Today began the next phase of the great monetary experiment, as reality plays a trump card.

Summary: Today began the next phase of the great monetary experiment, the collision of Central Bankers’ bold promises with reality.  History suggests skepticism about the odds of CB’s success (e.g., see the many unbreakable currency pegs and unions which broke). Today the Swiss National Bank folded its cards. Here we discuss the significance of this to them and to us.  This is part one; see tomorrow’s post for the conclusion. (2nd of 2 posts today.)

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Wizard of Oz

Bow before our Monetary Wizards!

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Since the crash, governments of the western nations have conducted the greatest economic experiment ever, with us as the subjects of unprecedented monetary and fiscal stimulus. We have had massive deficits, long periods of zero interest rates (for some now, negative interest rates), and repeated rounds of quantitative easing (in various forms). So far the results have varied by nation from good to great. But as with any experiment, preliminary results often don’t match the final tally. Today we began the next phase.  First here’s some background.

Switzerland’s bold monetary experiment.

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“The minimum exchange rate remains for the foreseeable future the key monetary policy instrument. We’re prepared to buy unlimited amounts of foreign currencies and, if necessary, take further measures …. We will continue to defend the minimum exchange rate with utmost determination …”

— Thomas Jordan, President of the Swiss National Bank, 23 September 2014 — Speech in defense of the 1.20 peg to the Euro set in September 2011.

To keep their exports competitive in September 2011 the Swiss National Bank (SNB) set a minimum exchange rate (a ceiling to the Swiss Franc vs the Euro). In September 2014 President Jordan promised to print unlimited Swiss Francs to defend this level. Some were skeptics, such as the people at Grant’s Interest Rate Observer, 19 September 2014 — Excerpt:

Like a celebrity in flight from the paparazzi, the Swiss Confederation demands protection from its pesky admirers. … The {Swiss franc} is still, for many, the monetary bolt-hole of choice. To the Swiss, whose exports generate 54% of Switzerland’s GDP, it’s a kind of popularity they can live without — indeed, they insist, must live without. So the SNB prints francs.  It drew a monetary line in the sand three years ago: The franc shall not rally through the 1.20-to-the-euro mark, the authorities commanded in September 2011. To enforce this dictum, they bought euros with newly created francs (the cost of production of the home currency being essentially zero).

What to do with the rising euro mountain? Invest it, of course. CFA fashion, the central bankers are diversifying across asset classes and currencies. Among these asset classes are equities, and among these currencies is the dollar. As of June 30, the Swiss managers held $27 billion in 2,533 different U.S. stocks, according to the bank’s latest 13-F report …

Here’s a metaphysical head scratcher. The Europeans conjure euros, which the Swiss buy with their newly materialized francs. The managers exchange the euros for dollars (also produced by taps on a keyboard) and with that scrip buy ownership interests in real businesses. The equities are genuine. The money, legally and practically speaking, is itself real.. But what is its substance? We mean, how is it different from air?

… In these stupendous interventions, the SNB is hardly unique. Nor is it alone as it attempts to undo, through administrative means, the distortions it creates through monetary policy. New “macro- prudential” directives have tightened standards for home-loan amortization schedules, minimum down payments, affordability, bank capital ratios, etc.

Grant’s recommendation:

{W}e venture that the SNB will sooner or later be forced to permit the franc to appreciate and thus to enrich the holders of low-priced, three-year call options on the Swiss/euro exchange rate. It’s a long shot, to be sure — the options are cheap for a reason — but we judge that the prospective reward is worth the obvious risk.

Four months later their recommendation paid off — big. Bloomberg describes the fireworks:

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2015 might bring an end to the great age of experts’ experiments on us

Summary: Beam us down to Earth on 31 December 2015. What will we find? My guess is that the massive experiments now underway by experts will have borne fruit, and we’ll know if they were sweet or poisoned. Interesting times lie ahead, and none can say how they will end.

