As the Fed moves towards monetary tightening, financial markets have started to not only consider the implications of higher policy rates but also the impact that quantitative tightening (QT) may have on financial markets, especially further out in US rates curves. It is our view that the impact of QT will be more keenly felt by risky assets, rather than via a significant increase in longer-end UST yields as purported by some commentators.
The Mechanics (QE/QT)
Central bank (CB) balance sheet expansion (QE) is a sectoral asset swap where CBs create CB reserves for other assets, usually government bonds owned by other sectors of the economy. A stylized QE takes the form as shown below with the CB purchasing assets from the private sector (pension fund as shown in the example by the BoE) via a financial intermediary (commercial bank). The CB finances its government bond purchase by creating reserves and subsequently crediting the reserves to the financial intermediary representing the private entity. The financial intermediary credits the private sector entity with deposits in exchange for the bonds they held. QE swaps interest-bearing, longer duration government bonds for a zero-interest, zero duration asset.
The Fed’s balance sheet size is currently approximately US$9tril (end Jan). Its securities portfolio stands around US$8.3tril.
Source: Federal Reserve. The Fed’s balance sheet (liability side) has transformed from one dominated by currency in circulation with limited reserves to one that is made up largely by reserves. Reflecting such changes, the Fed has moved to a floor system (abundant reserves) from a corridor system (scarce reserves) in its monetary policy implementation.
QT works in reverse. In QT, the Fed allows its asset holdings of USTs and MBS to decline, resulting in lower reserve & overnight reverse repo (ON RRP) levels on the liability side. For instance, consider the likely scenario that the Fed ceases to reinvest some of its UST maturities during QT. As the USTs mature, the Treasury delivers the par amount to the Fed; which in turn reduces the TGA by that amount. In order to replenish the TGA, the Treasury issues debt to the private sector; the bank of the new security buyer will have its reserve account debited (unless, the bank buys the USTs which will equate to an asset swap from reserves to USTs on the bank’s balance sheet), with a corresponding credit to the TGA. Ex-post accounts will show an unchanged TGA, while both Fed holdings of USTs and CB reserves will be lower (i.e. balance sheet shrinkage).
Hence the two main implications arising from QT: 1) private ownership of USTs and/or MBS will rise, and 2) a reduction of cash/reserves vs. an increase in collateral in private lending markets.
Below is a stylized accounting of QT implementation (where $10 of QT is partially ‘absorbed’ by MMFs, banks, and other private sector participants):
The extent/magnitude to which each of the accounting identities above occur depends on numerous dynamic interactions (beyond the pace/scale of QT).
We note a few examples below:
The structure of treasury issuance. E.g., An increase in the proportion of bills vs. coupon issuance would drain the O/N RRP relatively quicker as MMFs can shift allocation from the O/N RRP to bills.
How the TGA evolves. E.g., A rebuild of TGA cash would drain other aspects of Fed’s liability-side (reserves, O/N RRP) quicker.
How the private sector adjusts its asset mix. E.g., Commercial banks may increase/reduce its asset allocation to loans depending on the economic outlook, assessment of credit risks, and profitability vs. capital considerations (i.e. RoRWA), thereby holding more/fewer securities/USTs
Source: Federal Reserve.
The regulatory landscape. E.g., Regulatory exclusion of USTs in SLR requirements for banks introduced during the pandemic incentivizes dealer market-making in USTs markets.
Foreign buyers. E.g. The accumulation of FX reserves (in the form of USD assets) by foreign central banks – dependent on factors such as BoP dynamics and the extent of FX intervention.
The above illustrates how complex/unpredictable/incalculable such dynamic decision-making/interactions among market participants and policy-makers can be, making any approach to determine the identities of future ‘net buyers’ of USTs a futile exercise. As argued previously, the nature of flows into USTs – the global risk-free asset – is unique vis-à-vis other asset classes, given its role in absorbing a significant portion of global ‘excess’ liquidity and currency transaction flows. Direct buyers of USTs partly reflects where excess liquidity sits, depending on how global financial flows are directed/recycled (what matters for price/yields is how growth-conducive/sustainable such flows are, rather than the eventual balance sheet accounts).
Additional points to note (considering market narratives):
The choice between reducing holdings of UST and MBS have indirect consequences beyond the 1st-degree transfer of ownership. For example, focusing on MBS reductions can affect the inherent convexity within the rates market.
While 1st-degree accounting may suggest that banking system deposits may decline during QT implementation, actual deposit growth within the banking system has a very limited relationship with QE/QT implementation. Bank deposit growth is contingent on many other drivers (loans growth, economic trajectory, wealth velocity, regulatory landscape etc.). Private agents rebalance their balance sheets to adjust to the desired level of deposits.
The standby repo facility introduced by the Fed in July 2021 serves to reduce the tail risk in funding market squeezes as reserves decline (note repo-funding stress in September 2019).
We think all the above contain limited informational value (beyond signaling tightening intentions) regarding future UST price/yields. Many tout the notion that higher net supply (net of Fed purchases) causes yields to rise. Yet, while we are not keen to extrapolate past episodes, treasury yields have not had the expected correlation to net supply during QE/QT implementation (yields have in fact risen during periods of QE and vice versa).
Another seemingly intuitive argument is that the transfer of UST ownership from the Fed to the purportedly more ‘price-sensitive’ private sector will force yields higher. However, this implies two important assumptions: a) potential QT cannot be priced ahead by markets despite prior Fed communication (i.e. yields only can adjust when ownership of USTs actually change hands), and b) the ‘fair/true’ yields of USTs are significantly suppressed by Fed purchases. We disregard the importance of assumption (a) given that USTs is such a deep and liquid asset class.
To determine whether assumption (b) holds true at each point in time will require a more perspicuous segmentation and reading of the curves. Analysis needs to establish hurdle rates across the short vs. long-ends, real vs. nominal, term-premia vs. risk-neutral, spot vs. forward curves, and the path (pace and scale towards terminal) vs. destination (actual terminal & market neutral) of each rate cycle. We articulated this earlier (and will do so with an updated, follow-up piece) – the key point being that UST yields are primarily determined by expectations over its term structure and term premia. Implicit in the levels and shape of rates are the market assumptions over the Fed’s reaction function, its “neutral” and terminal rates, the “neutral” rates of growth and inflation considering the economy’s super-structure (socio-economic model, institutional framework, sectoral balance sheet profile, income/wealth distribution), and the expected dominant regime, going forward. Only after (i) thorough consideration of the factors above, and (ii) credibly determining that, if not for Fed purchases, segments of the curve will trade closer to higher ‘fair’/’justified’ levels, can one argue that QT directly lead to higher UST yields.
Source: FRBNY. As at 17th February 2022. The recent rise in rates is led almost exclusively by rising real risk neutral rates with inflation breakevens falling. Term premium, which according to conventional wisdom is significantly impacted by the Fed’s balance sheet policy, hardly moved despite the Fed clearly signalling QT. To the contrary, term premiums typically fall prior to and during a hiking cycle – broadly, the nearer/further the FFR is to its neutral rate, the lower/higher will be the compensation demanded for term premiums.Source: FRBNY. The rise in rates reflects markets’ expectations of an increased pace of Fed rate hikes, rather than a change to a more positive medium term growth outlook. The move is led by higher front-end rates with increases in the 5y5y much more measured (implying largely unchanged expectations of the “equilibrium” neutral). The relentless flattening of the curves suggests a similar conclusion.
What’s that lurking in the dark?
Rather, the predominant impact of QE and the Fed’s ZIRP (which the former enhances), is its impact on psychology and the change in market behaviour (elements of both signalling and portfolio re-balancing) amid an evolution of the financial market structure. The prices of assets are elastic, predominantly reflecting the asset allocation preferences of asset holders. Such preferences are heavily affected by both materialism and perceived reality (the material environment of financial markets limits/dictates available options which together with beliefs of market participants shape the consolidated asset allocation of markets).
The presence of the Fed’s ZIRP and QE, with its implicit central bank put, coupled with the evolution of the market structure – democratization of market access, rise of financial leverage (vis-à-vis real economy lending), levered-based (options-based long positions, delta hedging, repo-based lending by NBFIs)/ esoteric investment strategies (Alts, longshot investments), and the shift in investment strategies (buy the dip, momentum, vis-à-vis fundamentals) have led to a upward reflexive market – ZIRP + TINA + FOMO + YOLO + “Robinhoodisation” + Low Cost Financial Leverage + Fed Put + BTD – in this investment cycle. Not surprisingly, this has led to an outsized aggregate allocation to risky assets vis-à-vis history.
Source: Federal Reserve. AAII. Allocation to risk assets is at or close to a historical high.
Thus, the biggest risk from QT and the end of ZIRP, is the reversal of this process – negative reflexivity of markets. As interest rates increase and liquidity is withdrawn, the price of liquidity will rise, in effect, dampening the effect of TINA. Financial leverage will not be as cheap and readily available, making levered investments less appealing to both lenders and borrowers. The downward repricing of the Fed put makes “BTD” less attractive, with losses more likely to trigger forced closing of positions or the need to put up higher margins. ‘Democratization’ of markets makes trading easier, both on the way up and down, but the difference being a lack of bids in selling markets leads to illiquidity and price gaps. FOMO turns into fears of losses and insolvencies. Long-shot, loss-making investments now faces rising opportunity costs as zero profits and cash burn faces the challenge of rising risk-free rates. Financial markets could fall into a negative downward spiral, on more aggressive monetary tightening amid rising recessionary concerns.
Source: JPM Asset & Wealth Management.
Hence the key risks for financial markets are not that of higher UST yields from QT or the Fed’s Lift-off but its impact on broader risk markets, with assets of risk profiles furthest from the risk-free rate (think of PIMCO’s concentric circles) the likeliest to face heavier drawdowns.
