Yesterday we discussed the hugely stimulating topic of ‘economic structure’. That is, what are the determinants of an economy’s output…which industries grow and create employment, tax revenue and profit? It might sound like an arcane, boring and useless discussion point but it’s hugely important in modern day analysis.
That’s because the world’s two largest economies, the US and China, are completely reliant on easy money. As a result, their ‘economic structure’ is built on the very shaky foundations of easy money.
Economic structure is like the medieval villages you see in the magnificent Tour de France. In the centre of town there is usually a church and a town square. The structure of the town or village grows out from these focal points.
And while there are other determinants of economic structure than just low interest rates, the persistence of low, and always lower, rates around the world mean that over the past decade or so monetary policy has played an oversized role in determining global economic output.
It’s also completely financialised the global economy. That’s why we now have a situation where markets around the world hang on the every word of Fed Reserve Chief Ben Bernanke.
They’re at it again right now. Bernanke is speaking before the Congress and markets were waiting to hear whether he would provide any further clues as to the future course of monetary policy.
After day one of his two-day testimony, Bernanke basically said the same thing he’s been saying all along. That is, any decision to end or expand QE will be data dependent.
That seems like a pretty straightforward equation. But it’s taken the market ages to work it out. If ‘the market’ were a person we’d give it a whack about the head and tell it to stop whining and get on with it…to make its own mind up and stop relying on some dude with a finely manicured beard.
Because all the beard has left in his arsenal is talk…and as we know, talk is cheap (like money).
Our mate Dan Denning reminded us of that this week when he sent through a 2004 Fed paper, penned by one Ben S. Bernanke, with a little help from Vincent Reinhart (an academic) and Brian P. Sack, a guy who’s been in the Federal Reserve system for years and is now an ‘executive vice president at the Federal Reserve Bank of New York and a senior advisor to the president.’
Titled ‘Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment’, Bernanke listed three things the Fed could do when nominal rates hit zero:
(1) Use communications policies to shape public expectations about the future course of interest rates;
(2) Increase the size of the central bank’s balance sheet; and
(3) Change the composition of the central bank’s balance sheet.
Given Bernanke has already increased the size and changed the composition of the Fed’s balance sheet, all he’s really got left is talk. Of course he can keep increasing the size and changing the composition of the balance sheet but that’s just akin to digging a deeper hole. Right now, Bernanke is in the hole up to his waist, leaning on a shovel, talking. Soon enough he’ll start digging again.
And the structure of the US economy will continue to warp around the changing size and composition of the Fed’s balance sheet. The economy is now completely dependent on the continuation of easy money. Bernanke even said so in his testimony: ‘If we were to tighten policy, the economy would tank.’
It’s not just the real economy that would tank. Asset markets would take the brunt of it. For example, easy money has facilitated the enormous growth of derivatives — paper based financial products that derive their value from real things, or mostly real things if you take interest rates into account. (The market for interest rate derivatives is huge.)
This allows the market to think it can ‘hedge’ any and all risks. With risks hedged, players can then take on greater risks, always assuming the counterparty they are hedging with will pay out if anything bad happens. And if the counterparty doesn’t, well, there’s always the Fed.
Markets’ have placed their bets on the assumption of continuing easy money. Once that goes, they ‘tank’. Bernanke can’t take easy money away, not even gradually, without damaging an impaired economic structure. And no central banker or politician has the gumption these days to embark on economic restructuring, especially not one driven by monetary tightening.
But it’s not only the US suffering from an economy deformed by easy money. China is too. Earlier this week we explained how the rebalancing that China is trying to achieve has not even started yet.
Yesterday on CNBC, China bear Jim Chanos reiterated those remarks and reinforced the notion that easy money creates horrible long term structural problems.
He said China’s credit bubble was still ‘world class’. He said that, based on China’s latest GDP numbers, investment increased as a percentage of GDP and consumption decreased. That’s not rebalancing.
When asked why rebalancing wasn’t occurring, Chanos hit on the structural problem of easy money. He said that investment creates employment in things like construction, and when you try to ease off on investment jobs are lost and incomes go down, meaning people don’t spend as much.
In short, it takes time for the structure of an economy to adjust from one driven by investment to one driven by, say, consumption. Given the adjustment hasn’t even started in China’s economy, this is going to be one interesting economic transition to watch.
From Australia’s perspective, it will be more than just interesting. Chanos reckons the commodity super cycle is over. If he’s right (and we think he is) Australia will face its own (major) structural problems in the years ahead.
It’s not something easy money can fix. In fact, it just makes the structure worse. That’s a fact that policymakers just don’t seem to get.
for Markets and Money Australia
From the Archives…
The Agonists and the Ecstasy of the Financial Market
12-07-13 – Dan Denning
A Two-Faced Shock for the Australian Economy
11-07-13 – Dan Denning
Asiana Boeing 777: Lifesaving Defence-Tech ‘Miracle Materials’ in Action
10-07-13 – Byron King
Interest Rates: Something Wicked This Way Comes
9-07-13 – Bill Bonner
The End of a Share Market Correction… or the Beginning?
8-07-13 – Dan Denning