Big trouble ahead (posted by Leith van Onselen)

Back in May, former Reserve Bank of New Zealand advisor, Terry “Macca” McFadgen, wrote a guest post on MacroBusiness entitled: Will Aussie housing go bust? 

Now Terry is back with another serving of ‘Maccanomics’. In this installment, Terry provides a sobering assessment of the global economy, and maps-out how events might unfold. This is a must read article. Enjoy!


Macca was struck by a short piece in a newspaper last weekend titled “Pessimism is The New Black”. The theme was that the wave of pessimism hitting global markets was a bit like a fashion trend: no real rationale, just an inexplicable thing of the moment that would soon morph into something more congenial.

Sadly that is not the case. The underlying structural weaknesses that are roiling markets aren’t a fashion and they are not going to go away any time soon. Here’s a more sober assessment from the guy who is probably the highest paid fund manger in the world (Mo El Erian, CEO at PIMCO, formerly manager of Harvard’s $30b plus endowment):

“The world economy is now in the grips of a damaging feedback loop involving deteriorating fundamentals, lagging policy responses and destabilized financial markets. If policymakers do not act boldly, and do so in a globally coordinated fashion, the world risks slipping into a prolonged recession with worrisome institutional, political and social consequences”.[1]

As befits a former IMF economist, he minces his words. Unless something changes quite dramatically there will surely not be any bold, globally coordinated action and a prolonged global recession or near recession will follow this failure. That is now Macca’s central case.

What’s gone wrong?

Just about everything:

  • US growth data has been ugly. First and second quarter growth looked quite promising but data revisions have pulled that back and for the last six months growth has averaged a little less than 1% annualized. At this level no new jobs can be created and the 15m odd Americans looking for work will grow in number as new entrants join the workforce. Worse still, the American economy is going to have to cope with a fiscal contraction next year of about 2% of GDP as stimulus measures like payroll tax relief expire this December. A recession or near recession in the USA is pretty much guaranteed for 2012 in the absence of a new cross party stimulus deal. The media will focus on the “R” word-but it’s irrelevant whether growth is slightly negative or slightly positive. The USA needs strong growth to escape its current predicament and that is just not going to happen next year.
  •  US house prices continue to weaken a little and the 25% or so of households under water are running out of air. These families cannot move location even if they could find jobs elsewhere. The world’s largest economy is facing a future in which high unemployment will become structural as skills fade and motivation is destroyed. The social consequences- alluded to in passing by El Erian in the paragraph above but of huge importance- will potentially be nasty. The UK riots are a warm up.
  • The US debt ceiling shambles has destroyed investor and business confidence in the ability of the US political elite to manage the country sensibly. Don’t expect businesses to invest or start hiring in this climate. Would you? Sadly, business is the one sector that has cash ready to spend given that households and the Government sector are both in lockdown mode. The best lifeline for the US economy has now been cut by inane political games. As I write, US 10 year Treasury yields have hit their lowest level in 60 years.
  • The European Monetary Union is a shambles, and a debt -death spiral (where rising interest rates force austerity measures which cut tax revenues which  results in expanding fiscal deficits which pushes up rates once more) now threatens economies of real size and importance-Spain, Italy and France. They have responded with panic measures designed to cut fiscal deficits in the hope that bond markets will remain open at attractive rates. But as they all do the fiscal squeeze together, European demand is going to contract. Europe needs growth, not panic driven austerity. This week’s GDP data for the E.U was terrible and the Union now stands on the edge of a recession.
  • A partial break up of the Euro-zone is now Macca’s central case. This sees the weakest of the Club Med members being forced out (Greece and Portugal-maybe Ireland or even Italy) or the rich north (Germany, the Benelux countries, Austria and Finland) cutting themselves loose. It is a case of “choose your poison”. If the weak are forced out, a lot of German and French banks are going to have to be recapitalized to cope with the consequent write- downs in the value of bond holdings. If the rich north departs, then their new currency will appreciate rapidly and the north will end up in recession, at least for a period, as its exports get hammered.
  • Which takes us to China where inflation continues to rage out of control and no meaningful progress has been made towards a rebalancing of the economy away from building”bridges to nowhere”.  Growth in household consumption remains non-existent thanks to policy inertia in relation to wages(suppressed), interest rates on savings(negative real rates), and social safety net initiatives(nil).The best analysis Macca has seen suggests that China GDP needs to fall by about half (i.e. to around 5% pa) to bring inflation under control. Watch out Australia under such a scenario.

All this wouldn’t be quite so frightening if there were visible solutions. But there are not.

Three overriding problems block the view of happier days:

1) Further fiscal stimulus to support the world economy over its looming slump looks a very remote prospect. Most government balance sheets are now fully extended and those that still have capacity to make a difference to the world outlook (the USA, Germany, China) face high political barriers or other constraints.

2) The break up of the Euro-Zone now seems the most likely scenario and, as noted above this only offers lose/lose outcomes the scale of which is uncertain but surely very large.

3) Increasingly, the focus of investors and policymakers is turning to the underlying problem which is that the world faces a shortage of final demand. This is structural, not cyclical[2]. Successive attempts since 2000 to reflate economies with “money dumps” have failed. The latest round of QE dollars simply went into asset speculation or bank reserves. Commodity prices rose (including oil which ironically bit the hand that fed it), and so did stocks. The real economy did nothing. No new lending, no new jobs, no signs of life. The Fed may still be forced into QE3-but they will not do so with any conviction that the real economy will respond in the short term. The objective will be inflation and further USD devaluation (upon which I comment below.)

So the big picture is that of a shrinking or static world economy, a developed world with no gunpowder left in the fiscal or monetary magazines and deep structural issues which remain unresolved. Professor Joseph Stiglitz recently summarized all this as follows:

All of this [gridlock politics in the USA, excessive austerity in Europe] makes it likely the North Atlantic will enter a double dip, but there is nothing magic about the number zero. The critical growth rate is that which stops the jobs deficit getting larger. Problematically, America’s and Europe’s current growth rate of about 1% is less than half the amount required to do this.

When the recession began there were many wise words about having learnt the lessons of both the Great Depression and Japans long malaise. Now we know that we didn’t learn a thing. Our stimulus was too weak, too short and not well designed. The banks weren’t forced to return to lending. Our leaders tried papering over the economy’s weaknesses – perhaps out of fear that if we were honest about them already fragile confidence would erode. But that was a gamble we have now lost.

Now the scale of the problem is apparent, a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario”[3]

Pause for stiff drink here if you wish. Indeed Macca himself had to do so.

How all this will resolve itself is unclear. But three decisions are going to be critical:

  1. Will Germany Fold its Cards and Guarantee all the Bills?
  2. Will The Fed Inflate US Debt Away?
  3. Can A Grand Bargain Be Struck?

1. Germany’s Big Decision

The crisis in the Euro-zone could be solved overnight by Germany guaranteeing the rest of its members either by permitting the issue of Eurobonds backed by the EU as a whole (jointly and severally), or by greatly expanding the EU Emergency Support Fund. Germany’s credit is vast and unquestioned.

But the obstacles are many. For a start ,Germany would not even contemplate such a move without having a high level of permanent control over the budgets of all EU members-a perfectly reasonable requirement. (Would you dear reader want to be guaranteeing Berlusconi or the serial fiscal criminals in Greece, or for that matter the Spaniards with youth unemployment at 40%?).

How would such control be exerted in institutional terms? Does Germany really want that responsibility and how could the transfer of sovereignty possibly be sold to the rest of the EZ populace? The institutions are not in place to take such control, nor does the EZ populace understand the issues. Treaty amendments would be required as a minimum, and probably referenda. In 10-20 years that might be attainable-but today it seems a massive stretch, even under the threat of immediate insolvency in the Club Med.

But the alternative – a break up of the EZ – seems equally unpalatable. Unfortunately it is the default option and the smart money is backing it.

Maybe when we reach one minute to midnight Germany will blink and it will take control of Europe in exchange for its balance sheet. It’s an horrific decision for the German people. My guess – I stress guess – is Germany will not do so because the institutional and constitutional issues are too intractable. So the EZ will struggle on, hoping vainly for a change of market sentiment until it collapses some time next year. What then happens to the wider EU project is very unclear.

Macca wishes it were otherwise because the Euro has been a magnificent – albeit flawed-experiment and the social and political consequences of break up will be with us for decades. Let me offer some final words on this subject from Jeremy Warner, The Daily Telegraph’s economics writer:

“Watching Angela Merkel and Nicholas Sarkozy at their press conference on Tuesday [August23], it was clear that the two are still a million miles away from recognizing the enormity of the choices their nations face-and that the crisis will have to escalate at least a couple of notches before they will even consider the solutions that are required…

The truth is that a project meant to tame Germany and integrate her into the heart of Europe has backfired spectacularly. Far from making economies converge, it has succeeded only in driving them ever apart. From Britain’s island haven, we can only look on in horror as Europe once again stares into the abyss”[4]

British hubris aside, it is hard to disagree.

2. Will The Fed Inflate US Debt Away?

Unlike most other central banks, the Federal Reserve has a dual mandate-to maximize employment and to control inflation. The inflation target has never been formally stated, but like most central banks we can assume it is under but very close to 2% pa.

As long as around 25% of US households with mortgages are under water there will be no employment growth and deflation will be a constant threat. The household mortgage problem could (and should) be solved by fiscal initiatives (e.g. debt for equity swaps offered by the Federal Government), but these routes are almost certainly closed by Washington’s political paralysis.

So what should the Federal Reserve do to meet its mandate? Arguably it should (indeed must) encourage a period of above target inflation. Assume a household with a debt to house value ratio of 100%. Assume also inflation of 4.5% pa for five years. Assisted a little by the power of compounding, the ratio has improved to 80% by year five which is starting to look much more manageable. Household consumption is revived, employment grows, problem solved.

In reality such an approach would involve a massive value transfer from savers (whose savings are devalued) to borrowers (whose debts are being massaged down). The victims of this transfer would be a mixed bunch. Boomers would suffer but so would the Chinese, Japanese and Petro-zone countries all of whom are major lenders to the USA. The USD would be hammered and US yields would come under upwards pressure in the absence of massive QE to force them down.

But massive QE would be required anyway to get inflation going at a good clip. So stand by for QE3-probably after the joint congressional committee has reported on its savings proposal and there is nothing in it for homeowner relief or to ward off a 2012 recession.

Markets therefore see a high risk of US inflation/devaluation and it is not for nothing that the price of gold has doubled in a couple of years, or that the Swiss Franc has gone through the roof in the last month or so.

Apart from the destabilsation of economies outside the USA via currency appreciations (not our issue says the Fed), the major problem is calibration. What additional quantity of money dumped into the financial system is sufficient to get a reasonable amount of inflation but not an avalanche? The Fed will have models which point to answers – but the models are highly uncertain. Risks abound.

The politics too is likely to be fearsome. Savers get hit and over- borrowed households get a free kick. It’s election year and a political fiasco is in prospect which would see the Fed getting dragged into the political arena. Add to that prospect a geopolitical backlash as the value of Chinese US bond holdings is trashed.

Maybe you are now thinking that gold at $2000 per once is not silly and a little place in Bluff (the remotest place on earth for those not familiar with NZ geography) might be a good idea? The rush is on for inflation proof assets but there are not many places to hide. It’s scary.

So will they do it? In my view yes-unless Washington can come up with a fiscal package to head them off, which seems highly unlikely. Stand by for QE3, inflation and further USD weakness.

3. Can A Grand Bargain Be Struck?

As long as global final demand is weak the world economy will remain mired in recession. The global”business model” of the last decade and a half was built on fast growth of household demand in the developed world fuelled by easy credit, Chinese deflation and inflating asset values, particularly housing. That model is now dead. Note that an intrinsic part of the dead system was the build up of massive current account surpluses by China and Germany in particular as they suppressed domestic demand and gorged on exports.

