The Grapes of Wrath

I was asked this week whether it was possible under any circumstances for member states of a monetary union to operate different monetary policies. The standard response is simply "no" but it's worth going into it a bit deeper and I thought I'd at least out write down a few thoughts on the subject of monetary union in one place.  And advertise a couple of very good books in the process.

The Postwar International Money Crisis was published in 1981 and written by the late Victor Argy, an Australian economist who worked for the IMF and the OECD but finished his career teaching at Macquarie University. At that point, the EEC's attempts at any form of monetary union (the post-Bretton Woods "snake" were deemed a failure). Argy describes monetary union as "weak" if it is a system of pegged exchange rates, or "strong" if it involves a single currency. A strong monetary union is assumed to have a common currency and a common central bank. Capital markets are unified and independent monetary policy becomes impossible. Some independent fiscal policy continues to be feasible. And he goes on to list the conditions which make the costs of joining a union smaller, or the benefits larger. They are 1) that differences in growth rates and labour productivity are not large; 2) that intra-union trade is large; 3) that there is no long-run trade-off between inflation and unemployment; 4) the differences in propensities to inflate are relatively small; 5) differences in degree of domestic instability are relatively small; and 6) there is a significant degree of labour mobility.

Some of that sounds as if it was written at the end of the 1970s, as it was. But what strikes me, over 30 years later, is that 3 of those conditions represent the root causes of some of current woes; labour productivity (and competitiveness; propensities to inflate (Buba); and domestic instability (Spain's construction bubble).

Parts of  Europe suffered from a massive credit bubble, particularly in housing and construction, and when it burst it left devastation behind. The textbook solution in a monetary union is for there to be either fiscal transfer or labour movement. Both have happened in a very modest fashion. Large competitiveness and productivity gaps always existed but have become more apparent in the recession. And because the biggest country in Europe is much less inclined to inflate than most of the others, the only 'cure' to the productivity crisis is lower wages in the lower productivity economies, with huge knock-on implications for debt, fiscal policy and economic activity.

The situation has been exacerbated by the fact that while Europe shares a single monetary policy and a unified capital market, the way the capital market behaves is that there is no so single 'risk free' interest rate that all countries can borrow at. Rather, there is a tendency for regional borrowing costs to diverge dramatically.

A monetary union where the weaker members pay more to borrow, where the dominant member is the least inclined to inflate and therefore where productivity differentials can pretty much only be cured through falling wages in the lower-productivity member states, looks like a recipe for labour migration and social unrest. Is the fact that so far, migration has been relatively limited, a good thing or just a sign that we haven't yet reached that stage of the crisis?

Which brings me to my second book! I'm sure that when John Steinbeck wrote The Grapes of Wrath, or when Henry Ford made the film, they weren't thinking of it as a case study in the problems of economic shocks on a monetary union. But that's what it means to me. It's the story of a farming family from Oklahoma that migrate to California in search of work during the Depression in the 1930s. The fruit growers and pickers in the west of the United States are no more enthusiastic about the arrival of vast numbers of work-seeking 'Oakies' than you would expect and trouble follows. Oklahoma would have devalued its currency to cope with its economic woes, in a different era. Indeed, the east of the US might have devalued relative to the west. The United States share a common currency and use a mobile labour force and fiscal transfers to cope with regional and industry-specific shocks.


The economics of fixed and floating exchange rates, of monetary unions, are all about pros, cons and compromises. Steinbeck's tale is a cautionary one for Europe because if the US coped poorly with large scale economic migration in the 1930's, surely it would be even worse in the more disparate Euro Zone. That hasn't been a problem  - at least until now. There are huge regional economic variations, and the fiscal transfers to soften the blow aren't big enough. But mass movement of labour hasn't really been an issue. However, the image still lurks in my mind because one possibility is that people only really up ticks and move in large numbers when things get really bad. Worse than they are now, but perhaps not worse than they could be if the remorseless rise in (particularly youth) unemployment goes on.

Now to that question of whether you can have different interest rates in member states of a currency union. The simplest answer is that you need capital controls to do it. The Asian economic crisis of the mid/late 1990s was caused in large part by a foreign currency credit bubble. Central banks fixed their exchange rates to the US dollar, but operated separate monetary policies so that banks were tempted to borrow cheap dollars (where rates were very low in 1992/1993) and lend in domestic currency at higher rates. hotel and golf course developers, and home-buyers, were tempted into foreign currency loans as well, and when the US raised rates and the global economy slowed, disaster followed. This seemed, at the time, a damning indictment of a fixed exchange rate system and a clear argument that either floating rates or a full monetary union were preferable.