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Crystal Ball

Contents

  1. The age of experts’ experiments on us
  2. Warnings of Climate Change
  3. Economics: monetary and fiscal magic
  4. For More Information

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Photo from the Star Trek episode “Miri” – The landing party arrives in response to a distress call. Experts on the planet have run a massive experiment to produce a better world. Looks like it didn’t end well.

TOS: "Miri" - Landing Party

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(1)  The age of experts’ experiments on us
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The 21st century has seen some of the largest experiments ever by experts, different from the often-mad amateur experiments that shaped so much of human history (e.g., the French and Russian revolutions, the Fascist social “engineers” in the 1930s, the 1970s Khmer Rouge in Cambodia). Some have run to completion, such as the US military’s expeditions to Iraq and Afghanistan — using the techniques of COIN to defeat local insurgents and build new western-style nations (quite mad given the history of almost total failure since WWII by foreign armies fighting insurgents). Other and larger experiments continue running. Let’s look at two of the biggest.

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For Japan there is no road but to an economic recovery

Summary: the most contrarian thing you’ll read today.

Japan was a big story in 2014. The hopes for its rise — quickly crushed — created ripples around the world. Today’s post features an article by an expert asking if a new phase in its recovery story will unfold in 2015. A recovery in Japan would give the world economy another locomotive. The data looks provocative and the reasoning seems profound. (This is the 2nd of today’s two posts.)

“If something cannot go on forever, it will stop.”
— Herbert Stein’s Law (US economist, 1916-1999)

Japan: setting sun

A setting or rising sun?

Keiki Kaifuku, Kono Michi Shika Nai
“Economic Recovery,
There Is No Road But This”
—  LDP Campaign Slogan, December 2014

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By Peter Karmin of Fort Sheridan Advisors

From the Drobny Global Monitor, 11 December 2014

Posted with the generous permission of the author and Drobny Global Advisors.

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For years – if not decades – Japan’s shrinking demographics have been a primary cause for that country’s lackluster economic growth. However, Japan is now reaching a point in its cycle where the population shortage — combined with a scarcity in natural resources and the effects of “Abenomics” – will cause stagflation rather than deflation. This is a structural rather than cyclical change resulting from a shortage in labor and natural resources. The former is a result of declining population/workforce along with stringent immigration laws and the latter is a result of the closing of nuclear power plants following the 2011 Tohoku earthquake and tsunami.

During the past few years, Japan’s unemployment rate has gradually dropped and is now at 3.5% which is the lowest since 1997.

Japan's unemployment rate

Drobny Global Advisors, 11 December 2014

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Additional signs of improvement within the labor sector are seen in other surveys. For example, the “Jobs-To-Applicants Ratio” is now at a level (1.1 job openings/applicants) not seen since June 1992 when 10-year Japanese Government Bonds (JGBs) yielded 5% (we have only had to move the decimal over to the left one place during the past 22 years):

Japan: job to applicants ratio

Drobny Global Advisors, 11 December 2014

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Recent Bank of Japan Tankan Surveys show that both the manufacturing and non-manufacturing sectors are finding a shortage of available workers {DI: diffusion index}:

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Richard Koo gives a “Post-QE forecast: sunny, cloudy, or stormy?”

Summary: Prosperity, perhaps even survival, in the 21st century might require learning which experts we should listen to. In economics its a short list, if we limit it to people who have understood large aspects of the great recession and the aftermath.  Richard Koo certainly deserves to make that short list. Here he tells us what to expect next.

Storm

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“Post-QE forecast for leading economies:
sunny,cloudy, or stormy?”

Richard Koo, Chief Economist
Nomura Research Institute

25 March 2014

Excerpt

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{People} were roiled by Fed Chair Janet Yellen’s first press conference last Wednesday, where she suggested a rate hike could come as soon as next spring. The fact that {people} reacted so much led some in the media to question her communication skills, given her predecessor’s skill in this area.

{People} also appear to have been surprised and disappointed that the supposedly dovish Ms. Yellen indicated the possibility of a tightening of policy. “This wasn’t supposed to happen” seemed to be the general reaction.