Where might alternative sources of demand come from? That’s easy – it can come from Chinese, German and Japanese households none of which participated in the “developed country” consumption splurge.

If those households could be mobilized to spend some of their vast savings by appropriate policy measures then world demand could be rebuilt on a basis which saw current account balances restored to neutral levels. That is, the USA would move into surpluses via exports, and China, Germany and Japan would move into much smaller surpluses and eventually into balance. Within Europe the Club Med countries would also need to rebuild export capability to balance their current accounts vis- a- vis Germany and to replace burnt out households as a demand source. This they could achieve by exiting the EZ and devaluing.

The ingredients of a grand deal would look something like this (there are many variants on this theme):

  • China would take aggressive policy measures  to reorientate its economy towards more household consumption and much less infrastructure investment;
  • Germany and Japan would also stimulate household consumption and reduce their dependence on exports;
  • Currency realignments would be agreed to support these reorientations, including those required to assist the PIIGS;
  • Temporary funding support would be provided by the surplus countries (China, Germany, Japan) to facilitate the necessary economic transitions; and
  • The USA would agree to limit further QE (and inflation) and would support the USD at a defined value.

Grand bargains have been struck before – for example at Bretton Woods in 1944 and in the Plaza Hotel 5th Avenue in 1985. Will it happen again? No – not any time soon because in addition to the complex policy issues the political obstacles are overwhelming in the context of the current election cycle in the USA and the leadership transition next year in China.

Moreover, if China sees in the current situation the potential for the total breakdown in Western economic leadership, why not just watch the ship sink? That, beyond everything, is the question of the decade and maybe of our generation.

But if the Chinese can be persuaded that their interests do not lie in the direction of an implosion of the developed economies, then thereafter one might see a glimmer of hope as the world faces up to its two harsh options – either do a comprehensive deal realigning economies around available sources of demand, or face a very prolonged period of adjustment by slow degrees accompanied, one fears, by serious political upheaval.

So What?

You can slice and dice the answers to three questions above to generate a lot of different scenarios-none of them very attractive. And you can fold into the mix a wild card which is the potential for the Bi-Partisan Committee on US deficit reduction to surprise us all with an effective package delivering further short term stimulus coupled with longer term disciplines and a solution to the housing conundrum.

But viewed as a whole Macca says expect more bad news and keep your powder dry. Things probably have to get worse before they get better.

In fact there is no shortage of folk who see in this crisis the demise of liberal democracy and free market capitalism itself.[5] Macca used to scorn such predictions as rubbish but he does so no longer.

Sometimes people live through major inflection points in history without knowing it. How many Frenchmen understood that the revolution of 1789 would transform the world for centuries and how many Soviets understood that Perestroika heralded the demise of the Soviet Union?

Maybe we too are living through such a moment. The break up of the EZ-and possible end of the European project-would be bad enough, but if China decides to stay on the sidelines and dissemble, then all bets are off.

On the positive side, adversity can breed great leaders. That isn’t Obama, Merkel or Kan for sure – but maybe from left field our FDR or Thatcher will emerge. We live in hope.

[1] El Erian, “Pouring fuel on global debt fires” , FT, 15 August 2011.

[2] Brilliantly explained by Raghuram Rajan, former IMF Chief Economist , in his 2010 book, “Fault Lines” ; and by Charles Dumas in his 2010 work, “Globalisation Fractures”

[3] Stiglitz, “How to Make the best of the long malaise”, FT August 9 2011

[4] “As Merkel and Sarkozy Talk, Europe Slides Towards Disaster”, Telegraph, 17 August 2011

[5] For a very thoughtful look at this issue in the context of the entire history of mankind see Prof Ian Morris’ magnificent work, “Why the West Rules for Now”. For a more dramatic view see Prof Niall Ferguson’s “Civilization”. 

Unconventional Economist
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  1. A book written in 1990’s by Strauss and Howe called “The Fourth Turning” makes a pretty good fist of predicting where we are now, MIT is a sobering read once you get through the re-itterive style of writing.

  2. Most of it is a typical central banker thinking. Manipulate bond market, print more money and things will fix themselves. Where does it leave deep structural changes that occurred on a global scale? Will ongoing QE3 return manufacturing back to the US and create more jobs? How would Eurobonds backed by the Germans change the economy (and economic culture) in Greece? The ideas presented above are as good as saying that putting new wallpapers on cracked walls will prevent a house in disrepair from collapsing. The underlying real economy needs some deep structural changes to restore the balance and the only such change suggested above is restructuring the Chinese economy towards domestic consumption. If the Chinese are not willing to do it themselves what else can be done? Impose trade barriers?

    • Bravo! Well said.

      I was with Macca at the beginning, but it was all downhill from there. Macca, you’re good on identifying the symptoms but if it were me I’d be awarding you a big F on the cures you’re advocating. As JPK said – typical central banker stuff.

      With respect, central banker types need a total brain recalibration. Is there some kind of therapy that will permit you to unlearn all the trash you learned in Central Banker School. Go and study Engineering and apply those principles to finance. Learn about feedback loops and stable and unstable systems.

      Manipulation of the money supply WEAKENS confidence in the markets. Political “involvement” as you put it, does so too. The true political “involvement” this situation needs is the rule of law to be enforced – particularly with regard to fraud. The one (and probably only one) sustainable-long-term assistance politics can be to markets is to enforce the rule of law (assuming the legal system is well developed).

      The key problem is debt – enormous masses of it. We came to this point by way of a global ponzi scheme. All that needs to be recognised is that the method by which banks provided credit and expanded their credit base (at the encouragement of the political sphere, god help us) was fundamentally fraudulent and unsustainable. Prosecute that, and the problem will be largely solved.

      Macca’s approach (printing money) will only perpetuate the problems because it doesn’t strike at the root, and it will undermine confidence in the markets and disenfranchise those who have the most potential to grow the economy – savers. These are the ones who have been more prudent from the beginning. Steal their savings by compromising the currency and they will leave and you won’t see them again for a long time.

