Meaty article on policy & inflation targets

Since the summer of 2016, the global economy has been in a period of moderate expansion, yet inflation has yet to pick up in the advanced economies. The question that inflation-targeting central banks must confront is straightforward: why? 

NEW YORK – Since the summer of 2016, the global economy has been in a period of moderate expansion, with the growth rate accelerating gradually. What has not picked up, at least in the advanced economies, is inflation. The question is why. 

 In the United States, Europe, Japan, and other developed economies, the recent growth acceleration has been driven by an increase in aggregate demand, a result of continued expansionary monetary and fiscal policies, as well as higher business and consumer confidence. That confidence has been driven by a decline in financial and economic risk, together with the containment of geopolitical risks, which, as a result, have so far had little impact on economies and markets. 

 Because stronger demand means less slack in product and labor markets, the recent growth acceleration in the advanced economies would be expected to bring with it a pickup in inflation. Yet core inflation has fallen in the US this year and remains stubbornly low in Europe and Japan. 

This creates a dilemma for major central banks – beginning with the US Federal Reserve and the European Central Bank – attempting to phase out unconventional monetary policies: they have secured higher growth, but are still not hitting their target of a 2% annual inflation rate. 

 One possible explanation for the mysterious combination of stronger growth and low inflation is that, in addition to stronger aggregate demand, developed economies have been experiencing positive supply shocks. Such shocks may come in many forms. 

Globalization keeps cheap goods and services flowing from China and other emerging markets. Weaker unions and workers’ reduced bargaining power have flattened out the Phillips curve, with low structural unemployment producing little wage inflation. Oil and commodity prices are low or declining. And technological innovations, starting with a new Internet revolution, are reducing the costs of goods and services. 

 Standard economic theory suggests that the correct monetary-policy response to such positive supply shocks depends on their persistence. If a shock is temporary, central banks should not react to it; they should normalize monetary policy, because eventually the shock will wear off naturally and, with tighter product and labor markets, inflation will rise. 

If, however, the shock is permanent, central banks should ease monetary conditions; otherwise, they will never be able to reach their inflation target. 

 This is not news to central banks. The Fed has justified its decision to start normalizing rates, despite below-target core inflation, by arguing that the inflation-weakening supply-side shocks are temporary. Likewise, the ECB is preparing to taper its bond purchases in 2018, under the assumption that inflation will rise in due course. 

 If policymakers are incorrect in assuming that the positive supply shocks holding down inflation are temporary, policy normalization may be the wrong approach, and unconventional policies should be sustained for longer. But it may also mean the opposite: if the shocks are permanent or more persistent than expected, normalization must be pursued even more quickly, because we have already reached a “new normal” for inflation. 

This is the view taken by the Bank for International Settlements, which argues that it is time to lower the inflation target from 2% to 0% – the rate that can now be expected, given permanent supply shocks. 

Trying to achieve 2% inflation in a context of such shocks, the BIS warns, would lead to excessively easy monetary policies, which would put upward pressure on prices of risk assets, and, ultimately, inflate dangerous bubbles. 

According to this logic, central banks should normalize policy sooner, and at a faster pace, to prevent another financial crisis. Most advanced-country central banks don’t agree with the BIS. They believe that, should asset-price inflation emerge, it can be contained with macroprudential credit policies, rather than monetary policy. 

Of course, advanced-country central banks hope such asset inflation won’t appear at all, because inflation is being suppressed by temporary supply shocks, and thus will increase as soon as product and labor markets tighten. But, faced with the possibility that today’s low inflation may be caused by permanent supply shocks, they are also unwilling to ease more now. 

So, even though central banks aren’t willing to give up on their formal 2% inflation target, they are willing to prolong the timeline for achieving it, as they have already done time and again, effectively conceding that inflation may stay low for longer. Otherwise, they would need to sustain for much longer their unconventional monetary policies, including quantitative easing and negative policy rates – an approach with which most central banks (with the possible exception of the Bank of Japan) are not comfortable. 

This central bank patience risks de-anchoring inflation expectations downward. But continuing for much longer with unconventional monetary policies also carries the risk of undesirable asset-price inflation, excessive credit growth, and bubbles. As long as uncertainty over the causes of low inflation remains, central banks will have to balance these competing risks. 