Secondarily, market functioning may be disrupted by QT as reserves, deposit holdings, and access to liquidity are not equally shared across market participants. Large commercial banks are the main holders of such liquidity vis-à-vis smaller banks, NBFIs and other market participants. Tighter liquidity and rising interest rates may lead to disruptions in lending markets, especially for levered entities which have depended on leverage and financial engineering to juice up returns.
Source: Federal Reserve. Lending to the real economy has been weak compared to lending to financial entities. Such lending reflects a shift towards levered-enhanced return-seeking investment/trading activities and the rise in esoteric investments greased by leverage.Source: Federal Reserve. Reserves are not distributed equally and QT will have balance sheet implications for different financial institutions and participants.
To conclude, we believe that the implications of QT will be more keenly felt in other riskier assets vis-à-vis rates which may at worst see some negative passing effect before more important drivers forces rates to converge to its “equilibrium” level and shape.
Financial markets’ gyrations over the recent past have been dominated by shifting views over global monetary policies – with many central banks changing their guidance, sometimes abruptly – as inflation realities have proven to be more daunting than previously expected.
Inflation worries, and hence arguments for tighter policies, revolve around the i) lacklustre response of labour market participation and its impact on wages (subsequently, wage-price spiral), ii) sustained change in goods price inflation, reflecting the permanent shift in labour wages towards lower income consumers, iii) real estate prices and rents, and iv) supply-side shocks (energy, commodities).
Conversely, others highlight the implications of a sharp turn in both the credit and fiscal impulse, notwithstanding the impact of tighter monetary policy.
We, however, like to re-focus back to more secular drivers of the economy.
Contrary to some commentaries which suggests that inflation will be more elevated due to lower global savings, recent times actually saw a rebound in global imbalances. This reflects both the choice of policy responses (mostly supply-side subsidies) and the limited domestic income rebalancing seen in most surplus economies, and the rise in terms-of-trade of commodity producers, both reflected in rising current account surpluses.
Further, as Ryan Avent argued, many of the impediments weighing on the global economy pre-Pandemic remains broadly in place. Income disparity remains high with fiscal transfers having peaked. The world will likely remain mired by excess capacity and savings as supply shortages ease. Monetary policy, despite the shift towards AIT, lacks a credible bias towards employment and growth. The fiscal impulse will turn, sharply in some countries, negative in the coming years with income transfers enacted during the pandemic being phased out.
In a previous article, we have sought to explicitly identify the conditions that are critical for the global economy to achieve sustainable escape velocity. The global economy has yet to settle on a particular trajectory but appears likely to shift towards its secular stagnation phase, reflecting tighter fiscal and monetary policy amidst limited enactment of structural reforms required for lift-off:
Discussions over the likelihood of a regime change in both the global economy and financial markets have intensified. Commentators speculate that we are likely to shift from a regime dominated by subdued growth/inflation to an environment characterized by higher growth and inflation. This reflects the recent change in macroeconomic orthodoxies (change in policy preference and frameworks), especially in AEs, towards more liberal use of fiscal tools, coupled with accommodative monetary policies. These are happening amidst shifting domestic political paradigms and rising global geopolitical tensions. Covid-related disruptions too led to expectations of a re-configuration of global production organization (de-globalization; on-shoring; supply-chain fragmentation/re-organization), supporting the narrative.
Source: IMF WEO
Most, however, fail to explicitly identify conditions critical for the global economy to achieve escape velocity. Rather, discussions have been bogged down by shifting narratives reflecting episodic events, uncertainties over macroeconomic variables, and, worst, recent market moves (essentially circular reasoning). Arguments at times also fail to distinguish between cyclical and structural elements, even though implications for a regime change, by definition, must be structural.
We seek in this article to elucidate the key conditions, deemed necessary, for the global economy to achieve “Lift-off”.
Where We Left Off
Recall that Part 1 of the ‘Contemplating Investment Regimes’ series discussed at length the underlying fragilities of the previous low growth/inflation regime, and how they have been further amplified by the pandemic. Such fragilities include socio-political imbalances in major economies, the increasingly binding side-effects of accommodative global monetary policies, and the broadening of economic stagnation globally (economic pains broadens to surplus countries via the global shortfall of demand). We highlighted, back in 2H20, that prior fragilities were being brought to the extremes, rendering the regime unsustainable. Further, policymakers are forced to re-think economic/political ideals/constructs (central themes includes the importance of generating domestic demand, prioritizing resilience vs. efficiency, navigating geopolitical multipolarity, and technological competition etc.), accelerating the shift away from what was already a fragile regime near its breaking point.
However, and more importantly, the dislodgment of the low growth/inflation regime does not necessarily entail either a shift towards or the entrenchment of a higher growth/inflation regime (“Lift-off”); rather it simply suggests that the global economy is now in a state of flux. Indeed, the world may remain in a constant state of flux – vacillating among the various plausible “states”. Key elements of the various plausible regimes can co-exists, reflecting the circumstantial ebb and flow in major policy frameworks and policies – unless structural conditions underpinning the previous regime are, at least partially, meaningfully altered.
Conditions critical for “Lift-off”
In earlier posts, we have regularly highlighted strictures that are currently binding the economy to the low growth/inflation regime; they include macro ‘super-structures’ which limits “inherent wealth velocities” of economies (see this) and other inter-related elements such as the income/wealth disparities, elevated debt levels, an over-reliance on monetary policies, and inadequacies of the global financial architecture (see this).
Correspondingly, we believe conditions required to achieve “Lift-off’ depends crucially on i) the change in wealth/income distribution; ii) the quality, magnitude and permanence of fiscal policy, iii) global leverage, and the credit and investment cycle, and iv) global re-balancing.
Four unifying themes encapsulate these inter-related conditions, they:
1) entail changes to the macroeconomic ‘superstructures’, such that drivers become self-reinforcing and long-lasting,
2) drive sustainable demand generation,
3) help permanently increase the rate of change in “wealth stock” & its “wealth velocity”,
4) bring about reduced fragility for the global economy.
I. Wealth/Income Disparity – Reforms and Redistribution
We believe a central condition for a higher growth/inflation regime is the need, globally, to narrow income/wealth disparity. This is less borne out by any specific political/philosophical leaning, but reflects more a diagnosis that the world simply suffers from a lack of sustainable aggregate demand (i.e. circumstantial argument). The lack of sustainable global aggregate demand remains the key constraint of the global economy as opposed to supply-side impediments (such as the lack of savings/capital, cost of financing, structural availability of production inputs – labour/capital/technology) at this juncture. This is not to say that supply-side improvements are not important (policies should always consider its implications on potential growth) nor all economies suffer from demand-side deficiencies (importance of idiosyncrasies). Nor the less, this diagnosis, we strongly believe, is accurate globally in aggregate.
Under such a context, widening income/wealth disparity contributes to the problem. High disparity shifts income/wealth away from the consuming classes (debtors, labour, median and lower income households) with higher propensity-to-consume towards capital owners, rentiers, and higher-income groups who save a high proportion of their income/wealth, effectively constraining and dampening aggregate demand. We have clarified before how extreme wealth disparity leads to the prevalence of ‘hoarders’ which reduces the wealth velocity of economies – with further side effects such as ‘indebted demand’ (characterized by an entrenched environment of low interest rates and high levels of debt) and imbalanced financial asset cycles. In terms of global re-balancing, skewed income distribution further distorts the global current account imbalances, putting even more onus on structural deficit economies to absorb “excess savings”. Income/wealth disparity in a low growth environment also contributes to socio-political and geopolitical frictions.
Hence,our probability under-lying the ‘Lift-off’ scenario will be higher if we see signs that policies shift towards tackling such disparity globally. Such policies include higher public spending on improving the welfare of the lower income class (discussed below), removing policies which suppress the labour share of income in surplus economies (see this), proactively encouraging tight labor markets, and progressive tax systems amongst others. While much discussed, we see limited structural policies that will help re-balance income in a growth enhancing manner globally for now. Meanwhile, the pandemic has only served to widen both income/wealth disparity domestically in major economies and income gaps between AEs and EMs.
II. Fiscal Policy – Quality, Magnitude, and Permanence of Spending
The willingness of fiscal authorities to enact sizeable fiscal stimulus (at least in the AEs) during the Covid pandemic is a clear change in fiscal policy orthodoxy (compared to the preference of monetary over fiscal policy and political resistance to government spending in the past).
However, simply expanding fiscal spending (on our view on monetized fiscal expansion, see this), on its own, will not help the global economy achieve escape velocity. In our view, nuances and context matter greatly, with the i) quality, ii) magnitude, and iii) permanence of fiscal spending being far more important.
The quality of fiscal spending reflects its impact on the long-run productivity of the economy and the sustainability of demand, considering both the domestic and global context. Fiscal policy of sufficient quality must lead to higher real income growth (income growth must be higher than inflation by definition) and not higher inflation or a wage-price spiral (which usually impacts lower-income groups the most, considering their limited scope for asset diversification, coupled with less labour wage bargaining power). This can be achieved via either a) higher productivity growth and/or b) an increase in the labour share of income (note that lower corporate profit margins do not necessarily equate to lower profits, it depends on whether economic growth – top line – improves; also, efforts to appropriate corporate income without offsetting growth elements may be self-defeating, as it leads to a weaker economy instead).
Public investments with high returns to society can lead to higher future productivity and economic growth, considering prior under-investments and its high multipliers, while helping crowd in private investments. Such investment opportunities certainly exist in infrastructure and green investments. Further, such investments should not lead to rising indebtedness since the debt taken should be paid off with time even as debt levels may rise in the interim (productive investments/debt are self-liquidating by definition).
If the policy intent is to generate higher growth/inflation, fiscal expenditure will be better-targeted if it rebalances income towards entities with higher marginal propensity to consume while limiting its impact on labour supply (size of handouts for unemployed vis-à-vis minimum living requirements/market wages; income tax rebates; job credit schemes/subsidized apprenticeships; subsidized social, health and education schemes; pro-labour/low-income class taxation regime). Such fiscal programs – should they be made permanent – are likely to lead to a rebalancing of income, and a change in growth/income expectations.
