Three pieces of interest this weekend:

First, listen to this BBC podcast on FDI into the UK; this cuts to the heart of our future economic position, and getting a handle on it now will help when we get to the section on the UK's place in the global economy.It will be in your exams!

http://www.bbc.co.uk/programmes/b09c0p97

Next is a piece on the end of the current style of monetary policy as the policy of choice for the developed world from the Daily Telegraph; it is merely consolidating increasingly frequent commentary from a number of different economists. We will get more clarity on this in the sections on the Phillips Curve and Monetary Policy coming, but if you can carry away a few useful bits from this article it will really help you add depth to any question on economic policy. There is considerable crossover with earlier parts of the course, and it requires a step back to see how we got to where we are (check out the chart on interest rate trends, it tells you a lot). You also need to able to apply the concept of moral hazard to economic agents to grasp the full import of why monetary policy targeting inflation has been a bit of a cul de sac:

Apostasy in New Zealand spells end of global central bank era AMBROSE EVANS-PRITCHARD 1 NOVEMBER 2017 • 9:16PM

The cult of inflation targeting began in New Zealand in the late Eighties. We may date its demise to a remarkable ideological pivot in the same country thirty years later, and with it the end of central bank ascendancy across the world.

Let us at least hope that the great monetary misadventure has burned itself out. In the wrong circumstances such a doctrine is a formula for asset bubbles and deranged financial cycles, and that is precisely what events have conspired to produce.


Claudio Borio from the Bank for International Settlements says the policy fraternity is relying on a compass with a broken needle. Powerful global forces have smashed the old Phillips Curve model. Central bank forecasts keep getting it wrong. “If one is completely honest, how much do we really know about the inflation process?” he said.

New Zealand has had enough. Jacinda Ardern, the new Leftist premier, is to push for a change in the famous mandate of the country’s reserve bank. In the future it will target jobs as well as consumer prices. Her gripe is that “capitalism has failed”. I would rephrase that as a critique of central bank orthodoxy.

It is actually public policy that has failed. The US Federal Reserve, the European Central Bank, and the Bank of Japan, inter alia, have created a structure over the last quarter century that has pushed lenders, pension funds, life insurers, and investors into extreme risk. Hyper-globalisation and unrestricted capital flows have done the rest.

The original sin of central bankers began in the Nineties when interest rates were held too low for too long, just as a once-in-a-century “supply shock” was turning the world economy upside down. The ever more awkward contortions of recent years stem from monkeying with the "intertemporal" structure of interest rates. It is why the G4 banks have had to print $14 trillion (£10.5 trillion) to keep the ship afloat, or why the ECB’s rates are now minus 0.4pc.

The logic of constructing an entire financial order around one arbitrary variable such as inflation was never compelling. This technocrat urge to fine-tune prices is a radical departure from their historic role of central banks: to ensure financial stability and act as a lender-of-last resort in a crisis.

It is clear in retrospect that central banks should have let prices fall gently in a benign deflation 

The practical consequences have – observably – been nothing short of calamitous. It is all too convenient for central banks to blame speculators and commercial lenders for the dotcom bubble in the late Nineties, or the subprime bubble and the eurozone debt bubbles in the 2000s: the deeper truth is that the authorities themselves were the original authors of what occurred. They jammed the instruments. They set the incentive structure.

This is not a criticism of New Zealand’s Reserve Bank. Inflation targeting made perfect sense for the country in the late Eighties after fifteen years of double-digit price rises. It was the credible anchor needed to break the inflation psychology. It worked like a charm.

Yet those who copied New Zealand ignored known lessons. Formed by the trauma of the Great Inflation in the Seventies, they overlooked what can happen if inflation drops naturally because of surging supply as in Twenties America, the era of Ford’s Model T, electrification, and factory production lines. Falling prices obscured the rising dangers. The mad booms in Florida property and Wall Street equities were allowed to run rampant.

Japan saw a variant in the Eighties. The BoJ’s governor Yasushi Mieno confessed later that the bank’s great mistake was to suppose that it was safe to let rip with monetary stimulus since inflation was tumbling. The result was the Nikkei Bubble. The 9-acre grounds of the British embassy in Tokyo were theoretically worth more than Shropshire at the peak of the frenzy. Mr Mieno later warned his global colleagues that the most dangerous asset booms can only occur when inflation is low. Nobody listened.

By the mid-Nineties most of OECD central banks had inflation targeting regimes of sorts. That is when the variable they chose to target refused to behave. The fall of Soviet Communism and China’s dash for growth suddenly added two billion people to an open world economy. Multinationals could drive down costs by switching plants to cheap labour hubs. A tsunami of cheap goods poured into Western markets from emerging Asia and Eastern Europe.