 Nouriel Roubini, a professor at NYU’s Stern School of Business and CEO of Roubini Macro Associates, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

Nouriel Roubini on anti-globalisation moves:

Nouriel Roubini 

Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was Senior Economist for International Affairs in the White House's Council of Economic Advisers during the Clinton Administration.

The Great Backlash May 2014

NEW YORK – In the immediate aftermath of the 2008 global financial crisis, policymakers’ success in preventing the Great Recession from turning into Great Depression II held in check demands for protectionist and inward-looking measures. But now the backlash against globalization – and the freer movement of goods, services, capital, labor, and technology that came with it – has arrived.

This new nationalism takes different economic forms: trade barriers, asset protection, reaction against foreign direct investment, policies favoring domestic workers and firms, anti-immigration measures, state capitalism, and resource nationalism. In the political realm, populist, anti-globalization, anti-immigration, and in some cases outright racist and anti-Semitic parties are on the rise.

 

These forces loathe the alphabet soup of supra-national governance institutions – the EU, the UN, the WTO, and the IMF, among others – that globalization requires. Even the Internet, the epitome of globalization for the past two decades, is at risk of being balkanized as more authoritarian countries – including China, Iran, Turkey, and Russia – seek to restrict access to social media and crack down on free expression.

 

The main causes of these trends are clear. Anemic economic recovery has provided an opening for populist parties, promoting protectionist policies, to blame foreign trade and foreign workers for the prolonged malaise. Add to this the rise in income and wealth inequality in most countries, and it is no wonder that the perception of a winner-take-all economy that benefits only elites and distorts the political system has become widespread. Nowadays, both advanced economies (like the United States, where unlimited financing of elected officials by financially powerful business interests is simply legalized corruption) and emerging markets (where oligarchs often dominate the economy and the political system) seem to be run for the few.

For the many, by contrast, there has been only secular stagnation, with depressed employment and stagnating wages. The resulting economic insecurity for the working and middle classes is most acute in Europe and the eurozone, where in many countries populist parties – mainly on the far right – outperformed mainstream forces in last weekend’s European Parliament election. As in the 1930’s, when the Great Depression gave rise to authoritarian governments in Italy, Germany, and Spain, a similar trend now may be underway.

If income and job growth do not pick up soon, populist parties may come closer to power at the national level in Europe, with anti-EU sentiments stalling the process of European economic and political integration. Worse, the eurozone may again be at risk: some countries (the United Kingdom) may exit the EU; others (the UK, Spain, and Belgium) eventually may break up.

Even in the US, the economic insecurity of a vast white underclass that feels threatened by immigration and global trade can be seen in the rising influence of the extreme right and Tea Party factions of the Republican Party. These groups are characterized by economic nativism, anti-immigration and protectionist leanings, religious fanaticism, and geopolitical isolationism.

A variant of this dynamic can be seen in Russia and many parts of Eastern Europe and Central Asia, where the fall of the Berlin Wall did not usher in democracy, economic liberalization, and rapid output growth. Instead, nationalist and authoritarian regimes have been in power for most of the past quarter-century, pursuing state-capitalist growth models that ensure only mediocre economic performance. In this context, Russian President Vladimir Putin’s destabilization of Ukraine cannot be separated from his dream of leading a “Eurasian Union” – a thinly disguised effort to recreate the former Soviet Union.

In Asia, too, nationalism is resurgent. New leaders in China, Japan, South Korea, and now India are political nationalists in regions where territorial disputes remain serious and long-held historical grievances fester. These leaders – as well as those in Thailand, Malaysia, and Indonesia, who are moving in a similar nationalist direction – must address major structural-reform challenges if they are to revive falling economic growth and, in the case of emerging markets, avoid a middle-income trap. Economic failure could fuel further nationalist, xenophobic tendencies – and even trigger military conflict.

Meanwhile, the Middle East remains a region mired in backwardness. The Arab Spring – triggered by slow growth, high youth unemployment, and widespread economic desperation – has given way to a long winter in Egypt and Libya, where the alternatives are a return to authoritarian strongmen and political chaos. In Syria and Yemen, there is civil war; Lebanon and Iraq could face a similar fate; Iran is both unstable and dangerous to others; and Afghanistan and Pakistan look increasingly like failed states.

In all of these cases, economic failure and a lack of opportunities and hope for the poor and young are fueling political and religious extremism, resentment of the West and, in some cases, outright terrorism.

In the 1930’s, the failure to prevent the Great Depression empowered authoritarian regimes in Europe and Asia, eventually leading to World War II. This time, the damage caused by the Great Recession is subjecting most advanced economies to secular stagnation and creating major structural growth challenges for emerging markets.

This is ideal terrain for economic and political nationalism to take root and flourish. Today’s backlash against trade and globalization should be viewed in the context of what, as we know from experience, could come next.

Read more at http://www.project-syndicate.org/commentary/nouriel-roubini-likens-the-rise-of-nationalism-today-to-that-of-authoritarian-regimes-during-the-great-depression#mypu6W3LjXyClBQD.99

Resources for Balance of Payments

Balance of Payments

Follow-on material

Investopedia BoP video
https://www.youtube.com/watch?v=YlQgeyKV-QM

ONS UK current account video
https://www.youtube.com/watch?feature=player_detailpage&v=cbJIVmsKOZU

T2U BoP overview
http://www.tutor2u.net/economics/revision-notes/a2-macro-balance-of-payments-introduction.html

EOL BoP theory notes
http://www.economicsonline.co.uk/Global_economics/The_balance_of_payments.html

T2U BoP managing deficits
http://www.tutor2u.net/economics/revision-notes/a2-macro-balance-of-payments-deficits.html

For BoP in the news check out the F585 and IB International Scoop It boards.

http://www.scoop.it/t/f585-the-global-economy-by-adam-dean
http://www.scoop.it/t/ib-international-economics

Resources for International Trade

International Trade

Review the following....

T2U international trade presentation
http://www.slideshare.net/tutor2u/international-trade-25962434

T2U protectionism presentation
http://www.slideshare.net/tutor2u/protectionism-26223566

Learn Liberty videos
http://www.youtube.com/watch?v=y0gGyeA-8C4
http://www.youtube.com/watch?v=7yOHjRThM_o
http://www.youtube.com/watch?v=qdcQLWGaJoM

Global trade resources

TTIP links

global manufacturing competitiveness:

Boston Consulting Group interactive charts

Article with graphics and explanations of this:

https://www.bcgperspectives.com/content/articles/lean_manufacturing_globalization_shifting_economics_global_manufacturing/

Pictorial data on world trade

The risks and rewards ahead:

Must-read for Exchange Rates topic coming soon (A2)

The US Dollar and the Cone of Uncertainty

By John Mauldin | Dec 22, 2014

The Beginning of a US Dollar Bull Market
There Has Been No Deleveraging
The Biggest Consequence of a Rising US Dollar
The Fourth Arrow
Adding China into the Mix
A Dangerous Illusion

"Currently we have an international monetary non-system. Nobody has to follow any rules. Everybody does what they consider is in their own short-term best interest. The real difficulty is: What is in their short-term interest – for example, following ultra-easy monetary policy – could well backfire somewhere. It might be not in their long-term best interest. And as the easy monetary policy influences the exchange rates, it influences other countries. Almost every country in the world is in easing mode, following the Fed, and we have absolutely no idea how it will end up. We are in absolutely unchartered territory here."

– William S. White, former Chief Economist, Bank for International Settlements, in an interview for Finanz und Wirtschaft

"I visualize this process [of forecasting the future] as mapping a cone of uncertainty, a tool I use to delineate possibilities that extend out from a particular moment or event. The forecaster’s job is to define the cone in a manner that helps the decision maker exercise strategic judgment. Many factors go into delineating the cone of uncertainty, but the most important is defining its breadth, which is a measure of overall uncertainty.

Drawing a cone too narrowly is worse than drawing it too broadly. A broad cone leaves you with a lot of uncertainty, but uncertainty is a friend, for its bedfellow is opportunity – as any good underwriter knows. The cone can be narrowed in subsequent refinements. Indeed, good forecasting is always an iterative process. Defining the cone broadly at the start maximizes your capacity to generate hypotheses about outcomes and eventual responses. A cone that is too narrow, by contrast, leaves you open to avoidable unpleasant surprises. Worse, it may cause you to miss the most important opportunities on your horizon."

