“Those who promise us paradise on earth never produced anything but a hell.”
Commentary & Analysis
Global Rebalancing: Neo-Keynesians wrong again & US $ takes the brunt
It’s funny, but really sad, how the neo-Keynesians thought they had it all figured out. With their econometric models firmly in hand for the 2010 Group of 20 (G-20) meeting, and all attendees at attention, the NK’s laid out a simple roadmap to exit the problems of the credit crunch of 2007-2008 in order to avoid a prolonged 1930’s style depression.
1. Lower interest rates
2. Borrow more
3. Spend more
Based on actions since then, it seems the heads of the 20 major economies incorporated the neo-Keynesian roadmap as official policy. Central banks pumped and dumped, while governments borrowed and spent heavily in order to stimulate both domestic and global demand. You can see the results from following down the neo-Keynesian roadmap since 2010:
Here at Black Swan we believed the solutions espoused by the neo-Keynesians back in 2010 was exactly the reason we got into credit crunch trouble in the first place. In fact, we created this flow diagram for a presentation several years ago to explain out beliefs:
In theory, real world limits are difficult to model. In reality limits and feedback loops (or unintended consequences) abound. It is what happens when real people of the rational, irrational, and crazy variety get into the game. The greatest economist of all time—Ludwig von Mises—called this stuff Human Action and understood the limits of economic theory and modeling.
Our contention for many years has been based on the belief policymakers were missing the key element of recovery—letting the market clear. They have not allowed the invisible hand of Mr. Market to work its magic by clearing away the dead wood leftover by the prior manipulated boom; in short they weren’t allowing a real bust, which meant the recovery would be pro-longed and likely more painful (as we learned reading the Austrian School instead of the Keynesian one).
Below are two more diagrams we produced a few years ago to simplify what happens when markets are not allowed to clear:
To their credit, the neo-Keynesians understood quite well and elucidated the key differences between internal and external balances [this is why John Maynard Keynes was so disappointed by being over-ruled during the Bretton Woods agreement by Harry Dexter “Commie” White of the US. Keynes understood external balance—White did not].
A country, with its mix of monetary and fiscal policy, striving to maximize its internal balance can end up creating extremely destabilizing external imbalance; primarily because the world economy allows for the free flow of capital across borders and has floating exchange rates among the three major blocks—US, Europe, and China for sake of argument. [The Bretton Woods II currency arrangement many believed defined the US-Chinese relationship, i.e. the yuan effectively fixed against the US dollar— has ended and this further complicates matters relating to external balance.]
Neo-Keynesians expected increased fiscal spending, more borrowing, and lower interest rates would give time for the three major countries/regions (aka US, Europe, China) to take actions which would help alleviate the woefully external imbalances which were part and parcel to the credit crunch.
Thus, the solutions espoused:
1. US do more borrowing and spending and lower interest rates rapidly…
2. Germany should unleash its fiscal restraints and stimulate domestically in order to help the periphery of Europe instead of a sole focus on export growth at the driver…
3. China should reform more rapidly and transfer wealth to households instead of depending on investment spending to support export growth; and thereby let its currency appreciate to support external demand for both the US and Europe.
1. Five years of declining global growth
2. Interest rates are zero-bound and negative across the developed world-massive financial repression
3. Debt and debt service ratios have soared pressuring corporate profits and increasing country solvency risk
4. New business creation is stagnant
5. Unemployment globally hasn’t improved much
6. Germany has refused to budge, and continues to push deflation onto the periphery
7. China has made strides toward a more consumer-driven economy, but much if its massive stimulus has created investment bubbles and more excess capacity.
8. The US seems to have done its part (and allowed the dollar to appreciate), but many macro-economists suggest there is much more fiscal capacity to stimulate domestic growth.
9. China’s currency is depreciating (instead of appreciating)
Point #8 above is critical. It was believed for a long time China’s currency was 30-40% undervalued against the US dollar. But with bubble trouble, growth slowing, and Chairman Xi seemingly morphing into the next Mao, capital is running out of China and its currency is falling. This is bad news for global rebalancing and was not at all part of the neo-Keynesian roadmap to growth.
China’s falling currency will zap export growth from German and the US (and of course there are emerging markets and Japan which we haven’t factored into the equation). Thus, with China now back in maximizing internal balance mode, it will likely only exacerbate external imbalances at a time when global aggregate demand is at its lowest in five years. Yikes!
Germany is the glue holding the Eurozone together. But Germany is now facing a hose of its own problems, including:
1. Falling export growth; down 10% in July
2. Chancellor Angela Merkel’s disastrous immigration policy is adding political risk
3. German banks are reeling—Deutsche Bank is getting all the press, but the bigger problem may be the estimated 100 billion of dollars in global shipping industry loans held by German banks (a quarter of all loans to the industry). [From Reuters “Segments of the shipping industry are suffering their deepest downturn ever as international trade slows. Around 90 percent of world trade is transported by sea.”]
So we add to the list above more export pressure on Germany from a falling Chinese currency. Below is a chart of the Chinese yuan against the Euro—it is grinding lower….
So, what happens next? Interestingly the central banks seem to be coming around to the idea that zero-bound and negative rates aren’t stimulating demand as their theories implied. So I think we can sum it up by saying:
1. Global imbalances have the potential of getting worse
2. And asset class dangers are huge if the central banks don’t exit with care
From a currency perspective: I expect the US dollar will continue to take the brunt of more global imbalance by appreciating against Europe and China. And if I am right about the impact all of the above may have on emerging markets, as discussed in my last Currency Currents, it is very bad news for the commodity currencies.
US Dollar Index and its eras…now in Global Rebalancing and the New Abnormal: