Those low interest rate U-Zirpers at the BIS

FT Alphaville:

Those low interest rate U-Zirpers at the BIS

Posted by Tracy Alloway on Jun 29 08:15.

In the battle between Austerians and Stimulants, the Bank for International Settlements (BIS) knows where it stands. In its latest annual report the central banks’ bank takes aim at everything from delayed fiscal adjustments to the extended period of low interest rates in places like the UK and US.

The whole thing reads like a confirmation of every risk you might have suspected, to date, could accompany extended loose and unconventional monetary policy. It’s BIS’s job to identify risks, of course, but seldom are they so . . . forthright, or wide-ranging. Rage against the Zirp, dear BIS.

The summary:

. . . policymakers will need to consider the distortions caused by prolonged conditions of monetary ease. After all, sustained low interest rates have been identified by many as an important factor that contributed to the crisis (see BIS, 79th Annual Report, Chapter I). At the same time, policymakers should also closely monitor the distortions arising from unconventional monetary policy tools. These include price distortions in bond markets that can result from changes in central banks’ criteria for eligible repo collateral and from their asset purchases. Artificially high asset prices in certain markets might delay the necessary restructuring of private sector balance sheets. There are also distortions in market activity that arise from central banks’ increased intermediation during the crisis. Moreover, the asset purchases have exposed central banks to considerable credit risk, which together with the changed balance sheet composition may expose them to political pressures.

History offers little guidance on the economic significance of the side effects of unconventional monetary policy. By contrast, distortions arising from low interest rates have been observed in the past. In this chapter, we review these risks in the current context and argue that, if not addressed soon, they may contain the seeds of future problems at home and abroad. In doing so, we draw on lessons from the run-up to the financial crisis of 2007–09 and on Japanese experiences since the mid-1990s . . .

Uh oh — subprime and the Lost Decade? You know what’s coming — a rather stunning indictment of certain current central bank policies. Some choice bits recounted below, with our highlights.

For a start, the risks of that steep yield curve:

Low policy rates in combination with higher long-term rates increase the profits that banks can earn from maturity transformation, ie by borrowing short-term and lending long-term. Indeed, part of the motivation of central banks in lowering policy rates was to enable battered financial institutions to raise such profits and thereby build up capital. The heightened attractiveness of maturity transformation since the crisis was reflected in rising carry-to-risk ratios in 2009 and early 2010 (Graph II.1, bottom right-hand panel). Increasing government bond yields, caused by ballooning deficits and debt levels and a growing awareness of the associated risks, make the yield curve even steeper and reinforce the appeal of maturity transformation strategies.

However, financial institutions may underestimate the risk associated with this maturity exposure and overinvest in long-term assets. As already noted, interest rate exposures of banks as measured by VaRs remain high. If an unexpected rise in policy rates triggers a similar increase in bond yields, the resulting fall in bond prices would impose considerable losses on banks. As a consequence, they might face difficulties rolling over their short-term debt. These risks may have increased somewhat in the aftermath of the 2007–09 crisis, because the poor credit environment for banks and the greater availability of central bank funding have left many banks with funding structures skewed towards shorter maturities. A squeeze on banks’ wholesale funding might set off renewed asset sales and further price declines.

On extend and pretend, or the ‘evergreening,’ of loans:

One legacy of the financial crisis and the years preceding it is the need to clean up the balance sheets of financial institutions, households and the public sector, which finds itself in a poor fiscal position, partly as a result of the rescue measures adopted during the crisis. Low policy rates may slow down or even hinder such necessary balance sheet adjustments. In the financial sector, the currently steep yield curve provides financial institutions with a source of income that may diminish the sense of urgency for reducing leverage and selling or writing down bad assets (see also Chapter VI). Central banks’ commitment to keep policy rates low for extended periods, while useful in stabilising market expectations, may contribute to such complacency.