– Paul Saffo, technology forecaster

Saffo borrows the term “cone of uncertainty” from weather forecasting. While you may not be familiar with the concept, you see it in use every time there is a hurricane forecast. The further away you get from where the hurricane actually is at the moment, the wider the “cone” predicting its possible paths.

For the past two letters we’ve been looking at the global scene and trying to figure out which issues will help us outline scenarios for 2015. We finish the series today by looking at the impact of the dollar bull market on the probabilities for various 2015 developments.

Let me say at the outset that I think a global currency war (kicked off by Japan last year and just now heating up) and a rising bull market in the US dollar are the big macroeconomic drivers not just for 2015 but for the next four to five years. I think all future economic outcomes pivot along with these two major forces – they are the lever and fulcrum, so to speak. As we look at all possible futures, as we map our own cones of uncertainty, it is certainly true that that our assessment could change with the emergence of important new trends at the outer fringes of the cone; but I believe (and have believed for some time) that we need to organize our forecasts around the currency war and the dollar bull market.

The Beginning of a US Dollar Bull Market

Currencies are not supposed to have large movements in short spans of time and certainly not violent moves such as we have recently seen with the Russian ruble. Relatively stable currencies – ones that make moves measured in single digits over multiple years – are what you want to see for stable trade and world GDP growth. Violent moves like the ruble’s signal that something is seriously wrong, so wrong that it may well precipitate a deep recession. You very seldom if ever see a similarly rapid upward move in a currency. (Off the top of my head, I can’t think of one, but surely somewhere in history… and if I said “never,” I would probably be corrected by my astute readers.)

Over the last few centuries, as the world moved away from the gold standard and gold-backed currencies, the valuations of fiat currencies began fluctuating, sometimes wildly, over time. Currency wars following the onset of the Great Depression certainly contributed to the length of the downturn. After World War II, the financial leaders of the nations of the world came together and created a monetary system called Bretton Woods, named after the mountain resort in New Hampshire where it was created. Basically it was an anchored dollar system, where the dollar was convertible into gold and the rest of the world used the dollar for their reserves and generally pegged their currencies to it. The linchpin of the deal was the understanding that the US dollar would remain a stable currency.

We didn’t live up to that deal, printing too much money during the Vietnam War; and the nations of the world, led by France, began to ask to convert their dollars into gold. Since that would have drained the gold out of the United States, Nixon closed the “gold window.” We won’t get into the argument about the propriety of his move here.

The chart below shows the US Dollar Index (the DXY, which is heavily weighted to a comparison with the euro) since 1967. Prior to 1967 the dollar was generally stable. As the value of the dollar began to slide in 1970 – a troubling development if you were holding dollars in Europe – the world began to wonder if perhaps the United States was taking advantage of its position. Note that after the closing of the gold window in ’73 the dollar continued to fall but with greater volatility. This was mostly due to the Federal Reserve’s allowing inflation and printing money.

Then Paul Volcker came along and began to raise interest rates, and a major dollar rally ensued. The dollar doubled in value in less than five years. As interest rates came down from nosebleed highs in the late ’80s, the US dollar fell back to its original level and more or less drifted sideways for the next 10 years before once again climbing to 120. Then, in the early’00s, low rates and easy money took their toll, and the dollar fell to an all-time low in the middle of the credit crisis and has traded around the “80 handle” for the last six years. This is in spite of the Fed’s undertaking massive quantitative easing and flooding the world with dollars, which you would think would put downward pressure on the dollar. That is generally what happens when a central bank floods the world with its currency. Certainly, it is what is happening in Japan, and it is what we expect to happen in the Eurozone.

Something is different about the dollar, then. That difference can be explained mostly by the fact that the US dollar is the world’s reserve currency and the demand for dollars for global trade, which is growing at a rate the world has never seen, is stronger than ever. If the Federal Reserve had not entered into a policy of massive quantitative easing, it is entirely possible that we would have seen the dollar rise significantly over the last five years rather than languishing as it has.