  3. A grand bargain is all they can hope for. Slowly the realisation of the predicament is dawning on all. There is no easy way out of the current malaise as it has been so long in the making.

    From the US position at Bretton Woods, the neo-liberal forks of the IMF and World Bank, the abandonment of the Gold Standard in 1971 , the deregulation of markets in the 80s, the Wall Street invasion of the City of London, the financial fudge that was EMU, the Wall Street takeover of the US government…the financialisation of the global economy. The market rests its case…..

    The damage has been done and it’s now a case of serious CPR on the resulting corpse followed by serious recuperation. There is no doubt it is time for serious action and this will involve some serious negotiation at the highest level. A major realignment of exchange rates (as at Plaza/Louvre) to reflect trade positions, large haircuts all round on debt and a reorganization of the banking system via monetary dialysis.

    The most serious problem is that our politicians are ill-equipped to carry this out.

  4. I have to say that a criticism that a lot of the “we can engineer things to a fix” type approach normally assumes that everything else not directly stated will more or less stay the same.

    Good luck with that – hasn’t worked yet.

    The system is sick to death – let the debt go.

    Else, we’re just looking at more and more and more intervention to the point of govt takeover…

    My 2c

    • +1

      We a lot more thinking about debt forgiveness solutions to this crisis. I haven’t heard any specific proposals that sound terrific. Many solutions are politically difficult but debt-forgiveness seems to have the potential to have support across party/ideological boundaries. It’s a pretty easy sell to the indebted but a sound argument can also convince savers.

      Although Steve Keen has been rather silent on it, he has mentioned it here and there over the years. I imagine Steve will start banging on about it once he believes the time is right. He may have a plan up his sleeve. Steve’s somewhere politically on the left, with study of marx and communism in his past, he seems happier with a mixed economy these days. Other economists – can’t think of any off hand – that would be more associated with the right have favoured no bailouts and bankruptcies instead. If you look sideways at bankruptcy, you’ll see that it’s a debt-forgiveness mechanism.

      We had a great inflation. Now we need a great contraction with debt-forgiveness to make it less drawn out and hopefully less painful. No doubt some changes to banking are necessary to prevent a repeat. Might be enough to reboot the economy.

      • I linked a while back to a great article on this topic, partial debt forgiveness – can’t recall what site it was from. At some point it may be the only alternative to total collapse of the credit markets however is made more difficult by the activities of hedge and derivative markets.

        In my view, if the NPL issue in China gets too unwieldy it will be resolved via something akin to debt forgiveness – no need to destroy the entire system, recalibrate and put into place measures to ensure the situation is not repeated.

        • China has had a history of debt-forgiveness.

          They’ve done it many times in the past.

          They do it by recapitalising their banks when their NPL’s render their banks insolvent.

          They do it with printed money, which drives up (real) inflation. It is organised and deliberate theft from prudent savers and handing it to the imprudent.

          This, in turn, creates more incentive for imprudence, and the wheels stay on the ship only as long as appearances of stability remain.

          So, in summary, China has been trying a form of partial debt-forgiveness for a long time. It appeared to work for a long time (these kinds of anti-gravity schemes can because of the sheer size of the system), but I’ll wager that the cracks have already appeared and “something’s gotta give” soon.

          Fiscal discipline. Fiscal discipline. Rule of law. Consequences for fraud. These are the only long term solutions and the sooner we move in that direction the better and more prosperous will be the long term outcomes.

  5. “The most serious problem is that our politicians are ill-equipped to carry this out.”

    The most serious problem is that our political systems (MSM controlled representative democracy) failed. We have to change political system to bring people who will be able and willing to change economical and financial systems

      • that is 50 trillion dollar chicken and egg question.

        I don’t know what the solution is but I can clearly see what the problem is. Governments (western and eastern – some less, some more but all corrupted) are there to make solution for corruption problem but they are once who are corrupted. This makes finding solution very hard if we just follow usual paths inside the system (switching between two parties following election cycles). Some other ways to solve the problem (ones that include violence) will be worse than living with these problems.

        What world needs is bottom up social movement that will force politicians to change the system. We need to reduce power of money and MSM on election process. We have to break media empires into small and independent information (not opinion) providers. We have to make politicians responsible for promises they make (pre-election promises should be binding contracts with legal consequences). We have to change election system, get rid of political parties as we know them.

        We have opportunity not seen before: existence of new tools (e-democracy) that information technology offers us. We may use them to strengthen direct democracy procedures that could control power of politicians. We may get rid of regular election cycles and use these tools to make “normal” elections only when people feel elections are needed…

        There are so many things we could do to improve the system, some of them will take long time but we have to start now. Otherwise, by every day we will be closer to the ugly violent solutions that some people hope for. Fukuyama was clearly wrong, this is not end of the history. Instead our future existence is dependent on the way new history will written.

        • At
          Ron Hera comments:

          “As the collective encompassed by a government grows wider in scope, the constraints on individual behavior, and on the rights of individuals, grow accordingly. In a family, clan, tribe or village, leaders are more or less directly accessible and accountable and individuals have direct input on decisions affecting the collective. As the scope of the collective grows, individuals are increasingly subordinated, eventually having no meaningful input on decisions, no significant access to leaders and no influence over the policies of the collective. Political disenfranchisement, therefore, follows globalization in lock step.”

          It seems to me the locavore movement which to date has confined itself to food issues has a model to offer wider society. Farmers markets are beginning to show that individuals can lead changes by the choices they make.

          Citizens initiated referenda have been a big fail in New Zealand. Maybe online petitions such as those offered by are an opportunity for individuals to reclaim their voice.

          • Disagree Julienz, we have systems that are more local at the moment but are marred by less participation. Local governement elections have very low participation. There is near universal approval for the removal of power from state governements to the commonwealth, and has been for some time.

            I would suggest that much of this is occouring because people believe that their responsibility will become smaller as the group becomes larger.