It is clear in retrospect that central banks should have let prices fall gently in a ‘benign’ deflation – akin to the better episodes of technological progress under the 19th Century Gold Standard – before debt leverage reached levels that made such a policy impossible. Two decades later the global debt ratio is an unprecedented 327pc of GDP. The BIS calls it the policy “debt trap”.

Central bankers misread the twin deflationary shocks of globalisation, the "China effect" and the "Amazon effect’" Beguiled by the false signals from consumer prices, they kept monetary policy too loose and let asset booms run unchecked. Yet they intervened aggressively to clean up the mess after each financial bust.

The effect of this asymmetry was not just the creation of moral hazard, the so-called Greenspan, Bernanke, Yellen ‘Puts’. The BIS suggests that they may actually have caused the great monetary conundrum of our age: a relentless drop in the Wicksellian "natural rate of interest". Real rates peak lower with each cycle, and then trough lower. It is a self-fulfilling dynamic. “Low interest rates beget low interest rates,” says Mr Borio. 

Almost nine years into our global expansion yields on ten-year US Treasuries – the global price of money – are still just 2.36pc. German Bunds are trading at yields below zero all the way out to 2024.

Alan Greenspan and Ben Bernanke have their alibi: An "Asian savings glut" flooded the international system with excess capital, driving down global the cost of borrowing. This has become orthodoxy. “The view is so pervasive that it is almost part of the furniture: you simply take it for granted,” says Mr Borio.

Like all orthodoxies, it has some truth. Yet it has muddied the waters and let western central banks off the hook. They can excuse themselves for runaway asset prices, vaguely talking about the deformities of China’s Leninist capitalism, or the Confucian ethic, or some undefined exogenous shock from Mars. It has let them cling to inflation targeting shibboleths for far too long.

Premier Ardern is the canary in the mineshaft. It was the same New Zealand Labour Party back in the Eighties that pioneered so much of what we think of as globalisation, before it was gamed by the elites and began to go off the rails.

The Party now wants to reassert the primacy of the democratic nation state, and to call time on the excesses – starting with a ban of home purchases by foreigners. The global axis is shifting.

Finally, have a quick skim through the following piece - the introduction explains what it is about, and it's not a long article. There are about three things that will help you evaluate, but I understand not all of it will be accessible:

John Mauldin | Nov 03, 2017

What Will the Next Crisis Look Like?

One of the main topics of discussion everywhere I go is, what will the next crisis look like; along with: Where will it come from; what will the market response be; and what will be the source of the volatility? There is always volatility during a crisis.

I have been saying in writing for some time that I think the next crisis will reveal how little liquidity there is in the credit markets, especially in the high-yield, lower-rated space. Dodd–Frank has greatly limited the ability of banks to provide market-making opportunities and credit markets, a function that has been in their wheelhouse for well over a century. Given the massive amount of high-yield bonds that have been stuffed into mutual funds and ETFs, when the prices of those funds begin to fall, and the ETFs want to sell the underlying assets to generate liquidity, there will be no buyers except at extreme prices.

My friend Steve Blumenthal says we are coming up on one of the greatest buying opportunities in high-yield credit that he has ever seen – and he has 25 years of experience as a high-yield trader. There have been three times when you had to shut your eyes, hold your breath, and buy because the high-yield prices had fallen to such extreme levels. That is going to happen again. But it is going to unleash a great deal of volatility in every other market. As the saying goes, when you need money in a crisis, you sell what you can, not what you want to. And if you can’t sell your high-yield, you end up selling other assets (like equities), which puts strain on them.

But that is not just my view. Dr. Marko Kolanovic, a J.P. Morgan global quantitative and derivative strategy analyst, has written a short essay called “What Will the Next Crisis Look Like?” and it’s this week’s Outside the Box. He sees additional sources of weakness coming from other areas, too.

Frankly, the lack of volatility is beginning to worry me a bit. Minsky constantly reminded us that stability begets instability. Stability is a pretty good word to describe the current markets – but such stability always ends in a “Minsky moment.” We don’t know when; we don’t know where it starts; but we know it’s coming.

There was a great deal of response, mostly positive, to last week’s Thoughts from the Frontline, “The Fragmentation of Society.” If you haven’t read it, you might want to. I hadn’t recognized the similarities between today and 1968 until I was reminded of them by Dr. Kolanovic and his essay. But having lived through that era, I do get it. I think the next financial crisis will also be a trigger for a social crisis, not unlike 1968 and its aftermath. Remember, part of the follow-on was the collapse of Bretton Woods when Nixon took the US off the gold standard in 1971. Economic crises have big consequences. I will be writing about some of the current pressures again this weekend.