Past experience has shown that low policy rates allow “evergreening”, ie the rolling-over of non-viable loans. During the protracted run of low nominal interest rates in Japan in the 1990s, banks there permitted debtors to roll over loans on which they could afford the near zero interest payments but not repayments of principal. Banks evergreened loans instead of writing them off in order to preserve their own capital, which was already weak due to the earlier fall in asset prices. This delayed the necessary restructuring and shrinking of financial sector balance sheets. Moreover, the presence of non-viable (“zombie”) firms sustained by evergreened loans probably limited competition, reduced investment and prevented the entry of new enterprises.

And the international side effects of the search-for-yield:

Capital flows allow a better allocation of economic resources, and inflows are important contributors to growth, especially in emerging market economies. In the current situation, however, they may lead to further asset price increases and have an inflationary impact on the macroeconomy. They have also caused an appreciation of those target currencies that float, which corresponds to a tightening of monetary conditions in those countries. Nevertheless, further interest rate increases seem likely, and these may attract even more funds from abroad. This exposes the receiving economies to the risk of rapid and large capital outflows and the reversal of exchange rate pressures in the event of a change in global macroeconomic, monetary and financial conditions or in investors’ perception thereof. Chapter IV discusses the issues associated with capital flows to emerging markets in more detail.

The major worry then is what happens should these government efforts fail. All of their policies — Zirp, quantitative easing, debt forbearance, etc. — are predicated on the idea that markets just need time to start functioning again. That has so far not happened and, in the meantime, central banks are stuck.

As BIS puts it:

Unlike [in 2008], however, we have hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries. In short, macroeconomic policy is in a vastly worse position than it was three years ago, with little capacity to combat a new crisis – it will be difficult to find a source of further treatment should another emergency arise. Regaining the ability to react to economic and financial crises, by putting policies onto sustainable paths, is therefore a priority for macroeconomic policy.

Crikey. That’s quite a lot for so early in the morning.

Fed Monetizing and S&P 500 Index

Totalinvestor:
And now that the Fed is (mostly) done manipulating the stock market, traders are fleeing stocks. (Geesh, do we detect a trend?)

“There is a clear relationship,” writes James Turk of goldmoney.com, “between the rise in the S&P 500 Index from its March 2009 low and the Federal Reserve’s purchase of U.S. government debt instruments, which it calls ‘quantitative easing’ (QE). Another term for it is money ‘printing.’

“The Fed is simply turning U.S. government debt into more dollar currency, which of course debases the dollar. It also explains the correlation in the above chart.

“Note how the S&P Index started climbing with the commencement of QE. The S&P dropped early this year when the Fed announced QE would end. Interestingly, the stock market soon rallied thereafter, probably because few believed that the Fed would really take away the ‘punch bowl.’ But it did, and the S&P has been in a downtrend ever since...

“Now that the Fed has stopped printing, the S&P 500 Index not only stopped rising, but began falling to reflect the true state of underlying economic conditions. Consequently, I expect that there will be new calls in Congress for another stimulus package, but more immediately, it seems likely that the Federal Reserve will recommence its purchases of U.S. government paper. Quantitative easing, I expect, is about to get a second chance at reviving the moribund U.S. economy.”

Buy-and-Really-Hold Will Suck Your Portfolio Dry

Systematic Relative Strength:

It’s not often that a passive investor committed to Modern Portfolio Theory will help make our case for active management based on relative strength, but heck, we’ll take any help we can get.
In this guest article from Money Magazine, William Bernstein of Efficient Frontier Advisors discusses findings from a study by Dimensional Fund Advisors. The article gets to the thesis early:

It’s a little-known and depressing fact, but the majority of individual securities tend to post negative returns over the long run.

This, I think, is a ringing indictment of buy-and-really-hold investing. Often individuals assume that they can purchase shares of leading companies, shower them with benign neglect, and have the portfolio perform well. But, of course, today’s leader always turns into tomorrow’s laggard. The majority of stocks, given enough time, collectively lose money. Mr. Bernstein goes on to say,

In fact, researchers at the investment management firm Dimensional Fund Advisors found that from 1980 to 2008, the top-performing 25% of stocks were responsible for all the gains in the broad market, as represented by the University of Chicago’s CRSP total equity market database.
As for the bottom 75% of stocks in the U.S. market, they collectively generated annual losses … over the past 29 years.

The following chart shows that if you miss the best 25% of stocks, you will end up losing more than 2% per year.

Source: Money Magazine and Dimensional Fund Advisors

The chart is offered as evidence of the futility of stock picking and the triumph of index investing. What it really reveals is this: index investing would be an abject failure if it weren’t for two things: 1) active management and/or 2) relative strength weighting. First, if indexes didn’t replace companies that went out of business or were no longer “representative,” they’d have a buy-and-hold portfolio that, by their own calculations, would lose money. Replacing losers (dead companies) with winners (live companies) is, in fact, an efficient casting out process used for active portfolio management. Second, index returns are helped immensely by increasing the weighting of the stocks that go up the most. This is actually a form of relative strength weighting, more commonly referred to by index providers as “capitalization weighting.” Emphasizing the winners at the expense of the losers also tends to help returns over time.
The alert reader will quickly discern that ”missing the best 25% of stocks” is another version of the “if you miss the 10 best days” argument. There’s one problem: while it may be impossible to pick out the 10 best days, there’s a ton of evidence to suggest that it is possible to select the strongest stocks using relative strength. Even efficient market theorists like Eugene Fama and Kenneth French have admitted that relative strength works.
Bernstein writes:

This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these superstocks?

That’s exactly what I’m thinking! Why not, indeed! I’d rather own the superstocks. And I will even let Ken French pick the stocks. Instead of buying an index fund, I’m going to let Ken French buy the best recent performers and cast out the stocks that weaken each month. This chart comes from Dr. French’s own website and shows the equity curve for large-cap, high relative strength stocks since 1927.

As an investor, you have three basic options. You can buy-and-really-hold which will insure that most of the companies you buy will lose money over a long time frame. You can buy an index fund, which will tend to perform better than buy-and-really-hold due to the hidden active management process of casting out and/or through capitalization weighting. Or you can identify the strongest stocks and use both casting out and relative strength weighting to manage the portfolio. Option 3 has historically provided the best returns, but it will be volatile and will go through periods of drawdown. (Of course, Options 1 and 2 will also be volatile and will go through periods of drawdown!)
As a result, I see no reason not to prefer active management using a systematic relative strength process. It’s always interesting to me how investors with a passive approach can selectively pull out data that they then claim supports an indexing approach. [Note: a major part of the reason for the cognitive dissonance in Dimensional Fund Advisors' data has to do with the original research source. The finding that 25% of all stocks account for all of the market's gains came from a Blackstar Funds research paper, The Capitalism Distribution. Blackstar's own interpretation of the findings was that such a skewed distribution of returns supported a trend-following method focused on strong stocks--exactly opposite of what DFA suggests! We happen to agree with Blackstar.]

Does Japan really have a public debt problem?

UK economist Martin Wolf has an article on his blog about Japan. What is proposing, is basically a robbing of the savers. Thats not a solution a normal economist should agree with. But situation in Japan's public finance is really bad and this should be the way to avoid default. Btw, read the comments section. Lot of interesting opinions.

Martin Wolf's Exchange | FT.com:

The conventional wisdom in both Japan itself and the west is that the country has an unmanageable public debt problem. I find this quite unpersuasive. All the country needs to do is generate, say, expectations of 3 per cent inflation and the public debt problem should melt away like snow. But the longer it waits the bigger the ultimate adjustment will need to be.

In 2010, according to the Organisation for Economic Co-operation and Development, Japan will pay net interest of 1.1 per cent of gross domestic product on net financial liabilities of 105 per cent of GDP. Since 2000, Japan’s average rate of deflation (on the GDP deflator, the widest measure of inflation) was 1.2 per cent. So let’s treat the expected real rate of interest on Japanese government borrowing at 2 per cent.

So here is the plan.

First, extend the maturity of debt to at least 15 years from the today’s average of 5.2 years. (Whoever was responsible for allowing Japanese debt to be so short term when the government can borrow at incredibly low long-term interest rates seems utterly incompetent.) That would bring average Japanese maturities above the far more sensible UK level of 13 years.

Second, hire a central bank governor who knows how to create inflation - an Argentine, for example. I am quite sure that any moderately determined central banker could do this, if he wanted to do so, by direct purchase of public and private sector assets on a sufficiently large scale. The government should prod this along by giving the Bank of Japan an inflation target of 3 per cent, after maturities have been extended, while informing the policy committee that all its members will be sacked, ignominiously, if they fail to hit the target within two years.

Third, let us suppose inflation indeed goes to 3 per cent. That should raise the interest rate on JGBs to 5 per cent. Other things equal, the market value of the outstanding net government debt would fall by 40 per cent. So now the Japanese government buys back the outstanding debt at its new market price, reducing the face value by 40 per cent of GDP. In the new inflationary environment, the Japanese find the real value of their huge holdings of cash falling sharply. So they buy real assets and consumer goods, instead, and, at last, the economy expands vigorously.

Fourth, now the government raises taxes and cuts spending, moving into a small primary surplus. Assume that the government only needs to borrow to roll over its debt and the debt ratio stabilises. How big a primary surplus is needed depends only on the relation between the real rate of interest and the rate of growth of the economy.

So there we have it. By extending maturities of debt, moving from deflation to modest inflation, Japan eliminates almost half of its outstanding debt, relative to GDP, and normalises the economy, in the process.

It is simple, really. The government has baited the trap. Now all it needs to do is spring it.

Countries with their own central banks do not need to default; they can inflate, instead. Provided they can borrow at long enough maturities and on favourable terms, the amount of inflation needed to eliminate huge debt overhangs is not enormous, provided it is unexpected. In Japan, any inflation would now be unexpected, given current long-term interest rates. So the solution there seems to be perfectly straightforward. What do you think? Leave your responses below.

Print baby, print ... emerging value and the quest to buy inflation

Another great post form Dylan Grice, strategist from Societe Generale... Especially the part about Reichsbank.

Popular Delusions

The eurozone’s fiscal farce offers a revealing glimpse of the future: sovereign crisis begets banking crisis begets central bank nose-holding while the printing presses roll!! More immediately though, it’s making equities look interesting again. Markets overall merely look less overvalued than they did. But undervaluation is emerging in some areas. And the VIX recently traded at 40. Selling out-of-the money puts at such levels (or higher), on companies you’re happy to own anyway is a good way to be paid for your patience.

When faced with the prospect of a financial crash causing a nasty recession - or worse, a depression - few doubted that Anglo-Saxon central banks would do whatever was necessary, including breaking the taboo of deficit monetisation ... sorry, engaging in quantitative easing. But the ECB was supposed to be different. The ECB was supposed to be genuinely independent. The ECB was modelled on the Bundesbank .. itself forged in the white hot furnace of Weimar's hyperinflationary trauma ... So it was always going to be an interesting collision: what would happen when the unstoppable force of threatened financial wipeout met the immoveable object of the ECB's hard-money dogma?

Well, the force stopped and the object moved ... sort of. The market's panic over eurozone debt subsided ... for a while, and the ECB began quantitatively easing ... kind of. The EU's "shock and awe" $1trillion rescue was certainly a big number and reflected European governments going all in. But going all in is risky if you don't have a strong hand, and the EU's seems weak. Two-thirds of the rescue money comes from the EU itself, which means that the distressed eurozone borrowers are to be saved by more borrowing by ... er ... the distressed eurozone borrowers.

So there is virtually no new money coming into the European financial system. If a small bank goes down, the problem is solved when it is taken over by a bigger bank which injects new capital into it. If a bigger bank goes down, its problem is solved when it is taken over by the government, which injects new capital into it. If a government goes down ... well, then we're stuck. Where does the new capital come from now?