Now that quantitative easing is finally done and the Federal Reserve is thinking about   raising interest rates at a slow drip back to something that looks normal (possibly, maybe, perhaps, conceivably – we aren’t in any hurry and you may need to be patient for a considerable period of time and anyway everything is data-dependent), the coiled spring that is the dollar may be set free.

And since we are in background mode, we need to understand that there are many ways to measure the strength of the dollar. As I mentioned, in the standard US Dollar Index (the DXY), significant weight is given to the euro. To more accurately reflect the strength of the dollar relative to other world currencies, the Federal Reserve created the trade-weighted US dollar index (for more about it see here and here), which includes a bigger collection of currencies than the US Dollar Index.

The composition of the US Dollar Index (DXY) is

-          Euro (EUR), 57.6%

-          Japanese yen (JPY), 13.6%

-          Pound sterling (GBP), 11.9%

-          Canadian dollar (CAD), 9.1%

-          Swedish krona (SEK), 4.2%

-          Swiss franc (CHF), 3.6%

Thus a fall in the euro, as we’ve seen recently, changes the valuation of the index more than it might another index like the Bloomberg Dollar Index (BBDXY), which is composed of a broader basket, including emerging-market currencies, with less emphasis on EUR/USD:

-          Euro (EUR), 31.4%

-          Japanese yen (JPY), 19.1%

-          Mexican peso (MXN), 9.6%

-          Pound sterling (GBP), 9.5%

-          Australian dollar (AUD), 6.2%

-          Canadian dollar (CAD), 11.5%

-          Swiss franc (CHF), 4.2%

-          Brazilian real (BRL), 2.2%

-          Korean won (KRW), 3.3%

-          Offshore Chinese yuan (CNH), 3.0%

Note in the chart below that at times one index is stronger than the other. This is primarily a reflection of the strength or weakness of the euro and the fact that the Bloomberg Dollar Index contains a much higher proportion of emerging-market currencies.

So the takeaway here is that, when we say “the dollar is strong,” we are really talking about its strength relative to particular groupings of currencies. It’s a generalization. If an index included the Russian ruble or the Argentine peso, then the dollar would even be “stronger” as measured by that index.

There Has Been No Deleveraging

In general, nature keeps a balance in a given ecosystem. There is a continual adjustment between the number of predators and the number of prey, but over time the system tends toward balance.

Just as nature has a way of forcing balance in the order of things, basic accounting (math is its own force of nature) has a way of forcing balance in currency flows and valuations.Quantitative easing and the developing currency war have created a great imbalance in the global economic order. The process of rebalancing the world monetary system is somewhat chaotic and crisis-prone in the best of times. Now, the massive amount of debt, both public and private, that has been created in the past decade is making that process even more chaotic.

It is usual in a crisis like the Great Recession that there is a resolution in the amount of outstanding debt, through a process called deleveraging. The process can take many forms, but in the past it has almost always meant that at the culmination of the process there is less debt. However, in recent months I’ve highlighted papers demonstrating that this time around there has been no deleveraging. Central banks and governments simply did not allow it to happen. That means we have pushed the inevitable process of deleveraging into the future. Debt cannot grow to the sky – at some point it has to be dealt with.

Four years ago in Endgame and in speeches since, I’ve been proclaiming that the dollar is going to get stronger than anyone can possibly imagine. I was saying this even as the yen and the euro were strengthening at times against the dollar. Those who have been proclaiming the destruction of the dollar are just seeing one small part of the equation: quantitative easing. There is a far larger and more complicated process going on in the world, and the rebalancing that is underway is going to mean that the dollar will increase in value against most currencies, and against some currencies by a great deal.

The Biggest Consequence of a Rising US Dollar

The beginning of a bull market in the dollar has multiple consequences, many of them not benign. Let’s start with the BIG one, the USD breakout and unwind of the USD-funded carry trade.

The yen and euro are dropping fast as the USD strengthens. As of today, the EUR/USD is below 1.23, while the USD/JPY has climbed to nearly 120. This is a function of central bank policy divergence… which in turn is a function of economic divergence among the major developed economies… which in turn is a function of debt divergence in those various economies. Total debt-to-GDP is approximately 334% in US, 460% in the Eurozone, and 655% in Japan, according to Lacy Hunt’s latest note.