The article:

What Will the Next Crisis Look Like?

By Marko Kolanovic, PhD, and Bram Kaplan
October 3, 2017

Next year marks the 10^th anniversary of the Great Financial Crisis (GFC) of 2008 and also the 50^th anniversary of the 1968 global protests against political elites. Currently, there are financial and social parallels to both of these events. Leading into the 2008 GFC, some financial institutions underwrote products with excessive leverage in real estate investments. The collapse of liquidity in these products impaired balance sheets, and governments backstopped the crisis. Soon enough governments themselves were propped by extraordinary monetary stimulus from central banks. Central banks purchased ~$15T of financial assets, mostly government obligations. This accommodation is now expected to reverse, starting meaningfully in 2018. Such outflows (or lack of new inflows) could lead to asset declines and liquidity disruptions, and potentially cause a financial crisis. We will call this hypothetical crisis the “Great Liquidity Crisis” (GLC). The timing will largely be determined by the pace of central bank normalization, business cycle dynamics and various idiosyncratic events, and hence cannot be known accurately. This is similar to the 2008 GFC, when those that accurately predicted the nature of the GFC started doing so around 2006. We think the main attribute of the next crisis will be severe liquidity disruptions resulting from market developments since the last crisis:

• The shift from active to passive assets, and specifically the decline of active value investors, reduces the ability of the market to prevent and recover from large drawdowns. 

• Increased AUM of strategies that sell on ‘Autopilot’: Over the past decade there was strong growth in Passive and Systematic strategies that rely on momentum and asset volatility to determine the level of risk taking (e.g., volatility targeting, risk parity, trend following, option hedging, etc.). A market shock would prompt these strategies to programmatically sell into weakness. 

• Trends in liquidity provision: The model of liquidity provision changed in a close analogy to the shift from active/value to passive/momentum. This trend strengthens momentum and reduces day-to-day volatility, but increases the risk of disruptions such as the ones we saw on a smaller scale in May 2010, October 2014 and August 2015.

• Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly) counting on bonds to offset equity risk. At the turning point of monetary accommodation, this assumption will most likely fail. In the next crisis, Bonds likely will not be able to offset equity losses (due to low rates and already large CB balance sheets). 

• Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at their high end of historical valuations. This is particularly true in sectors most directly comparable to bonds (e.g., credit, low volatility stocks), as well as technology- and internet-related stocks. Sign of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial crypto- coin offerings’ that in many cases have very questionable value.

We believe that the next financial crisis (GLC) will involve many of the features above, and addressing them on a portfolio level may mitigate the impact of next financial crises. What will governments and central banks do in the scenario of a great liquidity crisis? If the standard rate cutting and bond purchases don’t suffice, central banks may more explicitly target asset prices (e.g., equities). This may be controversial in light of the potential impact of central bank actions in driving inequality between asset owners and labor (e.g., see here). Other ‘out of the box’ solutions could include a negative income tax (one can call this ‘QE for labor’), progressive corporate tax, universal income and others. To address growing pressure on labor from AI, new taxes or settlements may be levied on Technology companies (for instance, they may be required to pick up the social tab for labor destruction brought by artificial intelligence, in an analogy to industrial companies addressing environmental impacts). While we think unlikely, a tail risk could be a backlash against central banks that prompts significant changes in the monetary system. In many possible outcomes, inflation is likely to pick up.

The next crisis is also likely to result in social tensions similar to those witnessed 50 years ago in 1968. In 1968, TV and investigative journalism provided a generation of baby boomers access to unfiltered information on social developments such as Vietnam and other proxy wars, Civil rights movements, income inequality, etc. Similar to 1968, the internet today (social media, leaked documents, etc.) provides millennials with unrestricted access to information on a surprisingly similar range of issues. In addition to information, the internet provides a platform for various social groups to become more self-aware, united and organized. Groups span various social dimensions based on differences in income/wealth, race, generation, political party affiliations, and independent stripes ranging from alt-left to alt-right movements. In fact, many recent developments such as the US presidential election, Brexit, independence movements in Europe, etc., already illustrate social tensions that are likely to be amplified in the next financial crisis. How did markets evolve in the aftermath of 1968? Monetary systems were completely revamped (Bretton Woods), inflation rapidly increased, and equities produced zero returns for a decade. The decade ended with a famously wrong Businessweek article ‘the death of equities’ in 1979.