Living in unique economic/ financial times
“May you live in interesting times,"* is said to be a Chinese blessing or curse and we are today living through not only interesting times in economics and finance but unique ones in the history of commerce.
In 2002 Ben Bernanke, then a governor of the US Federal Reserve, gave a speech on deflation and he cited the "helicopter drop" of money, which was a term that had been used by Milton Friedman (1912-2006)— a famous American monetarist economist who Paul Krugman, the New York Times columnist, has called "one of the most important economic thinkers of all time, and possibly the most brilliant communicator of economic ideas to the general public that ever lived." More than a decade after Bernanke's speech, there are suggestions in Europe in particular, that the European Central Bank should give money directly to citizens in the Euro Area to revive demand. With interest rates at lows not seen in any other time in the past 5000 years, the public would likely see the "helicopter drop" as the last chance saloon.
The Bank of England was founded in 1694 and the current official rate of 0.5% set in March 2009 compares with 6% in Oct 1694 while the rate had never been below 2% until January 2009.
There is evidence of what could be termed official interest rates dating back to ancient times in Mesopotamia — from the Greek, meaning 'between two rivers’ and referring to the Tigris and Euphrates rivers, corresponding to modern-day Iraq, Kuwait, the northeastern section of Syria, as well as parts of southeastern Turkey and of southwestern Iran.
The genesis of loan interest was in places like the Sumerian city of Uruk, which in the fourth millennium had an official accounting system using clay tablets, and William N. Goetzmann, professor of finance and management studies at the Yale School of Management, details here how in the "the Sumerian language, the word for interest, mash, was also the term for calves. In ancient Greek, the word for interest, tokos, also refers to the offspring of cattle. The latin term pecus, or flock, is the root of our word pecuniary."
Later, Hammurabi, king of Babylonia in Mesopotamia, who ruled from 1792 to 1750 B.C. produced a legal code that was set forth on a basalt stone stele currently in the Louvre Museum in Paris. Hammurabi's code was based upon similar legal codes issued earlier by Akkadian and Sumerian rulers of Mesopotamia. Hammurabi limited the rate of interest to 20% on loans of silver, 33 1/3 % on loans of grain.
Professor Goetzmann cites a 1796 B.C. five-year loan contract with a 3.78% annual rate.
According to 'A History of Interest Rates' by Sidney Homer and Richard Sylla, in China banking transactions can be traced back over 2,000 years and in 200 to 300 A.D., Buddhist temples like counterparts in Rome, Babylon and Athens, ran pawnshops.
During the Tang dynasty (618-907), interest rates were generally high and legal limits for private loans ranged from 72% per annum in the earlier period to 48% compared with 20% to 33 1/3 % in the Han period of 200 B.C. to 220 A.D. By the nineteenth century the rate of government loans to merchants was down to 12%.
Meanwhile, an index of sovereign bond yields based on the yields of the leading power at a particular time in the West and spanning over seven centuries starts in 1285 and up to 1600, Italian bonds are used; General Government Bonds from the Netherlands are used from 1606 to 1699; yields from Britain are used from 1700 to 1914; From 1919 to date, the yield on US 10-year bond is used.
Click chart for commentary
Global Financial Data show that between 1285 and the mid-1600s, yields on government bonds fluctuated between 6% and 10% and in some cases were around 20%. "Because there is little data on government bond yields before the 1700s, the spikes in yields that occur can be attributed to specific events that affected the issuers, generally the risk of default stemming from wars that occurred. It may very well be that yields on other securities were lower at different points in time up to the 1700s, but the paucity of data makes it difficult to determine this. Nevertheless, the trend is clear. Since 1700, well developed markets for bonds have existed in London and New York enabling the yields on government bonds to be traced with accuracy. Since the mid-1600s, the average yield on government bonds has been around 4%. Before the 1600s, high interest rates were driven by risk; since the 1600s, high interest rates have been driven by inflation."
In Europe since Mario Draghi, ECB president, gave his mid-2012 commitment to do "whatever it takes" to save the euro, sovereign bond yields have fallen to historical lows.
In June 2014 the Financial Times reported that French 10-year yields had not been lower since at least the War of the Austrian Succession in the 1740s, according to Deutsche Bank; Spain’s were not as low since 1789. British gilt yields were below 1703 when records began.
