A Cage Full of Tigers

Henry Kissinger once described the vicious nature of academic politics, where tenure protection provides a virtually sanction-free arena for the participants, as being the ideal training ground for the White House.

In the case of economic differences these spats rarely make the public arena before they are drowned in a flood of algebraic symbols.

But that’s not the case with the battle over the Fed’s management of the global financial crisis.

The opening shots were fired last week when European Central Bank President, Mario Draghi, virtually conceded that global quantitative easing (QE) had failed and that the latest slow-down in global growth “is probably not temporary”.

It really burst into the public arena when Larry Summers fired the first broadside. Larry Summers, President Emeritus of Harvard University is about as tough as they come on the US economic scene. Be it politics or academe you will find him at the top table.

Summers prefers the bullring to the ivory tower and is notoriously outspoken.

Consequently, when Summers’ regular blog in the Financial Times headlined “Critique of Fed not backed by logic nor evidence,” I read it with certain anticipation.

Summers began, “My friends Mike Spence and Kevin Warsh, writing in yesterday’s Wall Street Journal, have produced what seems to me the single most confused analysis of US monetary policy that I have read this year. Unless I am missing something – which is certainly possible – they make a variety of assertions that are usually exposed as fallacy in introductory economics classes.”

Mike Spence was the 2001 Nobel laureate and Kevin Warsh is a former Federal Reserve Governor.

The two have authored “Growing Global: Lessons for the New Enterprise” which will be released this month. (Any economics book with the word “lessons” in the title can be guaranteed to offend somebody in the profession).

Provoking Summers out into the open on QE has been quite clever.

Spence and Warsh have upset Summers with their claim that the policies pursued by the Federal Reserve have hurt business investment and contributed to the weak economic recovery.

In reply, Summers argues Spence and Warsh do not focus on the inflation risks, financial stability risks or distributional risks.

Instead, he writes, “They assert a proposition that I have not encountered in 40 years as a professional economist – that overly easy monetary policy reduces business investment”.

“They blame the weakness of business investment during the current recovery on the Fed. This line of argument is – to say the least – surprising.

“Every major macroeconomics text book whether Keynesian, monetarist or classical in orientation teaches students that investment increases as interest rates decline.

“This is motivated in a variety of quite compelling ways.”

Spence and Warsh have used the Wall Street Journal to argue that economic textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy.

“Nothing”, they claim, “could be further from the truth.”

Over the past five years, earnings of the S&P 500 have grown about 6.9% annually. This is much slower than during prior economic expansions.

Furthermore, only about half of the profit improvement in the current period is attributed to business operations. The balance of earnings per share gains arose from the record level of buybacks. So the quality of those earnings, they say, is as deficient as their quantity.

The current economic expansion is also unusual because the stock market and other financial assets have boomed in spite of relatively muted profit gains. Spence and Warsh claim that the apparent divergence between earnings and asset prices can be attributed to the unusual conduct of monetary policy.

Extremely accommodative monetary policy, including the purchase of about $3 trillion in Treasuries and mortgage-backed securities during three rounds of QE, pushed down longterm yields and boosted the value of risk-assets.

Higher prices were supposed to drive business confidence and higher capital expenditure was supposed to result in higher wages and stronger consumption.

That didn’t happen.

While it could be argued that the current lack of capital investment stems from a shortfall in global demand, according to Spence and Warsh, the demand that drives capital investment is future demand.

That’s why efforts by the Fed to fill near-term short falls in demand by deploying QE and “forward guidance” have fallen short of expectations.

As a result QE has redirected capital from the rest of the economy to financial assets both at home and abroad.

One consequence is that the failure of QE to deliver stronger business investment on the back of QE is that policy makers are sitting on the sidelines.

Structural reform has hit the fence.

In May, the Australian Treasury Secretary, John Fraser, warned that the world would have a tiger by the tail when the winding back of QE got underway.

Fraser pointed to the redistribution of wealth that had occurred under the QE regime.

He claimed that there has been a breakdown in the social contract, citing the experience of his parents who lived in Melbourne suburb, Armadale. They had planned their retirement that would be partially funded from a nest egg projected to earn 4.5 per cent.

That was no longer feasible. At the other end of the scale, the corporate world has seen the greatest redistribution of wealth in history.

The vehicle of choice has been the buy back of equity to fund bond issues at historically low yields. The substitution of debt for equity has changed the balance of risk. The full extent of this practice is not known because it has been used to fund operations in emerging markets where disclosure is sometimes voluntary. 

That’s why emerging markets have been given such a hammering.

An uncertain Federal Reserve, growing economic inequity, secular stagnation, emerging populist political parties in developed markets and unanticipated demographic longevity provide ideal breeding conditions for those tigers John Fraser was talking about

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Max Walsh


Max Walsh was for many years one of Australia’s top economic and political commentators, highly regarded as a journalist, author and broadcaster. Throughout his career, Max was involved in all dimensions of the media industry, which has encompassed positions with two of Australia’s largest publishing companies and television networks.

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