On the contrary, one-off, reactive, tail-risk type fiscal responses will not help the economy achieve escape velocity. We believe most of the pandemic related fiscal stimulus measures globally are of such nature – one-off, temporary programs of limited size with mixed quality, and which have probably already reached a peak (uncertainty in the ebb and flow of politics; US mid-terms; elections in Europe; limited – either real/perceived – fiscal space in RoW).
Direct income payments made thus far are largely untargeted, temporary, and in some countries, too small, and designed, at least for now, with limited considerations for the future (essentially reactive response to the Covid pandemic rather than a clear rethink of the role of the state). The fiscal impulse will see a sharp falloff in coming years, even assuming a passing of an infrastructure bill in the US.
Source: IMF WEO
The prior build-up in private savings in economies with generous income replacement programs (private sector surpluses being the flipside of the public sector deficit) should help cushion the economy in the near term. However, as consumption picks up, the post-pandemic level increase in savings will likely normalize in due course (one-off fiscal support programs taper off). The savings rate will likely settle at a higher level since the untargeted nature of income support means that higher income entities – with low propensity to consume – will save such income permanently.
Further, public spending on investments remains limited in size and ambition in some (US’s AJP and Europe’s NGEU), while, reflecting limited fiscal/monetary space, totally lacking in others (EM).
We remain watchful of future developments (American Families Plan; political events and reforms in Europe; policies in China; Asia’s reforms), considering the importance that politics, and subsequently changes in policy frameworks, will play. It remains to be seen if the pandemic ends up as a catalyst for a seismic change in fiscal activism in major economies. As of now, we find it tough to argue that fiscal measures enacted thus far are sufficient for the global economy to achieve a lift-off.
III. Global Debt Overhang – Debt Jubilee/Restructuring/Productivity of Debt/Financial Repression
The global debt overhang adds to the huge uncertainties over future demand, given the need to deleverage, and, for some, restructure stranded assets and obsolete business models. Leverage and balance sheets, for most, have been made worse by the pandemic. Further, the pandemic has enhanced market concentration and mono/oligopolistic structures, with larger firms getting bigger, and zombification worsening. Demand for credit will likely remain depressed, limiting the potential for a secular global credit expansionary cycle and, corresponding, a credit-fueled aggregate demand cycle.
Source: BIS
At current debt levels and considering uncertainties over future demand, the urge to deleverage or to build up a precautionary buffer will be strong. This is especially so following the expiry of the fiscal support programs. Indeed, US bank credit, after a period of strong growth supported by government programs, have levelled off and is now seeing negative yoy growth. The credit impulse is now deeply negative, serving as a headwind to growth, going forward.
Source: FRED
A “radical”, but also equally politically improbable idea suggested by Prof. S.Keen – which, we think, can theoretically lead to a positive reset of the global financial situation of the indebted class – is the Global Private Debt Jubilee. The design of this plan is technically sound, revisits the role of ‘credit’, focuses on the interaction between the sectoral balances (public vs. private vs. foreign), fulfills the criteria of Pareto improvement while also addressing concerns over fairness; although we think any legislative process will need to consider concerns surrounding moral hazard. However, we suspect the next major Overton window for such a policy (either direct/indirect debt forgiveness /restructuring) remains a distance away.
We are less concerned about overall debt levels compared to the more vulnerable problem of rising debt burdens. The persistent rise of debt vs. income globally points both to a skewness in debt accumulation (lower-income groups lacking the ability to repay), and the falling productivity of debt. These are related to both the lack of growth impetus (credit demand from the private sector rarely comes from real activities, but reflects financial engineering; credit demand is also far higher for entities with weak/mismatched balance sheets), and the distorted incentive structures of major institutions (such as the inefficiency of capital allocation, skewed lending policies, preference for financial engineering). The former requires credible growth strategies (addressing income/wealth disparity and proactiveness of well-designed fiscal policies), while the latter requires more institutional reforms (e.g. capital allocation reforms in important economies such as CN/IN, financial reforms in AEs etc).
Without a re-structuring of liabilities, debt forgiveness, and/or credible growth strategies, we suspect financial repression – in effect a long-drawn-out amortization of debt burdens through an implicit transfer of resources away from holders of monetary assets – is likely to be the central policy to address indebtedness. Such a strategy is unlikely to be successful considering the current context (high debt stock, lack of growth/inflation impetus, rising negative side effects). The side effects (zombification/inefficient capital allocation/inequality etc.) has already contributed to problems surrounding the previous regime.
IV. Global Re-balancing and Reforming the Global Financial Architecture
We have written extensively about the adverse impact of global imbalances on global aggregate demand and financial fragility in the past (see this, this and this). Simply stated, global imbalances – a large part reflecting domestic income imbalances in major economies – have led to a shortfall in aggregate demand, rising indebtedness, and financial fragility globally.
The persistence of global imbalances, as we have argued before, is enabled by the current global financial architecture which severely lacks a self-correction mechanism (creating a high degree of stasis for re-balancing – chronic imbalances therefore usually resolve via financial distresses instead). We believe the current global financial architecture provides a conduit through which surplus economies transmit their domestic imbalances (skewed labour-capital share of income; shortfall of demand; export-driven models) via trade and capital flows (see this) with limited consequences, if any, currently. While unlikely, proposals based upon J.M.Keynes’ bancor (see this) have the potential to address the architecture’s weakness by providing a functional adjustment mechanism. Without major reforms, which is only possible with global policy cooperation, the onus of adjustments continues to systemically fall on deficit economies (e.g. the build-up and the subsequent un-ravelling of levered demand in the US which led to the GFC).
Another way to re-balance the system in a growth-conducive manner is for surplus economies to lessen or reverse such imbalances by boosting domestic demand at the expense of external surpluses. There have been positive signs of such policies being enacted in the recent past. However, they remain largely reactive in nature – in response to domestic pressures, both through the inevitable slowdown in growth (as limits to importing demand have been reached) and correspondingly rising political instability – rather than an explicit recognition for the need to change their respective growth models. Nonetheless, it is clear that a critical mass of reforms have yet been reached. Asia and to a large extent core Europe, continue to rely on export-dependent growth models. We believe re-balancing has minimal chances to occur, unless the labour/domestic consumption share of income sustainably increase in these economies.
The lack of global re-balancing is particularly stark when considering the effects of the pandemic. The US and UK, with arguably the most generous demand-side fiscal packages coupled with the most liberal capital markets (which allows ex-ante and ex-post current account and capital flows preferences to adjust with the most ease globally), saw their current account deficits widen (especially the US which saw a widening to -3.5% GDP; though still lower than the -5.2% seen during 2003-08), while key current account surplus economies (with support packages largely targeting the supply-side) kept their surpluses either largely unchanged or saw a positive widening. For instance, China saw its surplus widen to 1.8% GDP, an amount which in normal times will be tough for the rest of the world to absorb, considering its size. The US economy continues to play the role as the global demand provider of last resort. In our opinion, such demand is not sustainable (both economically and geo-politically) and following a cyclical boost, surplus economies will see demand weaken back closer to the pre-pandemic baseline (“pain re-distribution” – essentially a re-surfacing of underlying fragilities).
Source: IMF WEO
What if the necessary conditions are not achieved? No Permanent Regime Shift but Constant Oscillations in a State of Flux
We believe the conditions laid out above are all inter-connected, and addressing them is likely to help induce private investments, by convincing corporate executives that future demand will remain robust (a lack of future demand prospects, we believe, is a major contributing factor as to why investment spending has been lacklustre over the past decade — returns to financial engineering is far higher than real investment in an environment of limited growth prospects).
The failure to, at the minimum, meaningfully address some of the conditions stated above will mean that the increases in growth/inflation of the global economy (such as what we are witnessing currently) will likely be temporary bumps – the global economy is likely to gravitate back to its pre-pandemic trajectory eventually (“Stagnation” Regime) with both the fiscal and credit impulse turning negative and with limited secular productivity improvements. Even then, a reversion to “Stagnation” will likely have a short runway, considering both deepened fragilities and widening fault-lines (see this and this).
This brings us to the possibility of another alternative (“Global Friction & Disorder” regime) – one where rising domestic polarisation becomes increasingly a global phenomenon, accompanied by rising international fragmentation. We think isolationism and rising aggression internationally (dominance of realpolitik) is another distinct possibility (outside of “Stagnation” and “Lift-off”) not yet widely discussed, nor priced in by markets. This scenario may well occur should the transition from “Stagnation” to “Lift-off” fail to occur. Tell-tale signs include the rise of toxic nationalism (both political and economic), a return of populist figure-heads, and the dominance of realpolitik in international relations.
In such a scenario, outright growth/inflation beta bets become far more complicated and much less obvious, with the focus instead shifting towards sectoral/thematic alpha (e.g. economic nationalism can lead to either higher growth/stagflation/loss of competitiveness through the choice of policy – thoughtful nation building or impetuous, wasteful spending). Idiosyncratic factors such as the “sustainability” of government finances, the ability of the economy to generate sustainable domestic demand, possession of strategically important commodities/resources, the control over strategically important value chains (technological prowess, strategic resources, talents), and geopolitical leverage/optionality become far more important.
Parsing through the necessary conditions makes it clear that the challenges for a shift towards a more sustained/permanent ‘Lift-off’ are daunting. Most of the conditions require surmounting entrenched political constraints, profound geopolitical differences, and dominant mainstream economic ideologies. Hence, in the near term, we do not anticipate a rapid shift and permanent entrenchment of a new regime. Rather, the world is more likely to experience a prolonged period vacillating amongst the three regimes: “Lift-off”, “Stagnation”, and “Global Friction & Disorder”. As such, the probability over which regime will eventually be entrenched will ebb and flow depending on the choice of policies under-taken, now and into the future. Markets, thus, too will reprice the shifts in the odds of the various regimes, likely in steps rather than a smooth re-pricing, considering the significantly different implications on asset classes among the three regimes (Part III of this series will focus more on asset class implications).