            From the sense of the collective this is people looking to increase the size of the collective so that their own burden will fall, for the half of the population that are above average contributers this is likely to be untrue.

      • > We have to change political system to bring people who will be able and willing to change economical and financial systems

        Let’s outsource the government to Macrobusiness 🙂

  6. Well that’s put a dampener on the morning.

    I love the Grand Bargain. I haven’t seen a plausible (if unlikely) solution for the entire global economy described so succinctly before.

    Note to Fanboy:

    China would take aggressive policy measures to reorientate its economy towards more household consumption and much less infrastructure investment

    This is called the “greater good”. Look it up.

    Moreover, if China sees in the current situation the potential for the total breakdown in Western economic leadership, why not just watch the ship sink?

    But how does China do this? Where does the demand come from for its massive manufacturing capacity if the entire Western world is in the doldrums? You’ve already described China’s reluctance to rebalance away from investment and towards consumption.

    • “Where does the demand come from for its massive manufacturing capacity if the entire Western world is in the doldrums?”

      The military? Maybe they go US-style and ramp up domestic military spending to emulate the same demand for manufactured goods? If I had my tin foil hat on, I’d say current happenings present a lot of opportunities for China in areas beyond the markets…

      • Maybe thats a good way for Germany to stimulate demand without exporting to the rest of europe. A big military buildup.

  7. “So what should the Federal Reserve do to meet its mandate? Arguably it should (indeed must) encourage a period of above target inflation”.

    I think that is whats needed. Although a target of 4.5% in my opinion won’t do it. It needs to be 6-7% over 5 years.

    Another problem: If the Fed commits to a high inflation target by themselves, the USD will weaken, all the emerging market pegs will come under pressure, inflation will rise in the EM’s and they will respond by raising interest rates which will further depress global aggregate demand.

    Thats why I think a high inflation target has to be undertaken globally and led by the G3 (Fed, ECB & BoJ).

    “What additional quantity of money dumped into the financial system is sufficient?”

    In the current environment (where short term rates are zero and long term rates close to their floor) the quantity of the money dump needed to create the required inflation is huge. IMO, the best way out of a liquidity trap is for the central bank to buy equities as part of a high inflation policy. Unless something unconvential like this is undertaken, one round of QE will just lead to another (a la Japan), the economy won’t recover meaningfully and the hard money/inflation hawks will take the upperhand… then we are screwed.

  8. At least we have a few savers left in The West. How many would be willing to ‘do it again’, given the terrible consequence they would see their/their friend/ their parents/their grandparents savings suffer? I, for one, would never save again. We are at the financial point of ‘being good’ or ‘rewarding bad’; and a ‘bad society’ is not a society ( think London, writ large) that I think any of us would choose to live in.If pain has to be taken, let it be on those that took the risk; not those that ‘did the right thing’.

    • But in a democracy when the majority has taken the risk and the minority has been fiscally prudent, who do you think will win?

    • My German grandfather lived through the introduction of the deutsch mark. It was year 0 – everyone got a couple of hundred marks regardless; all other money was worthless. Because of that, he kept his money under his matress until he died in the 80s.

  9. Do You Feel Lucky Punk?

    But massive QE would be required anyway to get inflation going at a good clip.

    Can Macca explain operationally/mechanistically how QE will raise inflation to the levels indicated. We’ve had ~$2 trillion of QE (or thereabouts) and virtually no inflation. Macca needs to explain how/why further QE won’t simply end up sitting in excess reserves. For any policy measure to be inflationary the money needs to be circulating.

    • Virtually no inflation? Have you seen commodity prices? UK inflation? US PPI & CPI? Emerging markets?

      It may by cyclical, combating the structural deflation, but it’s still inflation.

      Money is circulating. Zero borrowing costs > carry trades > commodity prices rises > emerging market inflation > Western input prices rise > Western CPI rises.

      • +1. Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. (friedman–one of the ayatollahs of the current mess)

        we have learned nothing. the stage is quickly being set for WWIII unfortunately.

      • No one is borrowing so new activity is not taking place. However, if money was spent directly into the economy (investing into education for example), you would see that start to flow around the real economy. The big mistake the plums at the FED made was to ignore the real economy and try and re-float the financial one.

        They are major output gaps in all economies now. Direct stimulus could operate without fear of inflation.

      • Do You Feel Lucky Punk?

        Mate you’re hyperventilating. Calm down.

        The context was boosting US inflation. The only modification I’d make to my original comment is to change “virtually no inflation” to “virtually no increase in inflation”

        I’m not aware of any mechanism by which QE can boost inflation because, as the data shows, the money never leaves the Fed, it sits there as excess reserves.

        Additionally here is the inflation data:

        If you can explain how further QE will raise inflation to the levels discussed in the article then lets hear it. If you have data that shows QE money is circulating and US inflation is high lets see it.

        • DYFLP, I am not sure who you are referring to, but if QE does not create inflation, then why do it? There is no data needed here to prove the point that inflation is money inflation which in turn leads to price inflation.

          • Do You Feel Lucky Punk?

            PL: if the Fed printed (literally) $10 trillion in banknotes and then buried them at the bottom of the deepest mineshaft and covered it in concrete would you expect inflation?

            If you answered “no” did you do so because you concede that money has to be accessible/circulating to be potentially inflationary?

            Therefore can you explain how excess reserves can be inflationary?

            As for why they did it, at the time from memory (stand corrected) the talk was about them influencing the yield curve. Having said that it appears that some members of the Fed had an expectation that excess reserves would, at least in part, be lent into circulation …as per a link to FT Alphaville article on this website a few days ago.

          • DYFLP:

            I concur, I see the data, agree that burying $10TN, if not circulated, will not lead to inflation. But manipulation of the yield curve does distort the time price of money and the capital structure.

            The time price of money — interest rates — is the link between financial assets and real assets, as well as capital investment. Pushing rates to zero is completely stupid. There is more to this story, however, and it requires more thoughtful analysis than a top of mind response.

          • Do You Feel Lucky Punk?