Enter central banks. In 2009, the BoE printed L200bn, thus completely financing the UK government deficit. It can't have felt good about doing it but since the alternative scenario was so scary - financial meltdown and possibly IMF support - it held its nose and did it anyway. It said it was going to sterilise the intervention, but on discovering that such was the financial system distress it was unable to, it just carried on regardless. In the US, the Fed printed $1.25 trillion to monetise the problematic mortgage market. It also said it was going to sterilise the intervention, but like the BoE it soon found it couldn't, and like the BoE continued anyway because the alternative financial meltdown scenario was too scary to contemplate.

Today, the ECB is buying insolvent eurozone government debt which it is promising to sterilise. Yet they face the same stark calculus faced by their Anglo-Saxon cousins in 2008. You can only worry about the economy's "price stability" if the economy hasn't already melted down! So here’s my prediction: they won’t sterilise, and the program will expand.

Since banks are typically stuffed full of government bonds (the first chart below shows eurozone financial institutions' holdings of government securities as a share of capital), instability in government debt markets implies instability in bank balance sheets. So sovereign crises and financial crises are joined at the hip (second chart below). And since financial crises affect banks' ability to lend, which poses obvious risks to the rate of employment, the need for a central bank response to the threat of financial collapse is clear:

1) Print money

2) Keep printing until the financial system stabilises

3) Worry about removing liquidity later (and if removing liquidity stresses the financial system, go back to step 1)

What's interesting is that central banks feel they have no choice. It's not that they're unaware of the risks (although there are profound behavioural biases working against them in their assessment of those risks). They’re printing money because they’re scared of what might happen if they don’t. This very real political dilemma is what is missing from the simplistic understanding of inflation as "always and everywhere a monetary phenomenon." It's like they're on a train which they know to be heading for a crash, but it is accelerating so rapidly they're scared to jump off.

Incidentally, this is exactly the train Rudolf von Havenstein found himself on as President of the Reichsbank during the German hyperinflation. According to Liaquat Ahamed's work on von Havenstein's dilemma, in his majestic book 'Lords of Finance' " ... were he to refuse to print the money necessary to finance the deficit, he risked causing a sharp rise in interest rates as the government scrambled to borrow from every source. The mass unemployment that would ensue, he believed, would bring on a domestic economic and political crisis, which in Germany’s [then] fragile state might precipitate a real political convulsion.”

Most economists seem to think that QE puts us in uncharted waters. It doesn't. Printing money to finance government expenditure is a very well trodden path which is as old as money itself: persistent monetisation causes inflation. Of course the current monetisation need not be persistent. Central banks can theoretically just stop it at any time. But with government balance sheets in such a mess across the developed world (even with yields at historically unprecedentedly low levels), government funding crises are likely to be a recurring theme in the future. Since banks hold so much "risk free" government debt, those funding crises point towards more banking crises which point towards more money printing. When do they stop? When can they stop?

But what does it all mean? The question to my mind isn't whether or not inflation will accelerate from here. If government balance sheets are in as big a mess as I think they are, inflation is inevitable. The more interesting question is what kind of inflation can we expect?

I hope to explore this properly in another note soon, but suffice to say for the time being that the typical framework economists use to think about inflation - which they proxy by changes in the CPI - is narrow, incomplete and fails to do justice to the richness of inflation as a concept. Asset markets (e.g. real estate, equities, etc.) are as prone to inflationist policy as product markets (indeed, in recent decades they have been far more prone to inflation than product markets), so one way of buying inflation - at least in its early stages - is to buy risk assets.

Of course, buying expensive risk assets on the view that they're going to become more expensive is a dangerous game to play, but since government funding crises hammer risk assets while printing money inflates them, such funding crises should present decent value opportunities to buy into beaten up assets before the inflation ride.

Morgan Stanley: Paradise Lost

Another nice post from Morgan Stanley analyst Joachim Fels

Morgan Stanley - Global Economic Forum:

Once upon a time: In comparison to the challenges facing central bankers today, the one-and-a-half decades in the run-up to the credit crisis must have felt like paradise for monetary policymakers, where they could do (almost) no wrong. They were standing on the shoulders of giants like Paul Volcker and others, who had successfully fought the Great Inflation with restrictive monetary policies during the 1980s and had thus restored central bank credibility. Importantly, they were also helped in their pursuit of price stability by a combination of favourable external factors beyond their control - globalisation, deregulation and a productivity ‘miracle' - that kept inflation in check even when monetary policy was expansionary. Hence, central bankers could have their cake and eat it: they were able to slash interest rates aggressively whenever a financial crisis or recession came along, and to only raise rates very slowly thereafter, without creating inflating pressures or sacrificing credibility. If anything, these firefighting missions coupled with ongoing low inflation added to the image of central bankers as the ‘maestros' of their economies and financial markets.