Conclusion
The probability of such a regime shift towards a world with sustained higher growth/inflation will increase, in our opinion, if policies address: i) the lop-sidedness of income distribution, ii) the indebtedness of the system, iii) the lacklustre investment and credit cycle, and lastly, iv) the global financial architecture. Conditions need to address issues surrounding macroeconomic ‘super-structures’; other unifying themes behind these elements include the generation of sustained demand, a permanent increase in the “inherent wealth velocity” of the global economy, and reduced fragility of the global economy. Only through meaningfully addressing these key elements, at least partially, will conditions be more conducive for a more sustained/permanent “Lift-off”. The hurdles these conditions face, however, suggest a prolonged period of oscillation amongst alternative scenarios.
The trajectory of US interest rates depends on changes in expectations over its i) term structure and ii) term premia. We explore what truly matters for rates forecasts/positioning beyond the current dominant reflation narrative. We also discuss often-cited though we deem otherwise less relevant considerations.
Important Considerations
A. Embedding hurdle rates within valuations
Forecasting higher/lower rates than spot curves inevitably need to overcome embedded hurdle rates in valuations across various parts of the curve. We highlight the hurdle rates required for positioning/forecasting for higher spot rates below:
Short-ends: on the extreme short end of the curve (where term premium influence is negligible), Eurodollar futures, Fed Fund futures (FFFs), and OIS forwards have all but priced in a rates liftoff sometime in 2022. ED futures have now priced in 1.2x rate hike by end-2022, while 2Y3M OIS have essentially priced in close to 3 rate hikes by mid-2023 FOMC meeting. FFFs suggest liftoff sometime between Q3-Q422. Current pricing is more ‘hawkish’ than the Fed’s current dot plot (the median voter is guiding for ~two rate hikes by end-2023; although we question the usefulness of the Fed’s dot plot), and embed certain assumptions about the economy by end-2022. During previous FOMC meetings, the FOMC reiterated three criteria that would need to be satisfied prior to any consideration of a rate hike: 1) the labor market would need to reach levels resembling maximum employment; 2) inflation has risen to 2%; and 3) as assessment that inflation is on track to moderately exceed 2% for some time. For short-ends to lead spot curves higher, any rate hiking cycle expectations will need to be more aggressive than currently priced. This implicitly suggest that either (a) the above conditions will be met sometime earlier than 3Q22, (b) these conditions will be met by end-2022, coupled with strong momentum beyond (velocity to neutral quickens), or (c) the Fed changes its reaction function from its current guidance. Sequentially, it is likely that the completion of tapering will precede the first interest rate hike, hence moving rate hike expectations forward will also implicitly assume a quicker/earlier tapering program.
Medium-term Forward Rates: Market expectations of neutral/terminal – proxied via the spot 5y5y forward – are currently priced at around 2.13%. There has been a material re-pricing of neutral rate expectations (5y5y has risen 62bps YTD), with levels now higher than during the pre-pandemic levels seen in 2H19. For context, the peak FFRs post-GFC was similarly at 2.25%-2.50%, which on hindsight, turned out to be short-lived/unsustainable. Neutral/terminal rates expectations will need to be raised further and probably beyond the Fed’s perception of longer-run rates (currently ~2.5%) or past cycle peaks in order for medium-term forward rates to lead spot levels higher.
Breakevens: The YTD increase in optimism reflected in both the near-term liftoff and medium-term neutral rates is juxtaposed against the much more circumspect pricing with regards to medium-term inflation. An interesting aspect of the rates move YTD is the relative subdued performance of medium-term breakevens – 5y5y breakevens (@ 2.19%) are up 21bps YTD, while 5y5y inflation swaps (2.34%) are almost flat at +4bps YTD. The relatively subdued move in medium-term inflation forwards is driven by a decline in the 5s10s breakevens (-22bps YTD) with 5y breakevens (2.52%) up 55bps YTD and 10y breakevens (@2.34%) a lot more subdued at +35bps YTD. The market has priced in cyclically higher inflation (over the next 1-5 years), coupled with more subdued longer-term inflation maintained at a level close to the Fed’s 2% target (adjusted for the core PCE gap). Thus, going forward, markets will have to price in materially higher cyclical inflation >2.5% for inflation expectations to lead a further sell-off in the belly of the spot curve. On the other hand, 5y5y breakevens would need to rise to a level reflecting sustained core inflation above the Fed’s target for inflation expectations to drive a further bear-steepening of the curve on the longer-ends. For context, the US economy has failed to generate core inflation above 2% sustainably despite having much tighter labor markets and narrower output gaps pre-pandemic.
Real Rates: Establishing the hurdle rates for real yields would first require a determination of what real yields reflect in the current era/regime: a) an indicator to balance savings-investments, or b) a mathematical residual (nominal-breakevens) when central bank control over the nominal spot curve is high. For real rates to lead nominal spot levels higher for (a) require revised assumptions about the drivers underpinning the saving/investments imbalances. Proponents of (b) will find it difficult to envisage real yields leading nominal higher from here (with real increasing into deeply positive territory)unless one expects a material shift in monetary policy frameworks – we argued before (see this) that negative real rates essentially becomes an explicit policy objective under the AIT framework (i.e. nominal will lag breakevens in an upward trend; real yields typically rise only after breakevens decline with policy rates near the zero lower bound, hence accompanied by limited moves on the nominal). We estimate 5y5y real rates remaining in negative territory at -19bps, the rise YTD (~+37bps) mirrors the 5s10s flattening in breakevens (for context 5y implied real is largely unchanged YTD).
Term Premium: Establishing hurdle rates for term premia is highly difficult given the challenges in quantifying it with any precision, although we note the tendency for term premia to be negative post-GFC. Negative/low term premia is most probable when two key conditions co-exist: a) market conviction in central bank forward guidance to keep rates low is extremely high, and b) market conviction that the policy mix will fail to stimulate growth/inflation is extremely high. Indeed, episodes of term-premia led (change in ACM TP accounts for >70% of total nominal move) bear-steepening post-GFC were consistently accompanied by shifts in market perception regarding this dual-condition (albeit mostly temporary on hindsight): i) 2013 taper tantrum, ii) post-Trump elections in 2016, and iii) the 2021 YTD sell-off.
Hence, an even more meaningful term-premia led rise in nominal rates will require a more severe shift in market interpretation of CB forward guidance (this could either be a proactive change in reaction function or an unintentional loss in credibility), or a further change in market expectations over the ability of the current policy mix to impact growth/inflation (probably entail more meaningful shifts in ideology/scale/persistence/political constraints in delivering demand-side stimulus – see ‘regime shift’ section for elaboration). We doubt a term-premia led rise in rates can be unilaterally driven by the Fed – it seems premature to deviate from a newly-established framework, considering the importance of policy framework credibility (plus the risk that a hawkish deviation is also likely be interpreted as over-tightening). Risks to this dual-condition is also not one-way – e.g. if underlying conditions force a consideration of introducing YCC to keep long-ends anchored (i.e. a more permanent low/negative term premia state)/ a return to fiscal conservatism. We estimate 5y5y ACM TP at +38bps currently (i.e. positive TP is already embedded in the forwards); and this remains close to the highest of the range seen across 2018-2020 despite its recent correction (peaked at ~1.15% in Q121).
The relevant hurdles rates across various parts of the rates curves will need to be considered in totality, rather than in isolation (e.g. one may establish a view incorporating higher inflation going forward, but only under the condition whereby this is enabled by low nominals via monetary support – a bear-steepening and rise in forwards with short-ends near zero).
The hurdle rates to position for lower levels than the current spot curve will simply be the inverse of the assumptions stated above.
B. The Fed’s Reaction Function
We previously argued that the Fed’s new AIT framework remains very open to interpretation and accommodates a high degree of subjectivity. Key inputs to the framework remain unclear (e.g. the length of the inflation lookback window/what constitutes inclusive employment/the complementary conditions for sustained higher inflation), but reliable rate forecasts will need to lay out probabilistic outcomes about both the “path” (pace/timing of rate hikes, if any) and the “destination” (neutral/terminal rates in the policy cycle). Reflexivity will need to be considered too – e.g. the probability that a likely slower/later “path” vs. the old regime pushes up the “destination” of the new regime (this depends on one’s view of the extent neutral can rise due to supportive policies). Inversely, a reversion back to a Taylor Rule-like framework quickens the “path” but may decrease peak/neutral (i.e. markets pricing in over-tightening). The focus on the dot plots, we believe, is less warranted, considering its poor record as a guide to ex-post policy actions historically, and have complicated forward guidance. Indeed, the current dot plots have even less informational value than usual, considering the high level of uncertainty embedded in FOMC members’ assessments of future growth/UE/inflation (see uncertainty diffusion indices in the latest SEP).
C. Spot Levels &. Forwards Rates
The various connotations above will be captured by key segments of the forwards curve – e.g. views on the rates “path” will be expressed via the shorter-tenor forwards of the short-ends (2y2y/3y2y), while the medium-term forwards (5y5y) reflect the view on peak/neutral. Mathematically, spot curve forecasts will need to correspond to the implied forward rates (i.e. the explicit assumptions/rationale for spot curves forecasts must be consistent with/identical to the inherent assumptions embedded in the implied forward rates based on the same forecasts), else they become irrelevant.