Italy's 10-year bond yield fell below 2% — for the first time ever (Deutsche Bank calculated based on pre-1861 unification states as if they were one economy) despite Italy not once balancing its annual public finances since 1945.
Zero interest rate policy
The US Federal Reserve's funds rate of 0 to 0.25% dates from Dec 2008; the European Central Bank (ECB) cut its benchmark rate to 1.25% in Apr 2009 and the rate was reduced to 0.05% in Sept 2014; the Bank of Japan (BoJ) set a rate of 0.1% in Dec 2008 and in Oct 2010 set the range at 0 to 0.1%. We have seen above that the Bank of England's official rate since early 2009 has been at 0.5%.
The Japanese overnight call rate declined from a peak of 8.2% in March 1991 to 2.0% in March 1995. By September 1995, it was lowered below 50 basis points (0.5%) and had remained at that low level until 2008. A 2010 BoJ paper says: [during the period from 1995 to 2000, the BoJ adopted what it called a zero interest rate policy (ZIRP). The goal of this policy was to avoid further intensifying deflationary pressures and stop the economic downturn. The BoJ’s firm commitment to the ZIRP is reflected in the often-cited statement by Governor Masaru Hayami at a press conference on April 13, 1999: “We (the BoJ) will continue the zero interest rate policy until we reach a situation where deflationary concerns are dispelled."]
Sixteen years later, the central bank is still waiting.
Six to seven years after the leading central banks of the developed world cut official rates to close to zero, it has become another new normal.
Extraordinary becomes ordinary
David Folkerts-Landau, group chief economist of Deutsche Bank, who has previously worked at the International Monetary Fund, writes in an editorial for the June issue of DB's Konzept newsletter: "...the world seems to have entered a distorted universe and yet [economists go] about...making forecasts as if European sovereign bond yields, for example, were normal — not near their lowest levels in five hundred years. Just stop and think about that for a minute. Not their lowest ‘in decades’ or ‘since the second world war’ or ‘in a century’. Heavens, twenty generations have never seen interest rates at these levels! Even so economists discuss the current situation using the same old language and theories. Investors watch their screens as if nothing out of the ordinary is going on."
He adds: " Economists deal everyday in trifles such as: Where are Janet’s dots? Is a weak euro helping growth? Did core inflation rise a smidgeon in Japan? Yet the answers to such questions are immaterial next to $8tn-worth of quantitative easing (and rising) since the financial crisis. That is almost half the size of America’s economy in new assets on central bank balance sheets. And despite pretending otherwise no one really has a clue about the impact quantitative easing is having now, let alone what may happen when it ends. But it cannot be normal that some floating rate mortgages in Portugal turned negative, with the real prospect of borrowers receiving money each month from their bank. Being paid to own a house! Nor can economists agree on whether negative rates would have happened without quantitative easing anyway. What we do know for sure is that unprecedented distortions abound in part because an entire generation of investors has only known ever-lower borrowing costs."
From 1979 (when economic reforms began) to 2014, China’s real gross domestic product (GDP) grew at an average annual rate of nearly 10% while the World Bank estimates that from 1981 to 2010, 679m people in China were raised out of extreme poverty.
According to US data total trade between the United States and China grew from $5bn in 1980 to $592bn in 2014.
Dr. Folkerts-Landau says in respect of China's economic rise in modern times that the speed has been unprecedented: "Again the numbers are beyond comprehension. Humming along at double digit growth rates just before the financial crisis the country was using 23bn tonnes of natural resources a year, four times as much as the US, the second biggest consumer. Meanwhile, the global imbalances caused by China’s unprecedented accumulation of savings have affected everything from inflation in Portugal to the share price of Louis Vuitton. These imbalances remain with us today and also explain why the global financial architecture is changing before our eyes. New Chinese-led multilateral institutions such as the Asian Infrastructure Investment Bank were inconceivable not so long ago, as was full renminbi convertibility or its inclusion in the basket of currencies that make up the IMF Special Drawing Rights.
"What is more, if a relentlessly rising China made the world an unrecognisable place, do not expect things to become easier now that the country is cooling. A slowdown on this scale also is unprecedented. The reality is China’s working age population is shrinking as a proportion of the total and a historic mass migration from rural to urban areas seems to have run its course. Thanks to the lure of the city, China has almost the same number of migrant workers as America has people. Now only about a fifth of the country’s labour force is left working in agriculture."
More QE to attack the symptoms?