The Asian example is relevant because to the borrowers, it 'felt' like a monetary union. Exchange rates were fixed so it made sense to borrow at the cheapest rate possible. I am sure that is how it felt when Hungarian borrowers took out Euro or Swiss franc mortgages, too. So the borrower thought he was 'arbitraging' the system. At this point the regulator is supposed to either educate the market or regulate the market to make sure that foreign currency borrowings are not excessive. It is possible to have fixed rates and different polices ,as long as the flow of money is regulated. And surely, by extension, the same is true in a monetary union with a single currency, at least theoretically. But here's the problem - it may be possible to raise the cost of borrowing in some parts of a monetary union through regulation (tighter rules for German banks, and no access to foreign banks for German borrowers, say), but what Europe needs, is (even) lower rates in other countries and that's much harder to regulate. Because the perception that weaker countries and borrowers are inferior credits, raises their cost of borrowing and turning that upside down is pretty hard.

So, theoretically possible but not feasible? In the meantime, avoiding mass unemployment causing massive labour migration  would be a good start....

The virtues of the virtual pub and FF to you all

Once upon a time, I spent a lot of effort promoting the concept of a "virtual pub" as the heart of a good financial market research team (or any other research team, for that matter).

A pub (in my experience at least) is a place where colleagues, friends and acquaintances can go and argue vociferously without falling out. The rules of engagement  are that you arm yourselves with alcohol, stand very close to each other and disagree about almost anything, sometimes because you hold different views, and sometimes just because it's more fun to argue than agree. Views are expressed with considerable conviction (helped by tongues alcoholically-lubricated) and fingers are often poked in the direction of other debaters' faces. But it is considered extremely bad form for the argument to become violent, and it is of absolute imperative importance that at the end of the evening/argument, all participants leave, still friends and still respecting each other. If anyone drinks too much, or crosses any social lines of decent behaviour, a huge amount of embarrassed apology is required the following day.

I have had pub arguments about many things though perhaps mostly about cricket,  football, politics, and economics. Lots of them. Not all of these debates answered important questions, but they were almost all the very opposite of the group-think which is the arch-enemy of constructive thought and analysis. It's easy for a sterile office discussion to end up with a bland consensual view of the world; much harder to get to that point in a pub argument where if someone says something stupid, there will be heart-felt howls of derision, rather than polite nodding of heads.

An American once told me that a pub argument is a very British concept and that other folks are a little too straight-laced to be able to cope without being offended. Maybe that is true. In certainly find that if I embark on a tirade against the accepted view of the world or of a particular asset market, I get a lot of silence and nervousness from continental European colleagues. Which is a shame because I am not trying to upset them, only to shake them out of their railway-track thought process. It's easy enough to see with hindsight that most asset bubbles, (EM, credit, dotcom, to name the last three) are the product of, or the very least aided and abetted by, groupthink.

What has this got to do with social media? I think that Twitter, in particular  is replacing the virtual pub as the best mechanism for checking consensus and challenging it. If I think that someone on Twitter is talking codswallop, I don't have to start a fight, nor do I have to agree and seek a middle ground with a consensual view. I can gently challenge, or I can move to a different part of the pub. I can argue with the more robust souls who like that kind of thing, and I can listen in on the arguments and conversations of others without causing offence. I might try and be polite, but the worst someone can do is 'unfollow' me.

Facebook and Linkedin serve very different purposes. Linkedin would (I am told) allow me to keep tabs on the vast legions of people I have worked with, studied with, played with. Which might be useful if I were any good at networking. But I'm not. If Ex-colleagues, and clients, tend to ask if they can be on my research distribution list and the answer is usually yes. if they send me an email asking if i want a beer or coffee, the answer's usually yes, too. Why would I want Linkedin?

Facebook is a way for me to keep in touch with my friends - something I am incredibly bad at doing. But it appears time-consuming. I have agreed to befriend my wife, because it seemed wise and my brothers and sisters out of politeness. I know my children don't want me as a Facebook friend. To anyone else, I recommend sending me an email.

