he reasons are different yet very much related – deficits are big and growth still tepid in the U.S. and U.K., while emerging nations are worried about growth (and therefore demand) from their developed nation partners – but the upshot is the same: Central bankers across the world appear poised to ease.
A seminal moment in the conduct of public finance in the United States was the enactment of the Sinking Fund Act of 1795, which was amended in 1802. It was the continuation of a policy begun by Alexander Hamilton in 1790 as a means of establishing credit for the United States. The fund set aside a substantial amount of revenue for the retirement of debt, and it henceforth committed the United States to paying its debt through the collection of revenues. The act and the notion of public debts were very controversial at that time; after all, tax collections were at the center of complaints by colonists against Great Britain and a catalyst for the American Revolution.
Kearny (as quoted by Buchanan in “Democracy in Deficit: The Political Legacy of Lord Keynes”) describes how the act established conditions by which a system of public debt could be sustained, as it surely has, although not quite in the way envisioned:
“The Act of the 3rd of March, 1795, is an event of importance in the financial history of the country. It was the consummation of what remained unfinished in our system of public credit, in that it publicly recognized, and ingrafted on that system, three essential principles, the regular operation of which can alone prevent a progressive accumulation of debt: first of all it established distinctive revenues for the payment of the interest of the public debt as well as for the reimbursement of the principal within a determinate period; secondly, it directed imperatively their application to the debt alone; and thirdly it pledged the faith of the Government that the appointed revenues should continue to be levied and collected and appropriated to these objects until the whole debt should be redeemed.”
This issue of the Global Central Bank Focus features commentary from Tony Crescenzi on the abuse of Keynesian economics, Ben Emons on a new steady state for interest rates, and Lupin Rahman on emerging markets.
This system of commitment to the payment of public debts worked well until the advent of the Keynesian revolution in the 1930s, which ignited a decades-long abuse of the core principle of Keynesian economics, which is for government to increase its spending when aggregate demand in the private sector weakens and stymies job growth. Prudence toward fiscal matters has since been eschewed in favor of perpetual fiscal illusions that inflated the national debt.
American taxpayers have been hoodwinked for decades by fiscal illusions that lead them to believe that the cost they bear from profligate government spending is low relative to the benefits. The hoodwinkers have been many, in particular politicians in Washington, who lead the American people to believe that the use of debt is without cost. This is the essence of fiscal illusion, whereby the victims are ill informed and are taken advantage of by those who have control of budgetary matters and use debt to hide the true cost of their decisions.
Italian economist Amilcare Puviani first advanced the notion of fiscal illusion in 1903 in his book, “The Theory of Fiscal Illusion,” or “Teoria della illusione nelle entrate publiche” in Italian. Puviani sought to answer a simple question: How can a politician best use his powers of the purse to promote his political projects? Puviani explains that what is best for the politician is not necessarily best for the public. The motivated politician conducts his office by taking credit for all that is perceived as good about public policy, taking credit where credit isn’t due in pursuit of his self-interest and to self-promote.
James Buchanan, who in 1986 won the Nobel Memorial Prize in Economic Sciences for his work on public choice theory, advanced Puviani’s groundbreaking work in 1960, by tying fiscal illusion to the size of government, believing that politicians manipulate the gap between the public’s perception about the benefits of fiscal initiatives and their costs in order to grow the size of government. This can be done in many ways, including by the use of debt and by applying taxes that are less visible than those that are taken directly out of paychecks.
Central Bankers to Keynesians: No Money for You!
Politicians and the beneficiaries of their fiscal illusions for the past 80 years abused the Keynesian philosophy, relentlessly and dangerously pursuing the use of debt for self-aggrandizement. Today, the citizens of indebted nations bear a heavy burden and must begin repaying the debts. It is a herculean task, because the debts are mountainous. Yet, there is no choice, because investors have become intolerant of fiscal follies. They are saying no to Keynes, in other words.
Central bankers in the United States and Europe are also saying no to Keynes, pressuring their respective fiscal authorities to get their fiscal houses in order. They recognize that it is reckless to use their printing presses to monetize sovereign debt. Central bankers know that history is strewn with countless examples where the ravages of excess coinage debased currencies have wrecked economies.
Today, in a world where excessive debts are forcing nations to throttle back their spending, central bankers are once again under pressure to loosen further their stance on monetary policy. This is a condition that makes central bankers uncomfortable, as it further reduces their independence, which to some extent has been lost in the battle against the financial crisis. Central bankers would rather sideline their balance sheets and reserve their use for more pressing times, to put pressure on the fiscal authority to end its fiscal illusions and go back to the sort of fiscal prudence shown before the Keynesian era.
While fiscal prudence is seen as desirable – in fact necessary for the long-run health of nations – investors in the short run worry that fiscal austerity could negatively impact economic growth. They see indebted nations hamstrung and unable to ignite economic growth through policy actions. Investors therefore lament the absence of a balance sheet large enough to promote conditions in the private sector that will lead to sustainable economic growth. The central banker is left to shoulder the burden and will do so, even if reluctant, seeking all the while to pressure the fiscal authority to amend the abuse of the core principles of Keynesian economics and decades of fiscal folly.
The New Steady State
Irving Fisher developed a theory about the relationship between nominal and real (inflation-adjusted) interest rates determined by borrowers and lenders. When borrowers and lenders agree upon a nominal interest rate, they have an expectation of inflation but do not know what inflation will be realized over the term of their agreement. As inflation is assumed to be unknown, the nominal interest rate has therefore a component of an expected real interest rate and expected inflation rate. This became known as the “Fisher equation” that says when expectations of real rates and inflation change, nominal market and contractual rates change.