European Central Bank QE has helped — both in anticipation of it and implementation — to push bank lending rates in Italy and Spain to levels below some Irish rates. The wide margin in recent years with German rates has also narrowed — see here.
In the US the Federal Reserve’s purchases of trillions of dollars in bonds has given rise to charges that the central bank has increased inequality by pushing up prices of stocks, bonds, and other assets owned by the wealthy. However in June papers presented at a Brookings Institution meeting show that other sectors also benefited.
Josh Bivens of the liberal (American definition) Economic Policy Institute found that the Fed’s purchases did help support employment and workers’ ability to command higher wages — while the gain in stock prices attributable to quantitative easing may be lower than previously believed. The Fed not only boosted the value of stocks but also prices for houses, according to a second study by Matthias Doepke and Veronika Selezneva of Northwestern University and Martin Schneider of Stanford University. The authors say that middle-aged, middle-class households, which tend to have big mortgages, benefited at the expense of wealthy retirees.
However interest rates remain stuck at zero bound and according to Andrew Haldane, chief economist at the Bank of England and a member of the Bank’s Monetary Policy Committee, the financial markets suggest that in Japan and the Euro Area, official interest rates are only expected to have reached 1.2% and 2.0% respectively ten years hence. "And in the UK and US, they are only expected to have reached 2.5% and 3.4% respectively by 2025."
In a speech last June he said: [There is an old English aphorism, due to Walter Bagehot (first editor of the Economist) in the 19th century: “John Bull can stand many things, but he cannot stand 2%.” Prior to 2009, the Bank of England had been careful to avoid the wrath of Mr Bull: Bank rate had never been below 2% in its then-315 year history.]
In Oct 1939, one month after Britain declared war on Germany, right through the war, and then to 1950, interest rates remained unchanged at 2%.
Haldane said on the history:
[At a Parliamentary Committee hearing a few years ago I asserted, boldly, that global interest rates were at their lowest-ever levels. A wise colleague challenged me afterwards: “How do you know they weren’t lower in Babylonian times?” Several exhausted research assistants later I can report that, luckily, I was on safe ground. Interest rates appear to be lower than at any time in the past 5000 years (Chart 5 below).]
Evidence in August of increasing economic uncertainty in China has resulted in calls from two heavyweights in economics and finance for the Federal Reserve to both abandon a consideration of an interest rate rise in September and relaunch its bond-buying/ quantitative easing (QE) programme.
Lawrence Summers, the former Treasury secretary, Obama adviser and Harvard economist, and Ray Dalio, head of the world’s biggest hedge fund manager, indicated that the US central bank should consider restarting QE to counter deflationary dangers and ameliorate tensions on financial markets. The FT reports that in [an opinion piece in the Financial Times, Mr Summers wrote that raising rates in the near future would be a “serious error”, but later went further and suggested on Twitter that the Fed should even consider another bond buying programme.]
“It is far from clear that the next Fed move will be a tightening,” he wrote. “As in August 1997, 1998, 2007 and 2008 we could be in the early stage of a very serious situation...Right now problems are not overconfidence or investors oblivious to risk, so no need for Fed to send shock across investors’ bow.”
Dalio, the head of Bridgewater, a $200bn hedge fund group, in a note to clients predicted that the “next big Fed move will be to ease (via QE) rather than to tighten” due to global debt levels, the Chinese ructions and turbulence in emerging markets as a whole. “While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces,” he wrote.
Andrew Haldane says global interest rates averaged 5% in the 1980s and 4% in the 1990s. "So far this century, they have averaged 2%. Currently, they are around zero or slightly negative."
He says the explanations for this secular fall in global real rates include "excess savings in the East, deficient investment in the West, worsening demographic trends and rising inequality (Haldane (2015a)). Some have interpreted their downward drift as evidence of secular stagnation, in an echo of concerns raised after the Great Depression (Summers (2014)).
Whatever the explanation, there has been a further ratchet down in global real rates since the crisis. I wish to focus on two factors which have contributed to this fall: dread risk and recession risk. The first generates an elevated perception of risk, the second an asymmetric balance of risk. Both are relevant to explaining the path of interest rates, the likely fortunes of the economy and the optimal setting of monetary policy."