With such divergence comes the major macro risk that the US Dollar Index (DXY) is breaking out in a big way. To anyone who believes in technical analysis (and skeptics should keep in mind that a lot of macro and currency traders DO), it looks like the USD is ready to break out of a 29-year downtrend that began with the Plaza Accord way back September 1985. The reversal of a trend that has been in place for that long is going to catch a number of people offsides. Unfortunately in investment and economics, you get more than a five-yard penalty for being offsides on a trend this big.

We are now going to look at a number of charts in rapid-fire fashion. As noted above, the dollar bull trend is exacerbated by debt. Global debt-to-GDP has been rising over the past several years.

The pool of developed-world financial assets is still growing, after a minor decrease in 2008. Again, there has been no deleveraging.

Even though debt and financial assets have been growing in the developed world, the real explosion in debt and financial assets has occurred in emerging markets, where the unwarranted flow of easy money has fueled a borrowing bonanza on the back of a massive USD-funded carry trade.

These QE-induced capital flows have kept EM sovereign borrowing costs low and enabled years of elevated emerging-market sovereign debt issuance, even as many of those markets displayed profound signs of structural weakness. I’m seeing estimates for the USD-funded carry trade around the world ranging from $3 TRILLION to $9 TRILLION. Raoul Pal believes it is roughly $5T, with nearly $3T of that going directly into China. (Other estimates for China suggest a somewhat lower number, but whatever it is, it is massive.)

Earlier this year, Bridgewater argued that total portfolio flows into emerging markets had doubled between 2008 and early 2014, from $5T to $10T.

Their study gave us some very specific data on flows into the larger EMs.

The following slide from Hyun Song Shin, head of research for the Bank for International Settlements, estimates that total USD-denominated credit to non-banks outside the United States is more than $9T.

What I’m getting at here is that a reversal in flows from a forceful unwind in USD capital flows could have disastrous effects on emerging markets... and there are a number of ways the unwind could blow back on the USA and other developed markets in coming quarters. The crazy thing is that EM currencies as a group have already given back more than 10 years of gains… and their losses can get a LOT worse.

Companies and governments in emerging markets have borrowed in dollars because of the ultralow interest rates available, but they earn the money to pay those loans back in local currencies. If the local currency is dropping significantly faster than the dollar, then no matter how profitable a business is, it is sinking deeper into debt with every tick up in the dollar. That’s what happened in 1998, and it’s happening again today.

The Fourth Arrow

Moving on in our survey of the world, we see the Japanese yen continuing to fall as the Bank of Japan engages in the most massive experiment in quantitative easing the world has ever seen. And they are doing it at the time when Japan’s current account and trade balance are both deeply negative.

These three realities combined mean that the yen is going to fall much further. The fourth, unstated, poison-tipped arrow of Abenomics is the launching of a major currency war, the consequences of which are now starting to be felt, as we can see in the next chart.

The potential for policy mistakes or monetary crises on the part of other Asian nations is very real and very troubling. We could see a country lose control of its currency as it tries to respond to Japan, and it is not altogether unlikely that at some point Japan itself will lose control, which would bring about a whole different set of problems and crises. Meanwhile, the US dollar’s rise will go on creating further problems for dollar-denominated debt in emerging markets, including China, which may decide that it needs to respond by devaluing the renminbi.

Adding China into the Mix

China’s investment boom is cooling; its competitiveness is eroding; and markets may already be pricing in a renminbi devaluation. China’s boom was largely a result of foreign direct investment and a massive increase in debt in a short period of time. Even though bank lending has grown substantially, the real growth in debt in recent years came through an explosion in non-bank loan funding. China has created a shadow banking system that is staggering in size.

There have been a number of studies on the relationship between the rapidity of growth of debt and subsequent financial crises. Even if we look to a broad sample of 48 instances over the last 50 years where total social finance expanded by as little as 30% over five years (less than half the magnitude of China’s credit explosion), history suggests there is still a 50% chance of a banking crisis or an abrupt fall in growth during the post-boom period. My point is that there is a clear relationship between the intensity of a credit boom and the subsequent adjustment (downward) in GDP growth rate. There are no cases in modern history where an economy has managed to avoid a banking crisis or outright bust after experiencing rapid lending growth anything like China’s ongoing credit boom.