Marketsand media unaware that US is in QE trap

Nevertheless, it was easy enough to predict that the Fed would have to move in this direction when it began normalizing policy after years of quantitative easing. The media’s criticism of her dialog and {people’s} complaints about the lack of further accommodation tells us that most of them have yet to realize the US economy has fallen into the QE trap. Their ignorance is of far greater concern, in my view.

{People} and members of the media simply do not understand that an economic recovery in a country that has undertaken QE is going to be very different from a recovery in a country that has not.

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Japan leads us into a new future, taking the next step in the great monetary experiment

Summary: A first step to understanding comes from appreciating the wonders before us. Recognition of extraordinary events that lie before us. Not unique events (those are seldom seen), but event of unusual magnitude. Old Faithful, not the usual steam kettle on the stove. Today we look at one such, one of the greatest experiments ever: sustain large-scale monetary stimulus.

In “Forbidden Planet” a great distant civilization — far away, long ago — built a planetary-scale machine to grant their every wish. It didn’t end well for them, but they deserve high marks for the boldness and scale of the project. Today economists are attempting something less ambitious, but still bold beyond any precedents.

ATLAS experiment

In the basement of the Federal Reserve

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Size of central bank balance sheets for the major nations (2014 IMF estimate):

  • China: $4.8 trillion, 49% of GDP
  • Japan: $2.0 trillion, 39% of GDP
  • UK: $0.7 trillion, 25% of GDP
  • US: $4.2 trillion, 24% of GDP
  • EU: $3.0 trillion, 23% of GDP

These are mind-blowing numbers, become familiar to us in the five years since the crash.

Combined with artificially low interest rates (near-zero in all of the above but China), the major nations have sought to restore growth using extreme and unconventional monetary policy measures. The first phase — first aid to stabilize their financial systems during the crash (2008-09) were a success. The results since then, using monetary policy for extended treatment, remain unknown until the experiment concludes and monetary policy returns to normal.

As with any bold experiment, economists will learn much from the results. If successful, it will be a new world. Economic policy of the 21st century will look nothing like that of the post-WW2 era, any more than the dark nighttime cities of Victorian London resemble its brightly lite 21st century version. Future downturns — and even more so with future crashes — will be met with tsunamis of newly printed cash. Perhaps we’ve built a monetary savior, like the discovery of antibiotics.

We’ll know when the experiment is concluded. So far the results are cloudy; we’ll have to ask again later.

Japan leads the way

Haruhiko Kuroda

Haruhiko Kuroda

Japan is the cutting edge of this experiment, going boldly to where no nation has gone before. While other nations look to slow the monetary engines, they’re revving them up even more.

Bank of Japan Governor Haruhiko Kuroda said there were “no limits” to what the central bank can do if it saw the need to adjust monetary policy in the future, signaling readiness to expand stimulus further if risks threatened its price target {2% inflation}. … He also said it was “not as if there weren’t any steps left” for the BOJ to take if it were to ease again, countering views held by some market participants that having delivered a massive stimulus last year, the BOJ had no tools left to deploy.

— Interview on 13 March with Japan’s Jiji news agency, as reported by Reuters

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What happens if the economy hits some rocks? Will the Fed stop the taper?

Summary: The first phase of the great monetary experiment was guaranteed pleasure. Whatever the results, monetary stimulus feels great. Then comes the difficult process of withdrawing the stimulus. “Tapering”, as its called by economists (and, coincidentally, by heroin addicts). How much damage will be cause? How much pain? Today we have advice about what to expect from someone with more experience at this game than most economists.

The Taper

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One fascinating about political economy (the intersection of politics and economics) is the how frequently people believe with total certainty things that are not so.

After Obama took office in 2009 many people “knew” that the Keynan socialist would inexorably expand the size of the government bureaucracy.  In fact the Federal government’s workforce is up only 3.7% in the five years since then (less than the population increase of 4.3%), and down 4.4% since the May 2011 peak (vs population up 2.0%).

Many people “knew” that the has been no recovery from the great recession. Many people still believe this, despite the slow improvement in almost every economy measurement of the US economy (how that recovery has been shared is a different question).