Haldane said: "The psychological scars of the Great Recession, as after the Great Depression, have proved lasting and durable. They help explain the sluggishness of the recovery, and the adhesiveness of interest rates, since the crisis. And if the past is any guide, these scars may heal only slowly...If financial markets' guesses about interest rates are realistic, it is odds-against there being sufficient monetary policy headroom to cushion a typical recession."
In a paper, "Is the unthinkable becoming routine?," published last June with the annual report of the Bank for International Settlements, the so-called central bank for central banks, Dr. Claudio Borio, head of research at the BIS, wrote: "Such low rates are only the most obvious symptom of a broader malaise, despite the progress made since the crisis. Global economic growth may now be not far from historical averages but it remains unbalanced. Debt burdens are still high, and often growing, relative to output and incomes. The economies hit by a balance sheet recession are still struggling to return to healthy expansion. In several others, financial imbalances show signs of building up, in the form of strong credit and asset price increases, despite the absence of inflationary pressures. Monetary policy has taken on far too much of the burden of boosting output. And in the meantime, productivity growth has continued to decline.
This malaise has proved exceedingly hard to understand. Debates rage. Building on last year's analysis, this Annual Report offers a lens through which to interpret what is going on. The lens focuses on financial, medium-term and global factors, whereas the prevailing perspective focuses more on real, short-term and domestic factors."
He adds: "Our lens suggests that the very low interest rates that have prevailed for so long may not be 'equilibrium' ones, which would be conducive to sustainable and balanced global expansion. Rather than just reflecting the current weakness, low rates may in part have contributed to it by fuelling costly financial booms and busts. The result is too much debt, too little growth and excessively low interest rates. In short, low rates beget lower rates."
Low interest rates and QE should be boosting corporate capital expenditure (capex) but with big companies worldwide having an estimated $4.4tn in cash and near equivalents earning little, a report published by Standard & Poor's (S&P) in early August on global capital expenditure by non-financial companies, shows that capex is likely to decline in 2015 for the third year in succession.
Energy and materials accounted for 39% of global capex in 2014, and their capital spending in 2015 is expected to fall by 14% followed by a further 5% next year. S&P says "global capital spending excluding energy and materials is expected to grow by 8% in 2015. If realized, this will be the first positive growth since 2012. The optimism does not yet extend to 2016 capex, but many industries now appear willing to resume capex growth."
Big global services companies such as Apple, Google and Facebook today are less capital-intensive than their manufacturing counterparts were in the past.
Corporate cash piles rose by 6% to €870bn in the year ending December 2014 in Europe, the Middle East and Africa (EMEA), said Moody's Investors Service in a special report published last July.
However, what Lawrence Summers calls "secular stagnation" — a chronic savings glut, weak demand, ageing societies and falling productivity — can result in companies seeking a higher weighted average cost of capital (WACC), which represents the combined cost of the interest payments on their debt and the return that equity investors demand, despite low rates.
With emerging economies struggling and Europe facing long-term low growth, the US has returned to a familiar role as the global economic engine. However, the world's biggest economy has serious challenges such as a decline in the percentage of the population at work and rising inequality. In 2010 Moody's Analytics estimated that the top 5% of Americans by income accounted for 37% of all consumer outlays, compared with 25% in 1990.
John Authers, the FT's chief investment columnist, analyses the latest US jobs data with chief economics commentator Martin Wolf. What effect will the numbers have on when the Fed raises rates? Should it raise rates at all?
Low long-term interest rates encourage governments to take on additional debt; professional investors to take punts on risky assets and many individuals everywhere tend to see property in particular in capital and leading commercial cities, as the best destination to get reasonable investment returns. For older people, while defined benefit (DB) pension schemes with guaranteed payouts are now rare for new entrants to the private sector workforces in advanced countries, the decline in bond yields presents a big challenge for existing schemes as they calculate the value of their future obligations to members based on the yields of long-term corporate bonds.
We have seen during the crisis that the launch of a QE programme can boost confidence but like an antibiotic, the impact of new QE programmes would surely wane over time. Come the next recession with interest rates in the doldrums, central banks will lack powerful tools to boost growth while many governments will likely have high debt levels.
In 2007 the economies of the West were benefiting from a credit boom while in the East, China was growing by 14.2% and its demand for commodities was a huge benefit to other developing world economies.
In 2007, according to the Organisation for Economic Cooperation and Development, the longest retirements for women among its mainly developed 34 member countries, were in France, where retirement stretches on for about 27½ years; France also holds the OECD record for men – 24 years spent in retirement, compared with just over nine in Mexico.
