of conditionality also helps the central banks avoid making mistakes that create further bubbles. It puts its own brakes.
The Taylor rule we mentioned in chapter 4 is part of that policy, but there are other relevant ways to adequately implement conditionality.
It has to be based on short-term and midterm policies, not just on vague calls for discipline. Governments will always prefer to spend more and be told off than to take the required actions and lose cheap money.
Implementing tax reforms to boost competitiveness, incentivizing investment in research and development, reducing unproductive subsidies to obsolete industries, and putting more money in families’ pockets are essential drivers of an improvement of the growth model.
Denying overcapacity is a clear example. Europe, again, continues to go from stimulus plan to Juncker plan to Moscovici’s infrastructure program and no one asks the question “what for?”.
In any case, the reader will think that perverse incentives will not disappear, but the aim of this book is to provide an in-depth analysis and to realistically offer solutions to avoid the next big crash.
Conditionality, credit monitoring, mark-to-market, and limit on money supply to relative GDP growth are not “antigrowth” measures, but “pro–sustainable growth” ones.
Markets, governments, and central banks will always try to find excuses for imbalances. The important lesson here is that all can benefit from limiting the reckless behavior of one another, and everyone, particularly tax payers, will benefit from a process that limits boom and bust as the preferred policy method.
Central banks, governments, and markets have placed too large a bet on solving economies with policies that seem to give aggressive headlines but forget the most important factors: Families and Businesses.
The entire escape from the central bank trap depends on families and businesses recovering confidence, having more of their own money to save and spend, and investing wisely when required—not when mainstream economists and media tell them to—and on focusing policymakers’ actions on balance, not bubbles.
1 The Trouble with Macroeconomics. Paul Romer, Stern School of Business, New York University. September, 2016.
2 Money creation in the modern economy. Michael McLeay, Amar Radia, and Ryland Thomas. Monetary Analysis Directorate, 2014.
3 July 26, 2012.
4 A systemic approach to financial regulation A European perspective, Aglietta, Scialom, 2010.
5 The rule of more, The Economist, 2012.
6 Regulation of European Banks and Business Models, Centre for European Policy Studies, 2011.
7 Covering bank losses with bondholders and shareholders’ money, not public funds.
8 Despite the ECB QE plan and calls for recovery, banks fell in the stock market between 50 and 60 percent in 2016.