D. Spot Levels vs. Curve Steepness
It thus follows that rates positioning should accommodate differing degrees of conviction for absolute spot levels (absolute directionality), vs. the steepness of curves. For example, a view for lower 2y2y/3y2y forwards (i.e. a later/slower “path” over a 2y-3y horizon) can be expressed via a 2s5s flatteners rather than outright spot levels (similarly a higher 5y5y can be expressed via a 5s10s steepener; not necessarily a higher spot UST10). Focusing on the steepness of the curve (vs. absolute spot levels) can remove an additional layer of complexity when positioning is led by views on forwards (as illustrated above, 5y5y can decline via a bear-flattener when markets price in over-tightening, or simply a decline in medium-term outlook on the economy – in this case potentially a bull-flattener)
D. Reflexivity
Rate forecasts will need to be compatible with the underlying structure of the economy. For example, rising bond yields in a highly-leveraged economy (especially as marginal productivity of debt is declining) may ultimately be self-defeating if financing costs rise. In addition, to the extent that the Fed remains sensitive to financial conditions (one will need to consider the level of the Fed’s implicit put price, which is negatively correlated to the strength of the underlying economy), the unwinding of carry/levered trades can act as a circuit breaker to any sustained rise in rates. Hence, the higher/more crowded the levered positions in both the actual economy and financial markets, the likelier that higher rates is self-defeating, and vice versa.
E. The Unhinging, Oscillation & Entrenchment of Regimes
We expect markets to increasingly shift its focus away from the volatile near-term data (where re-opening supply/demand mismatches in labor markets, and goods & services are likely to subside over time) to evolving probabilistic views over the medium-term outlook. The latter is increasingly dominated by market narratives surrounding ‘regime shifts/change’ – that we are currently at an inflexion point where markets are likely to transition to and reflect a new regime (one which is significantly more inflationary than the post-GFC era). Indeed, we have previously highlighted the underlying faultlines/limits of the current regime (characterized by low growth/inflation, aggregate demand deficiency, zombification, & lop-sided global external flows), and how they have been brought to extremes rendering the regime unsustainable. However, it remains to be seen if markets will fully transit from an unhinging of the old regime to the entrenchment of a new one. We see two main outcomes (with differing impact on rates trajectory) over the medium term (2-3 years): 1) transition into a newly-entrenched higher growth/inflation regime via a significant shift in major policy frameworks, or 2) oscillation among various plausible regimes and where key elements of the old regime remain, accompanied by circumstantial ebb and flow in major policy frameworks.
We will attempt to lay out in detail the conditions we think necessary for a permanent phase shift to a higher growth/inflation regime in future posts. These necessarily entail structural changes to the macroeconomic ‘superstructures’ in order for the drivers to be self-reinforcing and long-lasting. For the domestic economy, we suspect it will inherently be conditions which allow the rate of change in “wealth stock” & its inherent “velocity” to permanently increase (policy mix that entail some degree of redistribution, a material shift in power dynamics, more persistent and dominant demand-side fiscal policies, explicit/implicit debt forgiveness). On the external front, necessary conditions may include a proactive/growth-conducive rebalancing towards domestic demand from economies generating persistent external surpluses. A much higher degree of global coordination will also be needed to address structural issues with the global financial architecture.
Less Relevant Consideration
A. Size of Fiscal Deficits without Context
We have previously mentioned why one should not relate government debt accumulation/higher fiscal deficits (as % GDP) to higher interest rates (high government debt levels and low interest rates may at times correspond as they reflect similar drivers). Supply dynamics (a function of fiscal policy and the treasury’s issuance plans) have also historically had no direct relation to UST yields. Ultimately, the outcome of any amount of fiscal deficit/government debt is entirely contextual (the need to be analyzed in aggregate via the flow-of-funds and sectoral balance approaches) – we explained the key considerations and emphasized the importance of macroeconomic ‘superstructures’ when determining such outcomes.
B. Identities of Direct Buyers/Sellers
Often, we encounter examples of economists/strategists using identities of direct buyers/sellers of US treasuries as ‘drivers’ of market movements (e.g. rate declines are described as being driven by specific buyers; when rates rise, the focus turns to the identities of net sellers). However, we find gauging underlying UST demand via the factual identities of direct buyers & sellers to be uninformative at best and misleading at worst (notwithstanding the fact that for every market transaction, there must be both a buyer and a seller – yet few explore the identities of specific sellers when rates decline for instance). This is because the nature of flows into the global risk-free asset is unique vis-à-vis other asset classes, given its role in absorbing a significant portion of global ‘excess’ liquidity and currency transaction flows. Direct buyers of USTs partly reflects where excess liquidity sits, depending on how global financial flows are recycled, rather than necessarily a unilateral innate desire/motivation by specific buyers to accumulate US treasuries.
As a simple illustration, consider the contrast between a) a foreign country choosing to recycle its BoP net inflows via FX reserves (the foreign central bank will be recorded as the final direct buyer of USTs) vs. b) a foreign country recycling BoP net inflows via purchases of USD-denominated corporate debt through domestic agents (these inflows may eventually get recycled back into US treasuries via US corporates or the banking system). Both scenarios entail the recycling of external surplus (e.g. perhaps to prevent FX appreciation of the foreign country) as a key driver for US treasuries accumulation, but with contrasting identities of the direct UST buyer. Another straightforward example would be the implementation of QE – which constitutes an asset swap for the banking system via a switch from USTs to excess reserves (in this case, it would also be inaccurate to attribute any rise in term premia – as we had “counter-intuitively” witnessed during past periods of QE – to supposed ‘forced selling’ by the banking system).
Instead, the right question to ponder is how the recycling of flows impact global growth/inflation (e.g. can QE stimulate the economy? Or does easing beget more easing? Are external surpluses sustainable/recycled to productive purposes?), rather than precisely identifying the direct buyers/sellers of USTs. The answers are therefore entirely contextual/circumstantial; we argued – back in 2015 – why global capital flows in aggregate are unlikely to be absorbed in a growth-conducive manner, considering the current global financial architecture (the underlying reasons remain highly relevant even today).
C. Spot Level Comparisons vs. Pre-Covid-19
We have also encountered several strategists/commentators arguing for a near-term rebound of longer-end rates (10Y/30Y) to pre-Covid 19 levels or above, given improved cyclical growth/inflation dynamics. Such forecasts will need to specify if the spot curve will reflect i) a much higher forward rates curve with the short-ends near the ZLB (this implies a much higher neutral vs pre-pandemic; assumptions going beyond a strong cyclical recovery), or ii) an accompanying increase in short-end (this implies a near-term weakening of the AIT framework), with only moderate moves in medium-term forwards. Else, such forecasts violate bond math, with the embedded assumptions in long-end spot levels and the implied forward curve inconsistent.
D. Like-for-Like Taper Tantrum Comparisons without Context
With regards to tapering, context matters. Like-for-like comparisons to the 2013 taper tantrum should consider the following as well:
– The communicated sequencing (completion of taper to precede rate hikes) and short-end market pricing suggest tapering should no longer be a surprise to market participants.
– EM current accounts are less stretched vs. 2013 (market turbulence from “fragile-5”) in general; especially in Asia where dependence on speculative external capital flows is comparatively less.
– The 2013 Evans Rule was no longer a constraint for future rate hikes (thus taper announcement pulled in and pushed up rate hike expectations), this is in contrast to the AIT framework, which by definition, ensures a lower neutral and/or a slower path for the same level of inflation/UE rate vs. 2013 (again, unless one assumes AIT loses its credibility). The gap between the FOMC’s longer run projection and market pricing were also much larger in 2013.
– Fed communication is now much more frequent (press conf at every meeting) and incorporates feedback provided by a wider subset of market participants (via regular surveys) – this reduces the element of surprise which was a major factor back in 2013.
– The 2013 taper tantrum narrative was amplified by the potential rumors surrounding the appointment of Larry Summers as next Fed chair (who was perceived as much more hawkish relative to Bernanke/Yellen).
Conclusion
We find rate forecasts based upon well-substantiated assumptions on the relevant considerations more reliable. On the contrary, forecasts largely premised upon what we deem as irrelevant drivers are less so. Positioning should also reflect one’s degree of conviction on probabilistic outcomes of the relevant drivers.
Note: All spot/forward rates cited above reflect 02 July 2021 EOD levels.
There has been a clear shift towards growing acceptance of “unorthodox” stimulative fiscal economic policies lately as reflected in both The Economist and FT articles. One commonality running through various seemingly more “radical” economic stimulus policy recommendations consists of some form of central bank financed fiscal spending directed by either the government and/or via the central bank (MMT, Universal Income, People’s QE/Helicopter money, fiscal inflation targeting, central bank-financed fiscal deficit spending). This has led to an intensifying debate surrounding “monetized” fiscal expansion (defined as fiscal spending financed either via money creation and/or central bank purchases of government bonds). Please see appendix for a more thorough (macro accounting) treatment of the various forms of government financing. Proponents of such policies essentially argue that any sovereign government, which as a monopoly issuer of its own legal tender fiat currency, does not have a specific numerical budgetary limit; and hence can create/spend money to fulfil its policy objectives insofar as economic capacity exists and inflation is contained (no nominal constraint; only real). As such, there is a free lunch just waiting to be had, purely through the act of creating money. Exponents, on the contrary, argue that such policies will inevitably lead to runaway (hyper)inflation, invoking the ills of state-centric policy-making, capital mis-allocation, the “moral ills” of monetization and its adverse impact on “confidence”.
Most arguments, however, fail to comprehensively lay out the underlying conditions which will impact the degree of success/failure (policy appropriateness/suitability) of utilizing such “monetized” fiscal expansion policies. The outcome of such monetized fiscal policy strategy, we believe, in supporting sustainable economic growth depends crucially on the superstructure underlying the economy and can result in both success or failure. These include, i) domestic socio-political-economic structures, ii) global economic structure/financial architecture, iii) income distribution, iv) the shift of income, assets and liabilities among economic sectors/agents, v) quality/type of spending, and vi) the wealth stock capacity of the economy.
We provide a brief background and some core principles underlying monetized fiscal expansion. Further, we discuss the key conditions underlying success or failure of pursuing such an economic policy.
