There’s no easy way to put this: the central banks are like the naked emperor in the well-known story. And the only solution that could save us from the next recession is so politically sensitive that it will not be put into practice.
First, about the central banks. They pretend they have new clothes (“unorthodox” policy tools) and that these clothes fit perfectly, but the reality is they have nothing.
When this boom cycle turns to bust, they have no ammunition to fight the next recession. And this is why, actually, we have witnessed the tantrum in the bond markets last week, when German bund yields increased all by themselves, despite bond-buying by the European Central Bank (ECB).
It was the first time in two years that money flew out of both European bonds and equities.
The realisation that central banks are behind the curve is creeping in, so expect more such “tantrums” ahead.
Analysts, strategists and investors are trying to guess how things will unfold for the markets if central banks are no longer able to control the economy.
Stephen King, the HSBC’s chief economy, says the world is facing a “titanic problem”: growth has been pitiful since the financial crisis.
Indeed, this has been the weakest recovery for the US economy since the 1970s, despite the Fed holding rates at zero and going through three rounds of money-printing.
Some have argued that this shows that there is still slack in the US economy, but King points out that unemployment and the rate of manufacturing capacity utilisation in the US are the same now as they were in previous cycles when the Fed had begun raising its rate.
“Indeed, it could be argued that the Federal Reserve is ‘behind the curve,'” King writes in a recent research note.
But, he goes on, this may not necessarily be the case right now because “a lower long-term growth rate — and associated weak productivity growth — would imply a structurally lower level of real interest rates, exactly what we’ve witnessed in the post-crisis world.”
So the markets’ attempts to “correct” the interest rates by selling off government and other types of bonds may be short-lived and futile.
But if that is not the solution, what is? If central banks have the pedal to the metal and all they have to show for it is little more than stagnation, what will happen when the cycle turns towards recession – as it soon will?
Work ’till you drop
King offers a few scenarios. One is the repeat of money-printing. At best, this would likely lead to the mis-pricing of financial assets (I would argue that this is already happening and that we are seeing various asset bubbles around the world).
The mis-pricing of assets would lead to a fall in the quality of investment and lower productivity over the medium term, says King.
(I would add that we are seeing this already, to some extent, in the UK – helped by government subsidies for house prices in the form of top-ups for low salaries with benefits, allowing low-wage workers to live in high-rent locations. It is true that UK household wealth jumped but this still has to be reflected in consumption.)
At worst, King says, the asset price bubble that has disrupted the global economy will be repeated.
“In the absence of conventional policy ammunition, an addiction to QE could ultimately mean that the second great depression was only postponed, not avoided altogether,” he says.
King argues that central banks should drop their rigid focus on consumer price inflation and instead look at wider signs of price rises – like I said in an article more than a year ago, asset price inflation should be included in the official data.
Another option would be to use fiscal policy in conjunction with monetary policy to stimulate growth – although for some countries, like the UK, this might be difficult considering that fiscal deficits are already high.
The healthiest solution from a structural point of view is the least likely to be put in practice, for political reasons. That solution would be to drastically raise the retirement age.
King has a neat explanation for why that would work. Countries with ageing populations “are full of people keen to postpone expenditure from the present to the future, in the hope that they will be able to enjoy a long and rich retirement,” he says.
While each person has an intuitive sense of how much wealth they would need in order to ensure they enjoy a good retirement, at a national level they collectively undermine their individual plans because the fact that they all save at the same time pushes interest rates even lower, and therefore their returns on savings diminish further. So they save more, pushing rates lower still, and the vicious circle repeats.
Raising the retirement age would reduce the need for high savings. This would mean higher demand and consumption, which would ultimately boost growth.
“Importantly, faster economic growth would also provide higher tax revenues and higher interest rates,” says King. “The ammunition needed to repel the next recession would be replenished.”
It looks like we’re doomed.