Maestro myth revealed: Alas, as is now widely recognised (also by many central bankers), these actions sowed the seeds for an asset price and credit bubble of gigantic proportions. Since the bubble burst, we have been moving from crisis to crisis - a credit and banking crisis, the Great Recession, an emerging market crisis and now a European sovereign debt crisis. With central banks having long been forced (by circumstances rather than government decree) to open the floodgates and apply an unprecedented series of unconventional measures, it looks more and more likely to us that the confidence crisis in banks and sovereigns will ultimately morph into a crisis of confidence in the central banks who act as lenders of last resort to both banks and governments. Yes, central banks can extend unlimited amounts of credit to banks and governments. But they do so by issuing ever more of their own liabilities - money. And just as the trust in banks' and governments' liabilities eroded when they issued ever more, we believe that the trust in money will erode if central banks issue ever more of it.

Gold and exchange rates illustrate confidence loss: A loss of confidence in the value of fiat money usually shows up first in the price of gold and in exchange rates. By these standards, the process has long started. The price of gold has more than doubled from its pre-crisis levels at the start of 2007, no matter whether it is measured in US dollars, euros or sterling. And exchange rates - the relative price of fiat currencies - have also reflected (relative) confidence losses. Last year, when the Fed embarked on active quantitative easing with massive asset purchases, while the ECB was less aggressive and engaged in the less risky versions of ‘passive' quantitative easing, the dollar weakened significantly against the euro. This year, when the Fed ended its asset purchase programme and the ECB was recently forced to become more aggressive by extending liquidity support to the banks again and starting to buy government bonds (though at a much smaller scale than the Fed) outright, the euro was punished relative to the dollar.

Inflation still low... Meanwhile, the internal value of money, as measured by its purchasing power in terms of goods and services, has been reasonably stable as inflation has remained low, especially in the US and Europe. But this is hardly surprising, given that the global economy only started to emerge from its deepest post-war recession at around this time last year. Moreover, it provides little comfort for the future as global monetary policies remain extremely accommodative despite the economic recovery and as we believe that the sovereign debt crisis will keep both the ECB and the Fed on hold for longer and will thus make it more difficult for many emerging market central banks to tighten monetary policy (see "XXL Liquidity",The Global Monetary Analyst, May 12, 2010).

...but the UK may be a leading indicator: Interestingly, the country with the highest current inflation rate in the G10 is the UK, with CPI inflation at 3.7% by far exceeding the 2% target. Even excluding the VAT hike (but only assuming partial pass-through), our UK economists think that CPI inflation would be running at slightly above 3% currently. Judged by the expansion of the Bank of England's balance sheet since the start of the crisis, the UK has also had the most aggressive monetary policy response, and sterling has weakened significantly versus both the dollar and the euro over the past couple of years. And, as an aside, the UK experience flies in the face of the popular theory that, in order to create inflation, you must have solid credit creation and broad money growth - both M4 and M4 lending (on the BoE's preferred measure that excludes intermediate OFCs) have only barely picked up fairly recently. Recall that similar arguments about preconditions for an economic recovery were put to rest last year when a surge in excess liquidity provided enough traction for the start of the economic recovery. Credit creation and broad money growth or the absence of economic slack would certainly aid and abet inflation, but their absence does not necessarily rule out inflation and inflationary risks when such expansionary monetary policy regimes are in place.

ECB the latest victim: More recently, the focus has shifted to the ECB, which has traditionally been viewed as the most independent and credible among the major central banks by many market participants. To a large extent, the ECB's credibility has been built on its very nature of a supranational central bank mandated with the primary goal of price stability, issuing a denationalised currency remote from government influence. However, the credit crisis that has morphed into a sovereign crisis has forced the ECB into actions that threaten to undermine its credibility over time.