            PL: setting the overnight rate to near zero (0.25%) is not QE. If anyone defines that as QE (and I note above the red herrings, in the context of a QE debate, about ZIRP etc.) then all central banks are doing QE always since they all have a target overnight rate.

            So let me put it to you and others that you are confusing two bank operations: setting the overnight rate and QE.

            Further, while it might have been the Feds intention to manipulate the yield curve the case can be made that they failed because they targeted a fixed quantity of purchases (600 bill) rather than targeting a price/yield. Interestingly Bernanke had said several years ago that you could set rates all along the curve by targeting the yield/price. Why they chose not to do that is curious.

            In any case the point I am making is that increasing excess reserves has not been, and will not be, inflationary so as a mechanism to achieve a much higher inflation rate, as outlined in the article, it will fail (unless someone can suggest a mechanism by which it can possibly work).

          • DYFLP, I am not clear about the QE process, but my understanding is that it is because — and I think you referred to this — the Fed is paying interest to the commercial banks (2% or so), so they hold it. If banks are sitting on the cash, then what compels them to, ad nauseum?

            But manipulating the yield curve does distort the capital structure, because it is a rate-setting mechanism. Thus it distorts the whole price/yield relationship.

  10. Great analysis, but he advocates more of the same as the solution – inflation. I am not saying it will not happen, but to assume above average inflation in the US and, “Assisted a little by the power of compounding, the ratio has improved to 80% by year five which is starting to look much more manageable. Household consumption is revived, employment grows, problem solved.”

    Obviously this is the magic of macro numbers. Simply increase the money supply. Oh, sorry, did he say inflation; what’s the difference? Transfer the wealth from the savers to the borrowers — we need a check on the morality of that! — and continue to bless the debtors – indebt yourself and pay off with inflated dollars (i.e. credit expansion via further Fed QE, more debt and hey presto, consumption increases as does employment). Wrong. There is no slicing and dicing of anything. The solution is not more consumption, as he advocates, but production – to extend the capital structure of production and provide more jobs. Producers (i.e. entrepreneurs) employ people not consumers!

    However, there is a paradox here: the Fed (and now the market) has kept bond yields low for too long. But business is not buying it. When consumers retrench and switch to savings, then those businesses that produce products borne of easy credit (and therefore a lower cost for that business) find that there are no customers willing to buy or at prices above their cost. So no amount of monetary expansion can distort the consumption/savings patterns of consumers. They adjust according to their lights and no easy manipulation of the macro levers will provide a “problem solved” scenario.

  11. Inflation is one of those things I watching keenly.

    As a saver, I will go in to debt if it looks like the world is going to inflate savings… and debt away.

    • Agreed, I am sick of my savings being eroded by inflation. Wish I had brought some precious metals a year or so ago when I was originally thinking about it.

  12. Is a major global depression such a bad thing at this point in time?
    I think without it there will be no ‘lessons learned’ from the GFC, thereby ensuring the necessary structural reforms are not enacted.
    The reforms are economic but at their heart they need to be based on a reassertion of our moral compass where individuals understand and accept that as adults in a liberal democratic society, people must take responsibility for their own actions.
    At it’s very basic level, the problem has been one of individuals abrogating their personal responsibilities. Thus millions of individuals made dumb, short-sighted, and essentially greedy decisions for more than a decade, and ran up personal debt levels that were always unsustainable.
    That rampant speculation/consumerism has always had one outcome….it was only a matter of when.
    Now the day of reckoning has arrived, we are told the ‘solution’ is to inflate away the problem, and/or forgive the debt. This will involve a transfer of wealth from those that were thrifty to those who were not.
    Why should entire countries full of hard working, honest and thrifty people now bail out whole countries full of those who over reached themselves? What message does that send to the profligate and greedy? It’s ok to do whatever you please as at the end of the day you will not be held accountable. so it’s no longer ‘too big to fail’ ….now it’s ‘too many to fail’.
    At a personal level, why should I who have saved diligently during that decade now allow a transfer of my wealth to my neighbour who embarked on a speculative binge of borrowed money to fund a life style they could not afford….and frequently told me I was a fool for not doing the same?
    No, if we are to chart a better course for the future, then let the ‘too many to fail’…

    • That is exactly why inflation as a policy will lead to increased crime, trade war, civil war and in the worst case, outright war.

      It will further divide and polarise society (and countries) against each other.

      Very easy ground to popularise and rise to power on…

  13. An interest rate rise would send gold and other commodities back down and ensure investors and savers that there is some point to it all. The potential for hyper inflation could be nipped in the bud. We would all benefit in the end.

  14. Lots of people suggesting ‘inflation is the answer’, and that at the end of this path lies some sort of new panacea.

    This might stealthily remove some of the debt, but does nothing to help the ongoing social problems and distortions. In fact, it will support and twist them still further.

    Remember that we are where we are because of an enormous credit binge. That credit has already led to huge inflation (e.g. houses) over the last decade.

    1. Society is already somewhat divided now into ‘haves’ and ‘have nots’ as a consquence of inflation. Further inflation will further drive that division. How is this resolved? How do you stop inflation turning into a cycle as people seek to protect their incomes and savings?

    2. Society is distorted with far too many people now working in FIRE related industries that arguably are parasitic to society as a whole. How is this resolved?

    3. Big business / finance / banking has become distorted and it’s whole existence now relies on continuous inflation and credit ‘pushing’ in order to exist as it does and make profits. How is this resolved?

    4. How do you purge the current societal meme of ‘leverage = get rick quick”? Unless this is fixed, any reduction in debt will just lead to everyone borrowing still more…

  15. We got to this ridiculous situation simply because as a result of inflation, resulting in negative after-tax interest rates, almost everyone di8d what was logical and borrowed more.
    Now we are going to fix it by doing the same thing but on a greater scale. Absurd does not begin to describe this thinking process. Gross stupidity!