Fiat Currency
As first principles to understanding monetized fiscal expansion policies, one needs to recognize what fiat money truly reflects in this day and age. Fiat money has no intrinsic value; it has no maturity and is irredeemable in anything outside of itself. Money generally needs to fulfill three criteria, i) store of value, ii) unit of account, and iii) medium of exchange. The most important characteristics, in our view, underlying sovereign fiat’s “value” are (a) viability as a claim on present/future economic production (stability/growth of purchasing power and aggregate supply) and (b) the state’s ability to use coercion (supported by its institutions – tax office, banking/financial system, armed forces, etc) to enforce its primacy in the economy as the medium of exchange (deemed legal tender). Economically, money (and most other forms of public liabilities) is essentially society’s claim on its present/future economic production (with the form of public liabilities to an extent determined by the intertemporal choices of the issuer/holders). Public liabilities serve as society’s collective promise/liability to reciprocate (economic output) upon demand by its holder. Outside of its “tangible” value (in exchange for goods and services), money, to some, provides the fulfillment of more abstract, psychological benefits including power, influence, status, greed, or the pure pursuit of money as a game.
Money is the most liquid form of risk-free public “liabilities” vis-à-vis longer duration/less liquid bills/government bonds. An injection of which via central bank money creation (or via banks within the reserves system) expands the stock of monetary base with government debt issuance shrinking the monetary base (debt-financed fiscal spending, not absorbed via money creation by either the central bank/banks within the reserves system, does not lead to an expansion in monetary base).
Intellectual Background of Monetized Fiscal Expansion
Abba Lerner’s Functional Finance argues that government finance should be undertaken only in consideration of actual economic outcomes.
“…government fiscal policy, its spending and taxing, its borrowing and repayment of loans, its issue of new money and its withdrawal of money, shall all be undertaken with an eye only to the results of these actions on the economy and not to any established traditional doctrine about what is sound or unsound”.
The principal role of government finance should be to support the government in achieving its explicit policy objectives – managing the business cycle, achieving full employment, ensuring growth and price stability. In terms of government finance, taxation is never to be undertaken with the intention to fund government deficits, but rather, it must be judged only by its effect (discourages certain activities/behaviors) – primarily extracting money out of the economy, dampening economic activities. Meanwhile, the government should borrow money only if it is desirable to do so (when interest rates are too low amid high inflation risks). The national debt is of no policy concern insofar as the government maintains a proper level of demand for the current output level with price stability. Most importantly, the successful implementation of Functional Finance should lead to a stabilizing level of national debt with time (Higher public spending >> Higher private wealth >> Less need to save/lower indebtedness >> Higher private spending >> Less need to undertake public spending >> National debt stabilizing). Lerner also believes that there is a multiplier effect (> 1) to fiscal expansion – Keynesian economics.
Another key concept underpinning the foundation of monetized fiscal expansion is Wynne Godley’s flow-of-funds and sectoral balances approach. The basic underlying principle, as alluded by the macro sectoral accounting identity (Government Balance + Domestic Private Balance + Foreign Balance = 0), is that income-expenditure are two sides of the same coin (as per asset-liability and credit-debt). The accounting identity can never be violated since someone’s asset is another’s liability and someone’s expenditure is another’s income. With regards to government expenditure, its budgetary surplus/deficit simply mirrors the inverse of the country’s domestic private sector (households/corps/financials) balance, and its foreign balance (current account). Sectoral balances must sum to zero. It follows then, that an attempt to reduce the government deficit, for example, will necessarily see an erosion of the private sector (domestic + foreign) surplus, and vice versa.
This is not to say that intra-sectoral shifts are not important (negative economic impact of income/wealth disparity within private sectors) or that any specific sectors should be running a surplus/deficit at all times. It all depends on the phase of growth, imbalances and superstructures underlying the economies. What truly matters then, is not merely which sector runs a surplus/deficit, but rather how surpluses/deficits are generated and the subsequent implications on the economy’s growth/inflation.
In addition, it is important to state that the process underlying shifts in sectoral balances are complex and dynamic (multi-order impact) and that actions taken to force adjustments (shifting surpluses/deficits among sectors) may lead to outcomes that differs from partial analysis. Government austerity policy is one example where the explicit policy objective of reducing the fiscal deficit led instead to a further deterioration (multiplier effect from reduced government spending led to a disproportionately sharper drop in GDP, thus increasing the budget deficit).
Taken together, both Lerner’s and Godley’s works suggest that fiscal policy does not require “financing”, and when under-taken at an appropriate time, can serve to galvanize the private sector’s income and balance sheet by injecting net income and financial assets into the economy.
At this juncture, the most prominent school of thought under-lying monetized fiscal expansion is the Modern Monetary Theory (“MMT”), first traced back to Warren Mosler, an American economist and hedge fund manager, in the 1970s. MMT largely revolves around the role and creation of money in a fiat currency world and its subsequent implications for policymaking for both fiscal and monetary authorities. Many of the ideas raised by MMT are far from “modern” or “original” but are instead heavily influenced by pre-existing theories/schools of thought, including ideas from the above-mentioned Lerner and Godley (with their work, in turn, mostly extensions of ideas that have been well-developed by Keynes/Minsky/Kalecki/Levy).
MMT’s proponents generally agree on the following core principles:
a. A sovereign government which is a monopolistic issuer of its own fiat currency can choose not to default on debt denominated in its own currency via its ability to procure its own currency.
b. A sovereign government which is a monopolistic issuer of its own fiat currency can create money and spend without taxation revenue or raising government debt.
c. Inflation will arise only after the economy’s real resources are employed, rather than how much money is created.
d. Without risk of default in debt of its own currency, there are no financial constraints to government spending (the government can create money indefinitely). The only constraint is real economic constraint, reflected by inflation.
e. Given the state’s ability (enabled by its status as a currency ‘issuer’ rather than a ‘user’) to anchor nominal financing costs, the costs of government deficits, relative to other forms of debt/liability accumulation by private sector agents, are low.
f. The primary role of taxation is not to fund government spending, but rather, to use the power of the state to impose a tax liability payable in its own currency which creates a demand for the currency and gives it value. Taxation can also be used to influence income distribution, the managing of business cycles, or to create incentives for specific objectives (such as environmental protection/corporate investments).
The idea surrounding the role of taxation (f) stems from chartalism (that a currency only needs government-imposed taxation to derive its value) – we believe the point does not have much implications on either the key principles or policy prescriptions.
A core policy argument of MMT – widely discussed currently – entails the heavy use of fiscal policy to achieve full employment. This is now largely mainstream academic consensus post the Covid-19 pandemic; what is relatively more controversial is the unorthodox approaches to fiscal and monetary policy coordination/consolidation argued for by proponents. Fiscal policy, they believe, should be the primary tool utilized to manage the business cycle. They also largely disregard conventional ‘financial constraints’ such as fiscal deficits/budgetary targets over the medium-longer term (the only constraint is real economic resources – inflation). The notion that one needs to manage its fiscal deficits over the longer-run (balanced budget requirements) is rejected.
To implement such policies, proponents argue for a more intense and formalized coordination between the fiscal and monetary authorities. The monetary authorities (i.e. central banks) would mainly serve to facilitate government spending/tightening (in the form of balance sheet management via money creation/destruction), with monetary policy essentially subjugated to fiscal policy (fiscal dominance). Actual proposed implementation typically incorporates counter-cyclical mechanisms/automatic macroeconomic stabilizers – e.g. the job-guarantee schemes whereby the government acts as an employer of last resort is a dominant policy prescription in MMT literature.
– A sovereign government which is a monopolistic issuer of its own fiat currency can create money and spend without taxation revenue or raising government debt.
– The buildup of a net liability position in the consolidated government sector, reflecting the government’s fiscal deficits, will be mirrored by the net asset position within the domestic private sector and/or a larger foreign balance (in the form of a current account deficit).
– Inflation will arise only after the economy’s real resources are employed, rather than how much money is created.
The impact and limits of monetized fiscal expansion can be worked through using the below formula which is a variant of MV = PQ,
W * Vw = P * Q (Nominal GDP)
The concepts of an economy’s wealth stock, W, wealth velocity, Vw, and capacity of “wealth” borrows from Jesse Livermore of Philosophical Economics (any error or misinterpretation are ours). It is slightly different from the traditional concept of money supply and its velocity in mainstream economics as it includes money + wealth held in other forms (other financial assets) which are readily convertible into money (dependent upon liquidity provided by financial markets).
The nominal GDP of an economy, at any juncture, is determined by the stock of wealth, W, of an economy and the velocity of wealth, Vw (rate at which wealth is exchanged in an economy). Nominal GDP rises if either the wealth stock increases, or if spending per unit of wealth increases. Whether nominal GDP adjusts largely through real growth or inflation depends on the economy’s wealth capacity (when an economy’s wealth capacity > wealth stock, there will not be inflationary pressures). To put it another way, an economy’s wealth capacity determines the inflation constraints of monetized fiscal expansion, while its wealth velocity determines the pace at which the economy reaches such constraints. Wealth velocity thus refers to spending/transactions per unit of ‘wealth’. Wealth capacity refers to the level of wealth stock where aggregate demand = utilization of productive resources before inflation constraints are breached.
With regards to monetized fiscal expansion, government deficits and thus debt (money) issuances expand the wealth stock, W, of the private sector. Hence, factors (superstructures of the economy; quality of fiscal spending) affecting wealth velocity and wealth capacity will determine the scope for utilizing monetized fiscal expansion with price stability. Output, Q, can be higher/constant/lower depending on how government spending is structured, marginal utility of labour/capital in production, income share of labour/capital, and capacity utilization and growth – all these factors impact Vw and subsequently to Q. It is important to note that all such analysis is highly complex and dynamic (Ceteris Paribas type analysis will invariably fail).
1. Prevalence of Wealth Hoarders
“The love of money as a possession — as distinguished from the love of money as a means to the enjoyments and realities of life — will be recognized for what it is, a somewhat disgusting morbidity, one of those semi-criminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease.” – J.M. Keynes
Higher private sector wealth, reflecting fiscal expansion, can be hoarded instead of spent, depending on the type of government spending, the prevalence of wealth hoarders, and the distribution of income/wealth of the economy. Wealth hoarders are typically higher income households and capital owners, with low-to-zero marginal propensity to consume. Wealth is accumulated mostly for its intangible characteristics – status/power – with limited intention to consume; accumulation for the sake of accumulation. Such accumulation deprives the economy of demand (Vw falls) even as the wealth stock (W increases) expands.