The common element of such stories: they are both comforting and conform to their biases. What do people know now about the next phase of the US economy’s story? What comforting stories do they tell us?

  • Most economists believe that there will be only a small cost (or impact) from the taper, and probably even from the larger process of normalizing (i.e., tightening) monetary policy (including raising interest rates) of which the taper is just the first phase.
  • Many people, especially on Wall Street, believe that at the first signs of turmoil the Fed will stop the tightening cycle, or even reverse it.

We can only guess at the first of these, the results of the great monetary experiment. My guess is that the process will be difficult. See Government economic stimulus is powerful medicine. Just as heroin was once used as a powerful medicine.

For an answer to the second we turn to one of Japan’s top economists, who draws upon lessons learned not only from US history, but also from Japan’s quarter-century struggle with similar problems. He believes that for good or ill the Fed will stop the normalization process only after a “huge plunge” in markets or large bank failures.

Nomura

“Fed tapering and emerging market turmoil”

By Richard Koo (Chief Economist), Nomura
4 February 2014

Minor shocks from emerging economies will not deter Fed

The recent market turbulence began with a steep fall in the Argentine peso, which quickly put pressure on other emerging market currencies. Nevertheless, the Fed’s Federal Open Market Committee (FOMC) not only decided to push ahead with tapering but also made no mention of the emerging market turmoil in its official statement. I suspect this is because — as argued in my last report — the Fed’s main scenario is likely to involve reducing asset purchases by an identical amount at each FOMC meeting, following the practice of former Fed Chairman Alan Greenspan, who successfully raised the federal funds rate by 425bp {basis point} this way in the 2000s.

Raising the policy rate by 25bp at each FOMC meeting was so automatic and predictable that once the market understood what the Fed was trying to do, long-term interest rates were largely unaffected by the tightening. The yield on the 10-year Treasury note rose just 60bp throughout the entire tightening cycle in spite of more than 400bp in rate hikes.

Today’s FOMC, which fears nothing more than an “unwarranted” rise in long-term rates, seeks a repeat of that experience. In that sense, I think it is extremely unlikely to abandon its current approach because of moderate turbulence in domestic or overseas markets.

Side effects of ending mechanical tapering would outweigh benefits

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The easy way to understand unconventional monetary policy

Summary:  It’s difficult to describe the magnitude of the monetary policy experiments now running around the world, most especially in China, USA, and Japan. At the end are links to a dozen posts attempting to do so with words and numbers. Today we do it with pictures.

Money world

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The monetary stimulus programs running around the world are in effect leaps into the future, leaps of a scale never before attempted, leaps beyond theory. Should they work the world will changed, for these tools — massive quantitative easing and extended periods of zero interest rates (ZIRP) — will be used again. And again.

How can I show you the fantastic nature of these experiments? How they move far beyond what’s been considered possible — even prudent — in the past. How their success would create a new world? And, most difficult, how the programs of each nation differ in scope and daring?

Let’s use picture to show this, as metaphors.

First, the below picture shows America’s monetary policy: five years of ZIRP and three rounds of quantitative easing — designed by the four hundred economists of the Federal Reserve System, using unconventional means to press conventional theory beyond its limits — to rekindle the power of the American economy.

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Fusion and Dr Octavius

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Second, we see Japan. They’ve had zero or near-zero interest rates since February 1999 (with intermissions), and several rounds of quantitative easing since March 2001 — attempts to re-ignite their economy since it flamed out in 1998. The latest is the three arrows of Abenomics (often described in different ways), announced by Prime Minister Shinzo Abe in December 2012.

  1. More fiscal stimulus, increasing the government’s deficit by 2% of GDP (to 13%).
  2. More monetary stimulus: doubling the money supply in 2 years to create 2% inflation.
  3. Structural reform — broad, deep, powerful (so far missing in action).

Abenomics is the desperate action of leaders who have tried everything in the playbook, and now tap unimaginable energies to unleash arcane regenerative forces that can revitalize Japan’s economy. They go beyond theory, a leap combining faith and science.

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