  16. I was not advocating out of range inflation as some have inferred, simply observing that given the Feds mandate it is quickly running out of other options.It could of course just sit on its hands and say this is a problem for the politicians-go fix it through the fiscal route.But it will be reluctant to get into a fight.And yes-QE funds are only helpful if they enter the economy-but at some point near zero yields on funds of any maturity sitting alongside real assets with a positive return(including rented homes), will flow to the latter and push up asset prices.It’s ugly but what is the alternative if politicians wont/cant tackle the problem with sensible fiscal initiatives like retraining etc.?

    • Do You Feel Lucky Punk?

      But asset speculation is different to a general rise in the CPI, which was the point I have made above. I see no mechanism by which further QE will lift the CPI to the level touted and the experience of a couple of trillion of QE would validate that.

      Additionally ZIRP is already locked in for 2 more years so this ZIRP inspired asset inflation can take place/continue without QE.

      So I am looking for someone to explain how QE (not ZIRP but QE) will lift the CPI a few hundred basis points as per the comment “But massive QE would be required anyway to get inflation going at a good clip.

      (BTW, I would have thought the amount of QE so far has been massive)

      • Well, firstly I think that CPI over the past few years has not adequately reflected ‘real’ price inflation in the real world.

        I think there are a number of mechanisms (direct and indirect) by which QE can influence immediate price inflation generally across the economy:

        1. Practically, periods of QE over the past few years correspond directly to periods of stock market and commodity boom (what do you think the prmary dealers do when they get their $$$?). This is therefore real money supply getting out there.

        2. Subsequent ‘currency wars’ and the fact that QE seems to lead to increased monetary stimulus by China, EU, etc. The Eastern money at least seems to end up in real estate leverage. Again, money supply getting out into the economy.

        3. Perception (which is after all, everything) that increased stocks / property prices means ‘more money supply’ and the fact that people no longer trust that the money created via QE will ever be ‘sterilised’. Is the ‘perception’ of increased money supply as good as the real thing in creating an inflationary cycle perhaps? This mechanism probably explains more why commodities increase in price almost immediately when QE is enabled.

        • Do You Feel Lucky Punk?


          The question, in the context of whether QE creates inflation, is not what primary dealers do with their money but whether or not there is any extra money.

          For a primary dealer to have got money from selling a bond it must first have purchased the bond, either with cash or borrowed money (ZIRP). So what is their net position after the bond sale relative to before they first purchase the bond?

          Again I think like most comments you are confusing ZIRP with QE.

          Is it a provable fact, that is, it can be supported with data, that QE simply resulted in an increase in excess reserves equal to the size of the easing. Everything else I am reading in relation to this is simply mythology devoid of supporting data and/or outcomes resulting from ZIRP that have nothing to do with QE.

          (and in point #1 you are confusing correlation with causation. I note that the improvement of collingwood in the last few years has also correlated to increased commodity prices. But neither collingwood or QE have added to the money supply. It is ZIRP that creates easy money — if you want to put it that way — not QE.)

    • Macca, I feel your view (like many other economists at your level and above) is heavily clouded by your own profession – a profession, I might add, that has generally done a lousy job over the past decades.

      Money printing is not the answer. The massive global debt overhang is the root problem. Trying to sweep the problem under the carpet by permitting the foolish over-leveraged to repay their debts with devalued dollars creates precisely the wrong incentives and sends precisely the wrong messages to the market.

      And the only way it would work anyway if there was coordinated global action to devalue all currencies. That is a pipe dream. The savers are the smart ones, and they aren’t going to stick around very long when the announcement comes that their savings are going to be stolen. In fact, they already know and are moving their capital.

      Please rethink your plan.

      Please re-examine the causes. I suggest the cause is a massive debt-overhang, which is (more or less) the result of a emotional super-cycle of risk-taking (by both banks and borrowers) and the deleterious political INTERFERENCE to remove the basic common-sense laws prohibiting banks from creating money out of thin air and permitting them to run at leverage ratios than any engineer will instantly diagnose as an unstable system.

      Then think about the best long-term cure. I suggest it is the enforcement of consequences for fraud and over-leverage (that is, jail for fraud and bearing the financial burden of losses). That will send all the right signals to the smart entrepreneurs and investors (yes, the very ones that are holding a lot of cash right now) and send them all the right signals that discipline and fiscal restraint is being restored to the market so they can have confidence that stability is returned to the system and they can deploy their savings in investment/business opportunities with better confidence that the rug won’t be pulled out from under them down the track.

      • Steve,

        (PS – this is John from MonitoringTheMadness)

        Of course you (and Macca, and everyone else) is entitled to their opinion, but I don’t think debt forgiveness is a solution that will bring about maximised future growth.

        It sends all the wrong messages to the market (and to the smart ones… the people who are currently saving and holding a lot of dry powder). It says “go into debt because there’s a good chance you’ll be forgiven”.

        It rewards the imprudent and greedy (they get to own the title on their McMansions they went in over their neck to “buy”), and conversely gives savers a slap in the face.

        Yes, bankruptcy is debt forgiveness but with the penalty (when you have no assets left) of being a financial cripple for a long period. It is no easy road. Nor should it be. Bankruptcy is the appropriate course only when it is found that the debtor has no other ways left to make good on his promises (that is, no assets left).

        The financial crisis doesn’t need to transition into a confidence crisis (crisis of confidence in the whole monetary system), but that is exactly where we are heading (in many, but not all, countries, I might add) specifically because the most basic fiscal disciplines are being undermined by people (well meaning, but misguided) who fail to see that their actions to try and short-cut a solution are undermining long-term confidence and causing more problems.

        Cheers mate


  17. There is a major flaw in all of this that needs to be addressed. The economics profession, its theories, and models are having a serious credibility problem. Politicians are not the total problem. There was some introspection after the GFC but that has gone by the wayside. Economic academics have an over inflated opinion of their field, their ability to control the economy and to forecast. Their forecasting ability is atrocious, their models and assumptions questionable, and theories subject to widespread criticism and debate. Look at the success of so called expert economists running or attempting to control the economies of the US, Japan and Europe. Those economies have been a disaster for some time. Most of us would have been sacked if we had performed as poorly as they have. Taylors Rule is neither physics or immutable. The profession needs to acknowledge its limitations, its mistakes in the past and conduct some serious introspection with outside assistance. In the meantime they should focus on telling us what happened rather than inflict pain by relying on flawed models and theories.