So one of the main social media helps people network, but I don't do that, and another is a way to chat with friends, but I've got better ways of dong that than Facebook. Twitter allows me to discuss with kindred souls about a subject dear to my heart but without leaving the comfort of  my study. I can save my real pub time for arguments about politics and football. As for fellow tweeters, those I follow or those that follow me - I'm grateful for the debate, for agreeing with me or for telling me I'm talking horse-manure. This is how I find my way to answer questions about where the world's markets are headed. FF to you all, as they say on Twitter.

Super Cycles.. not the end, perhaps the beginning of the end

David Stockman has written a piece in the NYT  ahead of the launch of his latest book,   The Great Deformation: Capitalism Corrupted which is out tomorrow. There has been plenty of fuss and he's succeeded in annoying Paul Krugman amongst others.

Mr Stockman blames crony capitalism, badly designed fiscal stimulus, financial bailouts and easy money for the woes of the US.  And of course, he predicts than when the next bubble bursts, the US will be left defenceless and the effects will be awful. Cue a decent Easter debate (that's the polite term) in the press, and on social media.

Away from the rhetoric and the politics, there's at least a core of truth in some of what he writes. Anyone interested in the subject really ought to start by studying the work of the Bank Credit Analyst and you could do worse than google the term 'debt super-cycle'.  Since the end of the Volcker era at the Federal Reserve, the US has seen a long-term downtrend in both nominal and real interest rates. That's the reward for the defeat of (consumer price) inflation, in turn helped by Mr Volcker but also thanks to the benign effects of globalisation.

What the Fed has done, is use the freedom created by subdued CPI, to adopt incredibly easy monetary policy at the first sign of danger, and keep rates very low regardless of the effect on other parts of the US economy. They started in the early 1990s, when the Fed cut rates to 3% in response to the S&L crisis. The denouement in 1994 and onwards, was fine for the US but catastrophic for many countries which had tied their currencies to the dollar. Some of you may say 'so what?' but it was hardly great global leadership. In 1998, the Fed cut rates far too quickly after the LTCM 'crisis' and was too slow to raise them, starting the housing bubble which lasted a decade and lighting the fuse for the dotcom bubble. And after a very mild recession at the turn of the Millennium, a period of crazy monetary policy was as much the cause of the credit bubble which ended with the 'Great Recession' as lax bank supervision and greedy bankers.

In 2008, I thought the debt super-cycle had ended.  It seemed obvious that households and companies would reduce their leverage and that the financial sector would be forced by regulators and natural caution to lend less, and build up more defensive balance sheets. What I hadn't reckoned on, was that the public sector could take over so much of the debt and that the Fed would respond by adopting even easier monetary policy. The asset bubble whose explosion triggered the recession, was caused by negative real interest rates. Economic recovery is being built on even more negative real interest rates, which have indeed triggered a recovery in asset prices from equities to housing.

I've learnt to be wary of saying that the Fed is out of bullets. QE and ZIRP are working. There is collateral damage in the form of increased economic inequality and in terms of overvalued exchange rates in some emerging economies, but the US is going to out-grow most other developed economies in the next few years. And since ZIRP, QE and the dollar's reserve currency status all combine to allow the US to borrow money at deeply negative real yields, I don't even see why the government wouldn't go on postponing sensible fiscal policies. If I could borrow 10-year money at less than 2% per annum to invest in an economy growing at 4 1/2% in nominal terms, I would. And after all, political gridlock in Washington doesn't look that bad when you compare it to the synchronised fiscal masochism in Europe.

I wouldn't rule out a longer period than many expect when US bond yields can stay below nominal GDP growth, continuing to support asset prices; when globalisation keeps on keeping wage growth down and CPI inflation under control; and the US can give a very decent impression of being in the early stages of an OK economic recovery. The rest of us, wearing our hair shirts and struggling to get out debt levels under control in the face of recession, will be thankful for any growth we can import from the US.

That's where I disagree with Mr Stockman. 2008 didn't signal the last 'mini-cycle' of the debt super-cycle; maybe it didn't even signal the last-but-one. The  philosophical rights and wrongs of mad money and ever-rising public sector debt levels, can fuel debate but when Ben goes and Janet takes over, the policy recipe could just stay the same. So Mr Stockman may find that he is an awful lot older before he is ever proved right in his warnings of doom...