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Deus Forex Machina

 
 

You are one of the few central bankers who believe asset prices are an important signal for monetary policy… How should we be thinking through the management of asset prices, particularly in light of the current environment?

I’ve been interested in international economics for 30 or 40 years. One of the things that really stands out from the first two-thirds of my career is that the economy responded mainly to real economic shocks; it responded to an oil price increase, inflation going up or the need to reduce inflation, and, in a country like Australia, whether commodity prices were rising or falling. In the latter third of my career I came to think that the financial sector is increasingly the source of the major shocks and not the real side of the economy. The nature of financial sector shock is that a period of excessive optimism occurs, a boom, when asset prices rise to a very high level. This is followed by a period of bust where everyone runs for cover.

The Asian crisis was essentially a financial shock. Excessive short-term lending to Asian countries, which set up booming asset markets there, followed by a trigger, which was in Thailand, and suddenly the money all rushing out again. Long Term Capital Management was definitely a financial market shock. The 2001 recession in most G7 countries was again a financial market shock precipitated by the dotcom boom and bust and the associated collapse in business fixed investment, which led to a recession. A mild one, but nevertheless a recession. That happened not that long ago, that was 2001.

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Six years later we’re having a re-run and this time, instead of it being an equity market event, it’s a credit market event.

I think basically the biggest single cause for this particular asset-price boom and bust is the massive excess supply of savings over investment in Asia working its way through the system and wherever the markets were craziest was where it was eventually going to show up. It turns out the craziest markets, as is normally the case, are in the US. We have seen this unbelievable collapse in lending standards in the mortgage market and also a generalised under-pricing of risk in all markets. So we’re now really having our fourth major financial shock to the world economy in the last 10 years.

And what do central banks do about it? What does policy in general do about it? The fact is, central banks do not have a mandate to do anything about an asset-price boom and bust. This is particularly troubling given that asset-price boom and busts are at least as likely to occur in a low-inflation environment as in a high-inflation environment. In fact, some of my former colleagues would say more likely to occur in a low-inflation environment.

It took 30 years for the relationship between central banks and governments to get sorted out into this implicit social contract where the central bank is given independence to pursue either an explicit or implicit inflation target. This has worked extremely well in the sense of what the central banks were asked to do, they have achieved. Their Consumer Price Index (CPI) target has been achieved. I don’t know how long it would take before we ever resolve the issue of who will become responsible for asset prices and equilibrium in the asset markets. But, at the moment, the central banks don’t have the responsibility. In fact they’re actually almost in a worse position. You can see this happening now that the bust is occurring and everyone turns to the central bank and says “fix” the bust.

But they’re not allowed to fix the boom. This, of course, is engendering a moral hazard problem and it helps explain why we’ve had four financial crises really in 10 years.

The inflation question is very important at the moment. Part of the reason we’ve seen this leveraging up of portfolios in recent years is because there was no fear of higher inflation and, therefore, no fear of higher interest rates…[and] core CPI is either flat or slightly falling in most major countries. But the things that a person actually needs to buy to live their life are all skyrocketing upward, from education to health care – even the price of cheese on a pizza is up 78 per cent in 12 months in the US… The official number isn’t reflecting real people’s experience.

I think that’s a bit unfair.

The one statistic I have real faith in is the inflation numbers – particularly the CPIs. I think the explanation for what you’re saying is that the statisticians of the world aren’t correctly measuring inflation. They’ve each got huge samples, 6000 items, and they make sure that you know each quarter it’s exactly the same thing they’re measuring and they’re taking account of the discounting and all that, or lack of discounting. They put an enormous amount of effort into it. The issue is that big-ticket items, particularly internationally manufactured trading goods prices, are falling and other things are going up. Again you’ve got to go back to Asia for the explanation. It is the massive increase in Asian capacity that is simultaneously holding down goods and services inflation and driving up asset inflation.

The story has to always start with Asia. [A question to ask is:] is the world Asia-centric or US-centric? At the moment, if you pick up a newspaper you would think it’s US-centric because of what’s happening in US credit markets. The effects are being spread from there to the rest of the world. But what’s happening in US credit markets didn’t have to be the US. Instead, what is happening in credit markets around the world is predominantly a result of some influences that originated in Asia.

Let’s turn to China for a minute. One problem is that you’ve had a huge amount of cash flow go into China. Typically, the more money that’s available, the less disciplined people are when it comes to investing or spending it. One could argue that there are many companies in China that have big order books, but their actual profitability may be quite limited, if not negative. And that’s combined with the fact that people in China are now selling their jewellery in order to buy stocks because they believe that the stock market is a one-way bet to riches. Add to that mix the fact that the United States Congress is becoming genuinely focused on restricting trade with China. Taken together, that’s not a great picture for the world economy’s reliance on China.

There is a threat of protectionism. Of course, that’s extremely worrying. Part of the explanation for the way China behaves the way it does is that its savings rate is almost God given. It’s very hard to change a country’s savings rate. This happens to exceed the investment rate in China, which is also extraordinarily high – it’s 45 per cent or something like that. There’s no reason to believe that they could possibly handle more investment. They have probably got over-capacity all over the place. They just do not have the financial infrastructure to handle that level of investment, nor probably does any country.

It’s not that the Chinese are incompetent in that respect. I think it would just be extraordinarily difficult to channel that amount of investment each year in a very efficient manner, even in an economy where there is a bottom line and you can fail. It seems rather difficult to fail in China.