The world is simply not prepared for a major China slowdown, let alone a hard landing. And gods forbid that the Chinese have a problem at the same time that Europe slides back into crisis.

The big question is, what happens next in China? Personally, I think it will be very difficult to avoid a real fall in the Chinese growth rate in the next 3-5 years. The reforms required to rebalance China to a more sustainable growth model will be very painful, and there is a real chance they could bring on a banking panic in the short term; but without those reforms, China literally has no chance. The Chinese Dragon is attempting a very intricate and delicate dance. The world needs China to succeed, but we must recognize that a Chinese hard landing is very much within our cone of uncertainty.

A Dangerous Illusion

I want to close this letter with a quote from William White, who recently did an interviewwith Finanz und Wirtschaft, perhaps the leading business and economics newspaper in Switzerland. White is the highly regarded former chief economist of the Bank for International Settlements. Longtime readers may recall that I have quoted him at length over the years, as his writing is some of the most thought-provoking in the economics world.

The interview focused on the decision by the Swiss National Bank to go to negative interest rates on January 22, 2015. Not coincidentally, the European Central Bank will be meeting that day to decide whether or not to implement its own quantitative easing program. The Swiss are quite concerned about the massive capital inflows that are pushing their currency to very uncomfortable levels. In a highly unusual move, they are going to start charging banks for the privilege of holding Swiss currency accounts.

For the Swiss to enact such a move means that they must be convinced that the ECB is actually going to do something on January 22. Technically, it is against the rules for the ECB to buy sovereign debt, and the Germans are adamantly opposed. But my highly connected friend Kiron Sarkar asks:

What if the ECB does introduce a QE programme, involving the purchase of EZ government debt, though only on the basis that the relevant countries meet pre-agreed targets? You have provided a massive incentive to introduce structural reforms, dealt with the German's/Bundesbank objections, and those countries that play ball will benefit from lower interest rates and a weaker euro. On the other hand, if EZ countries do not cooperate, yields on their bonds will blow out massively – just the right stick to wield. It's the classic carrot and stick approach. Too fanciful? Well, maybe, but...

I guarantee you just such a solution is being talked about. We will see what actually gets implemented. Now let’s turn to the conclusion of White’s interview (emphasis mine):

The SNB has to follow the ECB in its monetary policy. Is it not dangerous when the monetary policy of one country affects another?

Currently we have an international monetary non-system. Nobody has to follow any rules. Everybody does what they consider is in their own short-term best interest. The real difficulty is: What is in their short-term interest – for example, following ultra-easy monetary policy – could well backfire somewhere [else]. It might be not in their long-term best interest. And as the easy monetary policy influences the exchange rates, it influences other countries. Almost every country in the world is in easing mode, following the Fed, and we have absolutely no idea how it will end up. We are in absolutely unchartered territory here. This worries me the most. The Swiss National Bank has been doing well in what it was forced to do by this international monetary non-system. The Swiss have to do the best they can, because that is what everybody else is doing.

What are the risks of this non-system?

There is no automatic adjustment of current account deficits and surpluses, they can get totally out of hand. There are effects from big countries to little ones, like Switzerland. The system is dangerously unanchored. It is every man for himself. And we do not know what the long-term consequences of this will be. And if countries get in serious trouble, think of the Russians at the moment, there is nobody at the center of the system who has the responsibility of providing liquidity to people who desperately need it. If we have a number of small countries or one big country which run into trouble, the resources of the International Monetary Fund to deal with this are very limited. The idea that all countries act in their own individual interest, that you just let the exchange rate float and the whole system will be fine:This all is a dangerous illusion.

A data-rich source for A2s to dip into

Things that make you go hmmm... last edition

You don't have to read it all - and indeed, some of it is only really of interest to me - but take the time to try and absorb some of the information it contains, particularly re the following:

Credit and debt (particularly re China & EMs)

Gold and central banks adjusting reserves using gold

Japan and Abenomics

Many useful charts showing some interesting changes underway.

If this does not give you a sense of impending major structural changes you should not be studying economics...