Vw is more likely to fall (as wealth is hoarded), the more extensive the prevalence of wealth hoarders are in an economy (reflected in high wealth concentration and income disparity). This expands the economy’s wealth capacity, as the economy can hold more wealth per unit of additional government spending, as the net increase in wealth is hoarded rather than spent.
For example, tax rebates/tax cuts (higher government spending) for higher income households/corporates may lead to higher W, with limited corresponding impact on either P or Q, as most of the income is saved. This acts essentially as a net transfer of wealth from the government/public to such entities.
Alternatively, considering government direct handouts as a policy, in an economic environment of capacity abundance (labour and capital), low marginal cost of production, dominated by capital intensive production and high income share of capital (demand and income provided by cash handouts absorbed by rising production from idle capacity, owned and subsequently earned by higher income, low propensity to consume capital owners), both W and Q can increase, coupled with a fall in Vw, though to a lesser extent than the previous example – marginal propensity to consume is higher with direct handouts than poorly targeted tax cuts.
While the prevalence of wealth hoarders in an economy may extend the scope for non-inflationary, monetized fiscal expansion, nevertheless this may lead to other side effects. This creates the problem of indebted demand, where income earned from demand generated leads to purchasing power (claim on current/future resources) to be continuously transferred to high wealth entities with low-to-zero marginal propensity to consume, forcing the economy into a permanently low growth, low interest rate, high debt environment, retarding the impact on both fiscal and monetary policies. Further, it leads to higher financial instability as wealth hoarders may seek to rebalance their asset portfolio away from money/government debt, pushing other asset prices higher (Note the selling does not imply higher yields for government liabilities as demand for such instruments will remain high (liquidity, regulatory, diversification, etc), but will instead be reflected in higher asset prices elsewhere).
2. Share of Income and Degree of Wealth Recycling
Relatedly, as W expands, on the back of fiscal expansion, and assuming that it is spent, 2nd-order spending (Keynesian multiplier) and its impact on Vw will be dependent on which entities – high/low marginal propensity to consume – earns the income (high/low propensity to consume sectors).
For example, corporates engaging in buybacks/acquiring other financial assets/M&As instead of expanding production or paying higher wages means that income will not be recycled back into the economy, but instead hoarded as wealth. This is dependent on factors such as quality of fiscal expansion, domestic/international tax regimes, industry and investment policies, and capital-labour bargaining power.
Vw will be lower and wealth capacity larger with higher income disparity and as the degree of wealth recycling declines. Alternatively, Vw will be higher should the income earned be skewed towards entities with higher marginal propensity to consume and as the degree of wealth recycling rises.
3. Impact of Global Financial Architecture and Exposure to Structural Dis-inflationary Drivers
An economy’s wealth capacity will be higher if it is exposed to more and stronger dis-inflationary drivers (globalization, import competition, automation and technology, labour bargaining position.
As discussed above, fiscal expansion can be ‘leaked’ abroad in the form of a larger current account deficit. This is especially so if the global financial architecture lacks automatic adjustment mechanisms that corrects sustained external imbalances. We have highlighted previously (here and here) about the problems behind the current global financial architecture (one which results in high external imbalances adjusting in a non-growth conducive manner). We have also argued extensively that there is a need for surplus economies to generate more domestic sources of demand. MMT literature, for example, largely focuses on domestic drivers. However, we deem it essential that any monetized fiscal expansion policy proposed be gauged within the context of the current global financial architecture and balance of payments backdrop. This determines the extent of income/demand (and domestic assets held by foreigners) leaked abroad. This can have massive implications with regards to the spending countries’ financial sovereignty (currency movements and its impact on domestic macro stability – inflation/financial stability) and its asset markets (foreigners play a decisive role in asset inflation/deflation through choice of domestic assets held).
4. Other Considerations
Government’s competency, stability and strength of institutions
An economy’s wealth capacity is positively linked to the government’s competency, stability, and strengths of its institutions.
Foreign borrowings
An economy’s wealth capacity will be lower if the proportion of foreign-currency based borrowings is higher (lower degree of currency sovereignty).
Conditions for a Free Lunch
Indeed, there is seemingly a free lunch – the government can create money and spend, without constraint, on all its policy objectives, insofar as inflation is kept on target. Since money is created from thin air and spent into the economy, there is a net gain in the financial wealth of the private sector theoretically without a corresponding private “liability”. To many, this sounds too good to be true and suggests that the state can spend itself into prosperity for all.
This, however, is only possible, if certain condition(s) are met. These include, i) demand creating its own supply, ii) productivity of the spending, and iii) proportional decline in wealth velocity vis-à-vis stock of wealth (as discussed above). The interaction between these three conditions will have implications over the sustainability of utilizing monetized fiscal expansion as a policy.
Demand creating its own supply. In a macro environment characterized by a scarcity of demand and underutilization of economic resources (real capital or labour) – reflected by low inflation, monetized fiscal expansion by creating demand can lead to an expansion in economic activity by utilizing un-used economic resources. The incremental demand generated is met by “idle” supply, with limited, if any, upward price pressures. If spending translates to higher income for economic entities with higher propensity to consume – through labour employment or capital constrained growth entities, the Keynesian multiplier (> 1) applies as spending leads to further consumption/investment (higher levels of recycled wealth and rising wealth velocity), leading to higher GDP growth.
Productivity of spending. Fiscal stimulus directed at productivity enhancing economic activities will be self-financing (self-liquidating liabilities) in that future production created will more than make up for the increase in government liabilities. Such public spending will be doubly effective in economies with a chronic shortfall of public investments – infrastructure, public works and services, providing ample scope for the economy to absorb productivity-enhancing spending which provides high returns. Opportunities for such spending are evident in DM economies, following years of neglect in public investments, reflecting economic policy dogma (“crowding out”) and years of austerity.
Importantly, the rise in money/debt growth, for the above two conditions, are thereby matched by an increase in GDP growth (essentially there is no increase in the ratio of future claims – money/debt – to economic resources – self-liquidating liabilities; Lerner’s “equilibrium” state).
Irrelevant Critiques
a. Hyperinflation/Price Instability without Proper Recognition of Underlying Conditions
Zimbabwe and the Weimar Republic (hyperinflation) being the most common examples; most arguments do not lay out the conditions under which these examples apply (see J.Montier). Arguments citing the sudden loss of “confidence” leading to runaway inflation can be safely ignored, considering the lack of analytical rigor.
b. Growth in Money Supply (monetarists) as “Sufficient” Determinant of Inflation
“It is also evident, that the prices do not so much depend on the absolute quantity of commodities and that of money, which are in a nation, as on that of the commodities, which come or may come to market, and of the money which circulates. If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated; if the commodities be hoarded in magazines and granaries, a like effect follows. As the money and commodities in these cases never meet, they cannot affect each other.” – David Hume, Essays, Moral, Political, Literary, “Of Money“, 1741 [bold emphasis ours].
It remains quite perplexing as to why this remains a legitimate argument given the empirically weak relationship between money supply and inflation, particularly in recent years. As highlighted by Hume, an increase in the stock of money, by itself, is not enough to cause an increase in prices (though, sadly, this has never prevented proponents from plotting charts of M2 growth and arguing otherwise). As Hume so vividly portrayed, coins (wealth) can be locked up in chests, sank to the bottom of the deepest of oceans and essentially annihilated forever. For monetized fiscal expansion to be inflationary, growth in money stock must subsequently lead to an increase in spending (i.e. growth in the stock of wealth must translate into real demand for goods and services). Essentially, this depends largely on how and to whom such policies are targeted. If such policies do not lead to meaningful increases in spending, then they will not significantly affect aggregate supply/demand dynamics – which in turn determine prices. In fact, monetized fiscal expansion can be deflationary when targeted at indebted/unproductive/low propensity to consume entities (China and Japan are variants of such examples though both reflect different drivers).
To re-iterate, monetized fiscal expansion can subsequently be spent/saved (domestically/externally) or used to meet expenses/extinguish liabilities. It depends on the dominant superstructure of the domestic economy and the underlying conditions and context. One can consume, save, recycle cash into financial assets, or invest in the ‘real economy’. It is abundantly clear that each will have a different implication on growth and inflation of an economy. Inflationary pressures will only build when excessive demand is placed on the economy’s labor and capital resources (aggregate demand > supply). Essentially, the only variable that matters for inflation is aggregate total income that is spent or invested (in real resources). Income subsequently held as savings does not place any demand on real resources, and therefore has no effect on prices. Large government deficits can certainly be used to finance excessive spending leading to inflationary outcomes. However, in cases where monetized fiscal expansion is not excessive, either because of the existence of a sizeable output gap or when proceeds are saved, the result will not be inflationary
c. Fiscal Deficits Leads to Higher Interest Rates as Sovereign Solvency is Questioned
Monetary authorities retain the ability to control nominal interest rates directly or indirectly (such as a credible YCC regime). The direction of real rates, hence, can be entirely dependent on inflation dynamics.
Even if left entirely to market forces, high government debt levels and low interest rates may at times correspond as they reflect similar drivers. For example, persistently weak nominal economic growth augurs for lower interest rates, while debt-to-GDP ratio itself often grows faster as the denominator stalls (evident in most G10 economies). One thus should not immediately relate higher government debt accumulation to higher interest rates. Supply dynamics (a function of fiscal policy and the treasury’s issuance plans) have no direct relation to UST yields (one can simply plot a chart of fiscal deficits and/or government debt against treasury yields to be convinced) – rather neutral and terminal rates expectations reflecting longer-term growth/inflation dynamics and the directionality of term premia are the dominant drivers.
