I was sent an email yesterday asking me what I think will happen in the next global economic downturn. By the senders reckoning, we’ll be “pretty screwed” he explained, as interest rates are still close to zero since the last crisis, and the world has already done so much quantitative easing (QE).
This is a multifaceted question, and I thought I’d editorialise my answer into today’s letter.
Please note that this is my prediction for what will happen in an economic downturn, and not a credit crisis a la 2008 (). This is the game plan that I expect the state will follow in an attempt to jolt the economy when its momentum inevitably slows. It does not factor in events such as bank collapses or sovereign defaults – in a way, this is a “best case scenario”, with the least civil disorder and market collapses.
When the time comes for stimulus from central banks to prevent or sterilise a recession, I expect we’ll see rates pinned to zero by ever more players, like the US (who’ve managed a few rate hikes), us here in Blighty, and the Australians as well.
During this period, there will be much debate by the technocrats on the virtues of implementing deeply negative interest rates (which may require the abolition of cash). However, control over short-term interest rates will be put on the back burner, and cease to be the primary transmission mechanism for monetary policy – they’ll effectively be stuck on zero and forgotten about. It’s the long-term rates that will become the star of the show.
What you’ll see replace rate hikes and cuts as the central bankers main tool is the expansion of their balance sheet – ie, QE, though it may well be granted another acronym. Yes, we’ve seen huge amounts of QE already – but that doesn’t mean we won’t see a hell of a lot more (see Japan).
There may well be a few bells and whistles added on to make the strategy “different this time”, like yield-curve control, purchases of corporate bonds, or “green” bonds so the central bankers can say they’re doing their bit for climate change, or even the purchase of equities. But effectively you’ll just see what happened last time, but more so.
Yes, there are plenty of zombie companies out there who’re heavily indebted, but we’re starting to see the rise of negative yielding junk debt (companies with a poor credit score being paid to borrow cash, as we wrote about a couple days back)… and the central banks haven’t even started cutting rates yet! If you’re being paid to borrow money, profitability becomes less of a problem.
What’ll really mark a change from the norm is the arrival of fiscal rather than monetary stimulus. This will come a time after the monetary madness, but it will come. And with it, vast implications for investors – for it will herald the arrival of the long-lost consumer price inflation, an animal that hasn’t been seen in the Western wilderness for decades.
After the financial crisis, government’s implemented austerity to reduce their debt burdens. This time, we’ll see the opposite – governments will borrow shedloads for little to negative interest to fund whatever pet projects they fancy: infrastructure, housing, bank/corporate bailouts, public sector salaries, etc (I reckon defence will get a massive boost, but that’s another story).
Central banker-to-be Christine Lagarde laid out this “need”: for the government to start laying out the dough in an interview with CNBC in April (emphasis added):
… clearly, monetary policy has been pretty much left to its own in order to fix the solution, the fact that fiscal policies were not adjusted sufficiently rapidly. We contend that those that those that are in surplus or are at, you know, this black budget as the Germans call it, can actually afford to spend on education, to spend on broadband, to spend on infrastructure, while those countries that are in a more difficult situation and have rising debt have to be very cautious with that. So fiscal policy really needs to be adjusted. Those who can spend should spend. Those who need to continue to build fiscal buffers need to do that now, and it is still countercyclical to do so. When the next crisis comes about, they have some space to fight the next crisis
Lagarde is not a central banker by nature; she’s not an economics PhD who’s spent her life in academia. She’s a lawyer and a politico, and has been chosen for the role of European Central Bank president for exactly those traits.
As we’ve detailed in previous issues of Capital & Conflict, her role is to ram home fiscal union in the eurozone so the governments within it will splurge any surpluses they’ve got into reviving its stagnant regions – whether they like it or not.
And I reckon it’s this fiscal stimulus that will create the inflation that has been thought to be extinct, wrecking those who’ve invested in bonds. The dusty short-term interest rate lever may even be taken out of the central bank basement to counteract it.
While fiscal stimulus will increase the indebtedness of governments, the debt will be indirectly being bought up by their own central bank, allowing them to believe that they can spend money ad infinitum, as they won’t be disciplined by the bond market as they have been in the past.
This will lead politicians to further believe that “deficits don’t matter”, and adopt what’s known as Modern Monetary Theory, or MMT. The West will have adopted “capitalism with Chinese characteristics” in all but name… while facing China in a Cold War!
More to come,
Boaz Shoshan
Editor, Capital & Conflict
Category: Market updates