Recently, St. Louis Fed President Bullard used the Fisher equation to identify two combinations of nominal rates and inflation known as “steady states,” one of which occurs in the absence of any shocks, where nominal rates remain in a “steady state.” In cases where the inflation rate is either very low or negative, nominal short-term rates can move to an “unintended steady state.” Figure 1 from the St. Louis Fed shows these steady states occurring where the Fisher relationship crosses the line representing the Taylor rule.
With the policy rates near zero percent in the developed world and inflation expectations now at around 3% (as measured by the five-year break-even rate on inflation-indexed bonds five years forward – a fancy way of looking past current inflation to where markets believe inflation expectations will be in five years looking five years out) global central bank rates (except for Japan) are currently in-between steady states as depicted in Figure 1. However, unlike what the Fisher equation would describe, even with firmer inflation expectations it has become less natural for nominal policy rates to adjust higher. When the sovereign debt crisis intensified, the construct of the policy rate became further embedded into the real interest rate demanded on government bonds. Since the debt crisis enforces severe austerity onto economies, a risk of deflation remains high and could increase expectations of higher future real borrowing costs. According to the Fisher theory, the borrower and lender would have to agree to a new nominal rate that could be significantly higher. With much higher debt levels and lower growth, higher nominal rates may carry greater risk of insolvency and cause financial instability.
The sovereign crisis has created a new steady state, one where nominal policy rates have to be low to keep inflation expectations higher so real borrowing costs remain stable. As Figure 1 shows, the new steady state would be around 0% to 1% nominal rate with inflation expectations in a range of between 2.5% to 3.5%, as opposed to the traditional steady state that prescribes a 3% to 3.5% nominal policy rate.
In normal times policy rates would theoretically be adjusted to 3% to 3.5% with some degree of synchronized tightening amongst the world’s central banks. In an age of private and public sector debt deleveraging, however, the new steady state aims to prevent deflation rather than inflation. Moreover, although some central banks have started tightening, the new steady state demands very low nominal policy rates stretched out over time, as well as a reduction in the synchronization of tightening cycles among central banks.
The Global Soft Patch: Sweet Spot or Stagflation Risk for Emerging Markets?
A key issue facing emerging market central bankers is the implications of the current soft patch in global activity and renewed risk headwinds from the EU and U.S. for emerging market (EM) growth and inflation.
While emerging markets have fared relatively well since the crisis with most economies rebounding swiftly to pre-crisis activity levels, economic cycles and trade/financial flows remain closely tied with advanced country growth prospects.
There are also signs that headline inflation is peaking as global food and fuel prices have come off the highs of early 2011 (Figure 2). Nevertheless, with real policy rates in low or negative territory, the question facing EM policymakers is whether to pause or continue their monetary tightening cycles.
Markets have already discounted the impact of lower growth prospects and lower commodity prices on EM monetary policy (Figure 3). Local swap curves are now pricing in smaller hiking cycles, essentially assuming that EM central banks will take a wait-and-see approach to policy and delay additional hikes until there is further clarity on the global macroeconomic situation. The recent action of several EM central banks have validated this with monetary policy committees in Poland, Israel, Korea and Malaysia all keeping policy rates on hold in their latest meetings.
However, the decision to remain on hold is not without risks. India’s surprise +50bps hike in the repo rate to 8% illustrates that some emerging markets are taking a different approach to these problems. Emerging markets as a whole, and particularly in Asia and Latin America, have been growing above potential with increasing demand momentum driving domestic price pressures. In addition, while headline inflation may be coming off the highs, there are signs that core inflation is already picking up in some economies. Moreover, upcoming wage negotiations in the second half of 2011 are likely to be more backward looking than in previous sessions given the impairment to household disposable income from the recent spikes in commodity prices.
For these economies a key question is to what extent the global soft patch is transitory vs. permanent. A temporary shock reflecting supply disruptions related to the Japanese earthquake and/or demand destruction in advanced economies due to high oil would eventually pass through the system allowing positive growth dynamics to reassert themselves. A more permanent shock would be reflective of a global economy impaired by a significant deleveraging process which has only just begun and is currently transitioning to much lower New Normal growth rates.
The recent market action and recent EM central bank responses have so far viewed the moderation in global activity as indicating a temporary bump in the road. However, the implications of discounting a more permanent shock are non-trivial. For emerging markets living in an interconnected global economy, New Normal growth rates for advanced economies imply a structural shift in potential growth even as they continue to outperform advanced economies on a secular basis. The result of nearsightedness is therefore an underestimation of positive output gaps compared with pre-crisis levels, leading to growing imbalances and stagflationary impulses down the road.
For EM central banks, identification of these unobservable parameters given the problem of structural breaks is not easy. What is required is less of a reliance on pre-crisis macro models and more of an all-encompassing view of macroeconomic management. This would emphasize candid analysis of the drivers of inflationary dynamics together with assessments of how much policy normalization (fiscal/monetary/exchange rate) has occurred vs. what is required.
For investors, as markets and policymakers grapple with the uncertain global outlook, there may be attractive opportunities in EM local markets where curves have priced in higher hikes than we believe will likely materialize (e.g. Brazil and Mexico) and in emerging market currencies where appreciation will likely continue to be used as an adjustment tool (e.g. CNY, SGD, KRW). The risks include a sharp leg down in global risk sentiment which would increase the credit component and volatility of these positions, together with the potential for outflows given the extent of foreign exposures in the local market and a still evident home bias for capital in times of stress.