Here is a summary post of the wrap-up discussion on the closing weekend of the World Economic Forum held annually in Davos. The panel was composed of the following people, Christine Legarde – the managing director of the International Monetary Fund, Gary Cohen – Goldman Sachs COO, Larry Summers – Former US Secretary Treasurer, Ana Patricia Botin – Banco Santander Chairman and Ray Dalio, Bridgewater Assoc Chair CIO. Their questions and comments are insightful and revealing about the current state of the Euro zone.
Europe is leaning on the results of the United States QE, and evidence shows Dragis’ QE is already working. Spain has inspired confidence due to fiscal discipline, structural reform and the cleaning up of all banks on non-preforming loans.
Considering Gary Cohens’ Fallacy of Composition comment (below) Christine posed the following question… Given we are in a low/low, high/high environment in the Euro area, meaning low inflation, low growth, high unemployment, high debt environment… plus… given that structural reform takes time and deals with the supply side, where effectively what we need is demand and structural reform… can you stimulate demand by either monetary policy (monetary policy is at the end of its course) OR by fiscal expansion? Knowing that only maybe 2 countries in the Eurozone are ready to do that… is that enough to pull out of the LL, HH environment?
Gary responded noting Europe has a lot of ‘fiscal space’ but to adopt a common currency without a decision to use common fiscal space was/is an irresponsible decision. Therefore having made a common currency decision if it’s not to become a failure there’s no choice but to find mechanisms to support fiscal expansion on a common basis. Additionally it’s not being realistic about liabilities when you under-fund a pension you are placing a liability on the future… if you sell a building, but rent it back, all you’ve done has not changed anything really. But it does upset the long term math.
Wrap-up. It’s a mistake to compare economies except at the currency level. There is no Euro zone fiscal policy. The balance sheet is great but they’re not willing to go into binge borrowing at low interest rates. Much has been done in the last five years but fiscal union and banking union needs more progress. Huge potential in the Euro zone, but to think of it as one economic unit is not yet the case.
There are some big trade deals in the works and also a huge climate project. All of the countries need to pull their weight and all need to rally around the job and growth objectives in the works to create jobs.
We’re in the “End of a Super Cycle” or The New Normal… in which lowering interest rates causing higher levels of debt and debt servicing spending has come to an end. Since 1980 every cyclical peak and trough in interest rates was lower than the one before which is a deflationary set of circumstances. With 0 or (-) interest rates, it begins to call in the value of holding money.. what is money?
The downturn in the economy lowers the ability to control using monetary policy which works by lowering interest rates, which in turn lowers debt servicing payments and asset values increase. These two things together create a wealth effect and stimulation to the economy.The spread is the transition mechanism for monetary policy. when the spread was wide, people bought for higher returns, the result is the spread narrows to NO spread, and this is on bonds and futures as well as yields on equities.There are two levers… interest rates and currency. When interest doesn’t work, currency becomes more effective. There is a need for further depreciation of the Euro and the Yen. Note… the average cost of an European worker is 2X what it is of an American worker. Structural reform is needed to make that more efficient, and there is lots of opportunity to do that in Europe.
Currency depreciation has to be a part of it, it’s not a polite conversation. Currency will be a bigger influence ahead and this will produce a dynamic. Globally there is a lot of dollar denominated debt that’s becoming more expensive. A short squeeze is emerging in the DX similar to 1985. Back then there were falling commodity prices, falling oil prices, a relatively strong economy with falling inflation. Then we could lower interest rates, not now.
Wrap-up –The US has twice the rate entrepreneurships of Europe. Yet it’s hard to compare economies for example… youth unemployment is actually higher in the US. The US is optimistic about a productive force that is big data when we’re at that tipping point of not being able to use debt in the same way. For Europe, credit is not going to work the same way as it did before. Debt growth, don’t look to it as the solution. You can spend with debt or with currency. The ECB needs to put more money into the system, money can produce purchases. Structural reforms and currency changes together would be a constructive force for Europe.
Balance is like a four-legged chair between monetary policy (QE), fiscal policy, structural reform and TM, the transitional mechanism.
There has been deflation pressure on the banks. Out of a sample of 300 banks, many say they are more ready to help monetary policy work today, meaning to start lending again, but many are NOT in that position. A sample of forty of the largest banks in Europe, 2007 vs today, risk assets are at the same level, capital is more than double… return on equity is now 6%. This says banks are ready to lend again, in fact over the last year lending has grown by 4% in 9 out of 10 countries.
Related to PPP, purchasing power parity, the prevailing view is to have a lower currency to export against and generate tourism with which is another way of saying stimulate economic growth. The currency now is around 115, (114 at time of writing) about the correct level, the problem is where we came from which was a result of the US QE.
Wrap-up We’re ready to lend (!) an essential part of monetary policy. We need a balanced approach to regulation that takes into account the broader public policy issues discussed today.Noting she is a lot less negative about Europe than the rest of the panel, she stated “America is an emerging market in terms of growth and has strong institutions and that’s quite unbeatable.”
The risk of doing too little far exceeds the risk of doing too much, relative to the Euro zone’s QE. Deflation and secular stagnation are the macro-economic threats of our time.
- Mistake to think QE is enough, several differences with US experience.
- US QE was most effective at the beginning when markets where functioning less well than how they’re functioning in Europe today.
- QE worked well with interest rates in the 3% range, not with rates where they are now.
- QE also worked best when it was unexpected, rather than when it had been widely predicted.
- There are two channels, the capital market channel vs banking market channel and the banking market channel is still clogged by regulatory processes.
Wrap up – expect QE to be less impactful in Europe than it has been in the US. Europe has more complex institutions. Note*** No government has ever predicted a recession 1 year in advance. What happens is every 7 years, the fed lowers interest rates to combat deflation but you can’t cut anything from zero. There is a need for direct support for investment from public and private sectors. Recognize that the era when the central bank improvisation growth strategy working… is coming to an end.
What happened first… the transitional mechanism (TM) was broken which created the ‘New Normal’…
Pre – 2008 – Central banks decided what monetary policy would be. They would lower rates and increase money supply. They would flow it through banks, banks would flow it to customers, and from there to mainstreet. And it worked. They were able to control growth and the flow of currencies through regulation. Post – 2008 every time banks get money they build their balance sheet to make sure they’re bullet proof for the 10,000 year flood. As Ana said, she’s not distributing the funds but holding, and it seems that process is getting worse in Europe.
Everyone on panel must agree that austerity and acceptance of limited monetary accommodation in hopes that it will drive structural reform has proven substantially counter-productive. Instead where these policies are being applied, they are bringing radicals to the fore, indicating the situation in Europe is not yet in hand.
It’s good and desirable that the currency is lower. The worry is because there is already a set of positive developments from QE, yet forecasts look dismal from here… and QE is already built into these forecasts… so don’t mistake thinking Europe is in hand.
Wrap up – The coming of technology is more advanced in the US, which brings us back to the central point, Demand. The basic idea is a concept called the Fallacy of Composition. Here’s the classic example – if one person in a group stands up, he can see better, but if everyone stands up, no one can see better and, everyone is uncomfortable. So if any one country saves more or any one bank hordes capital, it will strengthen its’ position. But if all countries save more, there will be less spending… which will mean less income… which will mean less spending… which means… it will NOT get better. The central error that’s running Europe right now is that what worked for one once when applied universally will work for all. As long as that attitude exists success will be limited.
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