I don’t know the answer to this, other than that China is going to continue to do what it’s been doing. US macro-economic policy probably had to do what it’s done. It has basically delivered low inflation and reasonable economic growth for the last five years. What else could it have done? Sure, that means you’ve got a large current-account deficit but I come from a country that’s had a large current-account deficit for a century. So, I don’t tend to get as excited about that subject as the Europeans and Asians do. My worry is moral hazard.

What is the Fed going to do? Wall Street’s holding a gun to its head. Wall Street is saying, “We assume that you’re going to ease by at least 50 basis points and probably before the next meeting (18 September 2007), and we’re all panicking and if you don’t do it the panic will get even greater and we will stop lending to even credit-worthy customers.” This means the Federal Reserve is in a very awkward position.

And the irony is that even if the Federal Reserve cuts the Fed Funds rate, it is not going to save the losers.

I know. It’s an insolvency problem, not just a liquidity problem. If it’s a liquidity problem anyhow, then the thing to do is what the Fed has been doing: make sure that there’s enough cash in the system – I hate that word liquidity – to keep the banks lending to each other. That’s what you do, that’s what Bagehot said in 1880 or so and that’s still true today.

If there’s a macro-economic problem of insufficient demand, then monetary policy is supposed to come in. But what we’re looking is neither a pure liquidity problem nor at this stage a macro-economic problem. It’s an insolvency problem. Lenders don’t know where the insolvency is in the system. In that sense there is a lack of transparency, although I suspect there is always a lack of transparency. It is not as though this is the first time this has happened. There are real losses out there and no one can make them go away. There are real losses in the household sector and in the investment community. The biggest worry is that the losses are not just by people who own things outright. A lot of these investments have been held with leverage, and that means the losses are going to be much, much bigger.

So you’ve got a period of great suspicion as to where the losses are. Many suspect that the losses have occurred in hedge funds. If not – if the losses are in endowments and pension funds, that means un-leveraged – then these investors will just grin and bear it. It will not present a systemic risk.

Ironically, that is what we always thought was the virtue of these new [financial] products: that they would be able to allocate the risks to people or institutions that weren’t brittle, which had a lot of resilience and could take a very long-run view. But if it turns out that this is not what’s happening and that a significant part of this risk has been allocated to a group of people or institutions that have no resilience whatsoever because they’re leveraged, then that’s a different world.

Even if the pension funds and the insurance companies own these structured products and they can withstand the pain from the losses, they will also bring lawsuits. Lawsuits will effectively close the window for the whole securitisation machine. Who will the market sell these products to? In other words, there will be a change in the demand for the assets that are generated by the securitisation machine. This means a change in the demand for the underlying assets that feed the securitisation process.

That may be no bad thing. That may be a medium-term correction we all have to go through. If you talk to people who run operating companies – shopping malls, for example, or electricity generating facilities or distribution facilities – they’ve been complaining for years that the sort of assets they want to buy and operate have become more expensive. The prices of everything they need to operate have been driven up by the investment banks. These banks have developed off-market vehicles that go out and bid for this stuff, securitise it and then sell it on to investors.

It’s very similar to private equity. The securitisation process drives up the cost or value of physical assets. If the scale of that activity is reduced, it won’t be a bad thing for the world economy at all. We’re in a process of bringing the risk spreads back to normality. This will inevitably drive some players out of the securitisation business.

What if the critical issue today isn’t sub-prime mortgages? What if the event at hand is simply that there’s a permanent re-pricing of capital in an upward direction? That should mean that investors actually get a greater return for the risks they take. In the past they’ve been paid relatively little for the risk they take. Ultimately, this is good for the real economy. Now you will get paid for the work you’re doing.

Yes. It’s almost like Main Street getting its own back against Wall Street.

It’s very interesting because no one is thinking about this advantage in Main Street. Main Street is afraid.

No, the problem is that in the process they may both suffer. This is the big worry that the Fed’s got to face. The Fed, in my view, isn’t keen to bail the system out because it’s a very good central bank and it has a very long view. Deep down, central bankers worry about what people will think of them in 10 years’ time. They are not just worried about what people will think about them in one year’s time. The way to be thought popular in one year’s time is to cut interest rates. But, if you are just engendering the fifth financial crisis a few years down the track, it will be held against you in 10 years’ time, and so it should be.

So this is actually tougher than anti-inflationary policy. It used to be tough to raise interest rates when inflation was rising. Central banks that did became extremely unpopular. The governments asserted their power over them to make sure they didn’t. Now the situation has changed and they can do that. It’s much easier than it used to be. But the new challenge is to not too readily bail out the system when there is a financial crisis. And again this will be very unpopular. I read recently someone saying “Bernanke’s made a rooky error by not already cutting interest rates”. What sort of idiot is making these comments? This is obviously someone who is very inexperienced, with an incredibly short time horizon.

One difficulty is that central bankers, particularly members of the Federal Reserve, direct their comments primarily to Congress and the public. While the markets are an important part of the audience, they’re not the main focus. But the markets assume they are. So when US Senator Dodd calls a press conference with Ben Bernanke and US Treasury Secretary Hank Paulson and is quoted saying, “The Fed has agreed to use all possible tools,” the market interprets this to mean a rate cut is guaranteed. But what most likely occurred is the Senator was reassured that all possible tools are available, but that the assessment hasn’t yet been made and it may be that the Fed Funds rate isn’t the right tool. So the markets misinterpret what has happened.

I sincerely hope so. It’s amazing that Wall Street, within days of the first open-market operations to keep the markets lending, had already priced-in two rate cuts.

Ian Macfarlane was interviewed by Dr Philippa Malmgren for http://www.policyandmarkets.com/

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