Credibility undermined: First, the ECB had to make a climb-down on its collateral rules by accepting Greek government bonds irrespective of their credit rating. While justified as an exceptional step, it seems clear that the ECB will not be able to deny similar treatment to any other member state getting into trouble. Second, the decision to buy government bonds in the ‘dysfunctional' secondary market was a big step, as can be seen by the open controversy it created in the ECB Council. While these purchases do not violate the Maastricht Treaty, which only rules out direct lending to governments or bond purchases at auction, they clearly help governments finance their deficits at lower rates than otherwise. Third, by continuing to provide banks with unlimited liquidity at various maturities, the ECB keeps even the weakest players afloat and thus slows down the necessary consolidation and recapitalisation in the banking sector.

Hostage to financial and fiscal stability concerns: Of course, all these measures can be justified with concerns about domino effects and thus a potential meltdown of the system, and it is difficult to see how the ECB could have acted differently in these situations. Yet, these actions also delay the necessary adjustment as banks and governments have learned to rely on the ECB as a lender of last resort. And without the necessary adjustment in the form of banking sector consolidation or the threat of regulatory intervention (breakups, orderly wind-downs, etc.), recapitalisation of banks (especially those in public ownership) and major fiscal reforms, the ECB will likely remain hostage to financial stability concerns and find it difficult to respond to inflationary pressures when they appear.

Vigilantes asleep: In short, over the next several years, central banks will face an uphill battle to defend their credibility, and many of them will have their hands tied by financial and fiscal stability concerns. Amazingly, though, while the gold price and currency markets have been sensitive to these concerns, bond markets appear to be lulled in by liquidity, carry and roll-down that seems to springs eternal. But this is not new: bond markets also took years to take on board the Great Inflation of the 1970s and the big disinflation of the 1980s and 1990s. The famed bond vigilantes are fast asleep, again.

Did we miss a trick?

Deus Ex Macchiato:

Larry Elliott has a thought provoking article in today’s Guardian. He quotes Roubini, who says

… that it is precisely because the downturn has been handled more deftly this time that the impetus for deep, structural reform has faltered. “Had policymakers failed to arrest the crisis, as they failed during the Depression, the calls for reform today would be deafening: there’s nothing like ubiquitous breadlines and 25% unemployment to focus the minds of legislators.”

But, thankfully, policymakers did avoid most of the mistakes of the 1930s and we are where we are. In the circumstances, what the future holds is either full-blown recovery courtesy of the breathing space provided by central banks and finance ministries; another crash preceded by what the late socialist thinker Chris Harman described as “zombie capitalism”; or reform and renewal.

Full recovery would mean that the global economy could continue to prosper even when governments withdraw the support provided by low interest rates, tax cuts and higher public spending. That looks improbable, particularly since there is likely to be a simultaneous tightening of fiscal policy in many countries.

Zombie capitalism is where governments continue to buy up worthless paper from banks, where fundamentally insolvent institutions are kept alive for fear that their failure would cause systemic risk, where every country tries to export its way out of trouble, where the shrinkage of the financial sector depresses growth rates, and where the global imbalances between surplus and deficit countries remain worryingly large. That looks a more likely option.

What, then, are the prospects for reform and renewal? At the very least, this route is likely to be long, hard and strewn with setbacks. It may not be chosen … until there is system failure.

This is an interesting thesis. I don’t wholly buy it, but the idea that precisely by doing enough to fix the immediate problem, but not enough to address its causes, we have left ourselves exposed to a Japanese style slow, shallow but long lasting recession is interesting. Certainly by missing the chance to nationalise the worst affected parties, such as RBS, we also lost the opportunity to restructure banking broadly. It might well turn out that that ideologically-motivated decision was a bad one. That won’t be clear for some years, and it may well be that the summer 2010 panic is minor. But if it isn’t, we will be criticising 2008’s crisis management for some time.