French men generally retire at 59. So a male entering the workforce at 24 would have 35 years working and 48 years as a dependent of the state and parents.
Janan Ganesh wrote in the Financial Times in 2013 on the challenges facing British workers:
"Western electorates have long viewed globalisation as a menace to their livelihoods, but their leaders are barely wiser about viable solutions. In the 1990s, it was hoped that investment in 'human capital' would see off the threat of wage competition. Our workers might be costlier but they would also be better. But results have been patchy at best and it takes a very sunny disposition to believe that the ideas now in vogue – fiddling from the right, daydreaming from the left – will fare much better."
Richard Freeman, the Harvard economist, has calculated that:
"In 1980 the global workforce consisted of workers in the advanced countries, parts of Africa and most of Latin America. Approximately 960m persons worked in these economies. Population growth — largely in poorer countries — increased the number employed in these economies to about 1.46bn workers by 2000. But in the 1980s and 1990s, workers from China, India and the former Soviet bloc entered the global labour pool. Of course, these workers had existed before then. The difference, though, was that their economies suddenly joined the global system of production and consumption. In 2000, those countries contributed 1.47bn workers to the global labour pool — effectively doubling the size of the world’s now-connected workforce."
Inflation is well below central bank 2% target rates and the Fed's policy committee meets on 16-17 Sept with pressure to defer the first interest rate rise since 2006. The preferred US measure of inflation — personal consumer expenditures (PCE) — rose 0.3% in the year to July. However while the Fed focuses on consumer prices, asset price inflation is strong and The Wall Street Journal reports that "the value of US commercial real-estate transactions in the first half of 2015 jumped 36% from a year earlier to $225.1bn, ahead of the pace set in 2006, according to Real Capital. In Europe, transaction values shot up 37% to €135bn ($148bn), the strongest start to a year since 2007...Tightened US Treasury rates could suppress capital costs, widening yield spreads for investors using leverage...A 10-year Treasury note is yielding about 2.2%. By contrast, New York commercial real estate has an average capitalisation rate — a measure of yield — of 5.7%, according to Real Capital."
The Wall Street Journal reported from this month's Federal Reserve symposium in Jackson Hole, Wyoming, that central bankers aren’t sure they understand how inflation works anymore.
Inflation didn’t fall as much as many expected during the financial crisis, when the economy faltered and unemployment soared. It hasn’t bounced back as they predicted when the economy recovered and unemployment fell.
“There is definitely less confidence, a lot less confidence” about how inflation works, James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview.
The Journal concluded that low yields on government bonds suggest investors expect very low inflation well into the future. "Surveys of households and businesses, on the other hand, have been stable since the crisis. If bond yields are right and the Fed is losing the public’s trust that it can return inflation to 2%, it might become a self-fulfilling prophecy."
Despite headline unemployment falling to 5.1% in August, earnings rises since the crisis have been meagre.
A July 2015 paper by Andrew Figura and David Ratner, Fed economists, suggest the labour share of income — the portion of GDP that flows to workers via income — has dipped from an average of 70% in 1947-2001 to 63% in 2010-14.
Meanwhile economists, politicians and central bankers are also puzzled by falls in productivity and growth in general — so-called structural factors: demographics, innovation diffusion and so on.
According to the White House Council of Economic Advisers (CEA) from 1960 to 2007, the US economy had seven recessions, and the average annual rate of growth of real GDP during the 12 quarters following those recessions was 4.2%. In contrast, during the 12 quarters following the trough in the second quarter of 2009, the average annual rate of growth of real GDP was 2.2% and it has been the same rate in 24 quarters to June 2015.
Average GDP growth in 1960-2007 was 3.4%.
The Euro Area and Japan has struggled with weak growth and now the emerging markets are causing alarm.
2007 is not going to return anytime soon for most of the world.
Rising interest rates, though they may hurt stock markets, would ease the pensions dilemma for millions of people and many companies, says the FT's John Authers.
Once the US Federal Reserve raises interest rates it is expected that it will stop at 2%, a zero real rate. David Riley, head of credit strategy at BlueBay Asset Management, tells the FT’s Dan McCrum that investors need new strategies for this higher risk world.
*Many claimed English language Chinese aphorisms are a puzzle to English-speaking Chinese and that is my own experience too!