  18. Must say I’m in the camp that says QE won’t succeed in creating the Western inflation required to inflate away the debts. The headwinds of tepid growth and high unemployment overwhelm commodity price inflation. Of course, it’s a different story in the East and emerging markets.

    Which brings me to my theory that QE is as much a tool to turn the screws on China as anything (not that the Fed would ever admit it). The Fed can continue to print under the guise that it MUST do something in order to be seen to be pursuing lower unemployment and higher inflation. But I believe it is equally about devauling the dollar, pushing up commodities prices and putting increased pressure on China to revalue its currency.

    When animal spirits are dead, the (Western) economy as a whole is deleveraging and the weight of the debt burden guarantees sub-par growth, this is not a broadly inflationary environment. Just ask Japan. In a balance sheet recession, you can’t just switch on inflation.

    But for the reasons above, I believe QE3+ is a certainty.

  19. “there is no shortage of folk who see in this crisis the demise of liberal democracy and free market capitalism itself”

    I don’t understand why this is the end of liberal democracy… I can understand why capitalism [the way it’s been played] has become a symbol of corruption.

    But I thought the trend would be toward liberal democracy… ie the progressive left.

    Somebody please explain what the author means.

  20. I see no solutions, short of mandating all firms to cut everyone’s hours by say 25 to 33% and then requiring them to hire extra workers to make up for it.

    I admit this is a truly bizarro solution, but as I see it, it will be the unemployed who will lead the societal breakdown, best to minimize this ‘somehow’ through some sort of shared sacrifice that although we will all be earning less at least more will be employed. In order to reduce training expenses for firms all training of the unemployed would initially be unpaid.

    Not at all anything like a coherent solution, merely something aimed at reducing great depression style unemployment. Perhaps the reduced hours might spawn innovation as people find time to tinker in the garden shed as it were?

    • The current level of unemployment is still low by any comparison with the longer term dating back to the mid 70’s

      I was a callow (and unemployable) youth back in days when it was nudging 10%. I don’t remember anyone with a job offering to share a job or their wages with me but I also don’t remember there being riots on the streets as a consequence. Many of us decided to useful things while we waited for the jobs situation to improve, including going to Uni….and at that time, the govt did us a favour and provided it free of charge.
      In hindsight, that decision, based on a lack of work, was a life changer for me, and perhaps indicative of what will happen in the event unemployment rises again toward 10%….people adjust their lives accordingly.
      Perhaps the biggest concern this time round will be that a rise in unemployment will be protracted, lasting for a decade or more as the global economy, and Australia deleverage from excessive debt. The problem with long periods of unemployment is that individuals effectively become unemployable if they cannot accumulate experience of working.

      • Yes – my comments were perhaps more directed toward US/UK,France,Spain,Greece etc rather than conditions exisiting in Australia at the moment.

        I’m sceptical of the go to University argument. Reason being it is expensive. If you have no money and have been unemployed for a while, how do you realistically do it? Especially in countries where university does not enjoy state support.

        If you believe some things are cyclical there is no reason some occupations can’t go back to pure on-the-job training as they were decades ago.
        Anyone has been through Uni can see that many ‘degrees’ have basically been invented for revenue generation by the Uni, and the students don’t really learn all that much that they could not pick up on the job, particularly if they are motivated for the job.

  21. increase wages? in the usa the minimum wage amounts to slave labour, just as it does in china.

    there is plenty of dough floating around – but most of it is in the pockets of those who don’t need to spend it.

  22. The thing that annoys me about this article is that the main solution given is to increase final demand. What about peak resource, peak oil, ocean collapse. How does this play into into? Why can’t we talk about transition to a zero growth world economy?

  23. “How many Frenchmen understood that the revolution of 1789 would transform the world for centuries and how many Soviets understood that Perestroika heralded the demise of the Soviet Union?”

    In both cases: Plenty. All the revolutionary leaders in France had wildly grandiose ideas about their place in history, and the revolution’s impact upon it. They fully understood that they lived in spectacularly influential times.

    In the Soviet case, the leaders may not have understood where Perestroika would take them – but normal people had known the Soviet system was doomed for decades. Ask anyone who lived through the 80s in Russia. The end of the Soviet system was widely predicted and anticipated by millions.

    • That’s why the world is waiting for the new Robespierre… who was right by the way.

      It took rolling guillotines, boatloads of royalists [read corporatists today] dumped into the Loire — ah, the Noyades at Nantes!!

      Violence will make a difference. It always does… hey, America knows this better than anybody!

      A few necklace bombs placed on a few hedge fund managers youngest kid… and VOILA — you’ll have REFORM.

      V is for Vendetta… don’t forget

  24. Helpful reportage, a couple of theoretical problems: Macca says that the “underlying problem” to all of the recessionary news is a “shortage of final demand.” He uses “final demand” in this connection at least twice, so I do not think that this is a typo. But this means that Macca is arguing in a theoretical circle: Since “final demand” is exactly what is measured by GNP/GDP (so too the world sum of these), to say that “final demand” is the “underlying problem” merely restates the problem, explaining nothing. Perhaps he means the “aggregate demand” of Keynesian fame; which is supposed to magically materialize out of deficit spending. Alas, this too begs the question regarding the real-world economy, and hasn’t worked out too well since the 1970’s counterexample of “stagflation.” A closing theoretical recommendation: If Macca or anyone else wishes to comprehend the current economy, he/she should begin by identifying its genus, which is capitalism as a system. He/she would then read that capitalism is historically crisis prone; and that a minority of economists have said that it is inevitably so. In a word: Macca’s handwringing amounts to re-arranging the deck chairs on the Titanic; a ship that is doomed to sink, and sink again . . . .