Important Considerations
a. Political Constraints
Monetized fiscal expansion, to us, is simply another economic policy tool. A select group of economies (given their underlying structures/conditions) have the policy option to utilize such a fiscal expansion policy when the circumstances are appropriate. The practical constraint, outside of those discussed earlier, remains political in nature, as opposed to the technicalities. Ultimately, for such policies to be enacted effectively will entail a significant re-evaluation of the relationships and power dynamics between the government (which comprises of both the treasury and the central bank), domestic corporates and financials, elites, capital, labour, and the external sector. This can only be resolved via the political process which needs to satisfy, in aggregate, each country’s unique circumstances. As argued, political outcomes will impact both the quality and distributional effects of fiscal spending, ending in either a growth-conducive/non-conducive manner. For example, MMT trivializes the political complexities underlying fiscal-monetary coordination, which obviously requires a meaningful shift in dynamics which may not be probable. This is notwithstanding the complicated political struggles among different interest groups due to self-interests, ideologies, class, wealth, and social-standing.
b. Fiscal Profligacy
Proponents of monetized fiscal expansion may have placed too much faith in fiscal policymakers’ capacity and willingness to properly manage the economic system. Indeed, there continues to be a lack of well thought out actionable policies which, for example, mitigates political capture by the executive or allows for the automatic adjustments of counter-cyclical spending policies.
c. Practicalities of a Federal Job Guarantee
MMT proponents argue for the government to act as an employer of last resort (targeting full employment and determining the effective wage floor). However, this assumes an abundance of productive jobs which otherwise will not have been available unless provided for by the federal government. A side effect of such policy may be the rise of market-distorting, unproductive wages, which in turn structurally erodes the economy’s competitiveness. This is notwithstanding the administrative complexities of running such a program
d. Super-Structures
We have argued that the sustainability of monetized fiscal expansion will depend on both the quality and distributional impact of fiscal spending (beyond the 1st order impact). Both factors are highly influenced by the global/domestic super-structures with the impact of expansion policies introduced differing based on the unique conditions and circumstances underlying each economy (explained through the example of the US below)
e. Financial Markets and Cycles
We have argued earlier that the recycling of income/wealth primarily back into financial assets has limited transmission to the real economy (both aggregate demand and supply), this relates to the underlying incentive structures of financial markets/intermediaries. Hence, policy efficacy will be partially determined by >2nd order spending decisions (buy-back/M&As vis-à-vis real investments), global taxation regimes, as well as concentration of real/financial assets ownership, for instance.
Fiscal-Monetary Policy Coordination and Monetized Fiscal Expansion, in the context of the US Economy
We explore various potential forms of fiscal-monetary policy coordination and implementation of monetized fiscal expansion. Using the US economy as a short example, we conclude that a poorly designed, untargeted, monetized fiscal expansion program by US policy-makers will be far from being a panacea to economic growth, considering the current macroeconomic context and underlying super-structures.
Fiscal-monetary policy coordination and forms of implementation of monetized fiscal expansion
With regards to global fiscal-monetary policy alignment, much of the world, we believe, is currently already at the most foundational level of policy coordination. This entails a tacit understanding from both set of policy-makers that circumstances warrant an alignment of fiscal and monetary policies, each should work to reinforce one another. While, monetary and fiscal policy-makers may, at times, have contradictory goals, the objective of supporting the economy is commonly held by both. This may require both fiscal and monetary authorities to be strongly aligned at times. Hence, room exists for coordinated policy responses while still upholding policy independence.
Such a regime is currently in place in the US (though may be temporary). The AIT-framework, as argued, provides a credible assurance that fiscal spending will not be contradicted by tight monetary policy from the Fed (implicit fiscal-monetary policy coordination). Meanwhile, US domestic politics also increasingly favor expansionary fiscal policy and income transfers to the lower income class. The coordination between the Abenomics and the BoJ is also an example of such coordination.
Going beyond the foundational level of fiscal-monetary policy coordination will require a more extensive comingling of monetary and fiscal policy. This will entail CBs ceding monetary authority to fiscal policy-makers (fiscal dominance), effectively subordinating its own policy independence, at least temporarily, to fiscal policy-makers. A closer form of fiscal-monetary policy coordination, for example, can be broadly categorized as direct monetary financing of the Treasury and/or interest rate pegs – both of which have been pursued in the past.
Effective YCC was implemented during WWII to support war efforts. The Fed formally committed to an interest-rate peg of 0.375% on short-term Treasury bills in April-1942, and also capped the interest rate on long-term Treasury bonds (=>25 years) at 2.50%. To maintain YCC credibility, the Fed essentially gave up control of its balance sheet size and the corresponding money stock. Interest rate targeting was eventually brought to an end by the Treasury-Fed Accord in March 1951.
Direct monetary financing was also utilized post-WWII when the 1942 Second War Powers Act was enacted. The Act provided an exemption to the 1935 Banking Act (which prohibited direct Fed purchases of treasuries), thereby allowing the Federal Reserve to directly purchase treasury securities (up to a maximum of USD 5bn), bypassing financial constraints – the modern day analogy will be the UK’s “Ways and Means” facility. This authority lapsed in 1981. Since then, the Fed is no longer allowed to lend directly to the Treasury.
A more modern, rules-based, form of fiscal-monetary coordination would be to align both fiscal and monetary policies trajectory to macroeconomic targets/thresholds (growth/inflation/unemployment),. This approach circumvents the, at times, messy and cumbersome, political process which may hinder counter-cyclical fiscal policy. The ‘Sahm Rule’ (recession indicator), for example, can act as the trigger for immediate fiscal stimulus when monetary policy is close to the ELB. Finally, there may be future means – enabled by technology – whereby the CB can bypass the banking system, at least initially (through central bank digital currency), and inject cash directly to targeted recipients.
Monetized Fiscal Expansion in the Context of the US Economy
As argued, the impact of monetized fiscal expansion depends largely on context, underlying conditions, and the overriding superstructures underlying each economy. In the context of the US, monetized fiscal expansion will create stronger demand if targeted at money/credit constrained entities. High unemployment and low inflation exacerbated by the Covid-19 pandemic points to low utilization of economic resources, especially labour. Hence, demand, we believe, is likely to create its own supply through higher employment and capacity utilization – real GDP expansion with benign inflationary pressures. Stimulus will be more impactful for the domestic low productivity services/consumption-based sectors (as the economy starts opening up from Covid-19) – lowering unemployment and leading to higher services inflation (the extent depending on the magnitude of stimulus provided).
However, the superstructures under-lying the US economy – high concentration of wealth, narrow ownership of the factors of production, low global marginal costs of real/financial supply production, suggests that 2nd-order multipliers will not be high (close to zero) should such conditions remain entrenched (wealth will be hoarded). Further, the US is likely to see significant demand leakage, coming through in the form of a widening current account deficit (as already evidenced by rising current account surpluses in surplus economies following the pandemic relief package).
Most significantly, the use of monetized fiscal expansion policies without major changes in both domestic and global economic structures (shifts in income share, labour/industrial policy, real investment, employment beta to growth, anti-trust, corporate/managerial class taxation and welfare reforms, reform of global financial architecture – especially the bancor initiative) will not, we believe, be able to revive the US economy sustainably. A well-designed systematic strategy which encompasses socio-economic, financial and geo-political reforms are required, rather than just domestic demand side management policies.
Conclusion
Academic evolution and its influence on policy-making have always been circumstantial (material interactions/constraints) throughout history. A shift has occurred, we believe, in economic consensus that neo-liberalism has failed in delivering sustainable economic prosperity for all (though we suspect that neo-liberal elites, to stay relevant, are seeking to revamp and co-opt other schools of thought). The same applies to Friedman’s monetarism and the dominance of central banking over economic and financial policies. There is no “end of history”. We support the premise that monetized fiscal expansion is simply a matter of policy choice for governments that are monopoly issuers of fiat currency, operating under specific circumstances as described. We strongly endorsed the framework that macroeconomic policies, including fiscal, should always be analyzed in aggregate (flow-of-funds and sectoral balance approach), considering only actual outcomes (which admittedly can be multi-faceted, considering the complexity of understanding the impact on a sovereign’s superstructures). As per Lerner, macroeconomic policies “shall all be undertaken with an eye only to the results of these actions… not to any established traditional doctrine about what is sound or unsound”, where sound and unsound to us purely reflects one’s ideological leanings and preferences of each economic-socio-political structure (material constraints).
We appreciate the potential benefits of introducing monetized fiscal expansion as part of the macro policy toolkit. First, its efficacy in achieving inflation targets is, we believe, more effective vis-à-vis other forms of policy. The current global context also warrants a larger fiscal response, coupled with synchronized monetary policy-making (the pandemic has inevitably triggered an era of fiscal-monetary coordination globally, to varying degrees). A well-targeted fiscal stimulus program can also help address structural issues plaguing the global economy, such as unemployment, income inequality and addressing longer term global challenges such as climate change.
Yet, monetized fiscal spending is far from a panacea to achieve global prosperity. In essence, whether spending will be conducive for sustainable future growth depends on the prevailing “return on assets” (RoA) vs the “cost of liabilities” (CoL) for the economy (the appendix illustrates how assets/liabilities shift across different macroeconomic agents). While, technically, the monetary authority can suppress nominal interest rates infinitely, the CoL may increase via other channels – including inflation, financial instability, indebted demand coupled with minimal growth/inflation. Critiques include the trivialization of political constraints and the downplaying of its short-comings (political dominance, fiscal indiscipline, impact on aggregate supply due to skewed incentives, practicality). MMT policy recommendations such as a federal job guarantee lacks practicality. Most importantly, proponents do not comprehensively lay out the underlying conditions and circumstances whereby monetized fiscal expansion can be most effective/counter-productive. These become obvious once we consider superstructures which affect the quality and distributional impact of spending (impact on wealth velocity/capacities; aggregate supply/demand responses; >2nd order impact and the sustainability of such policies).
Appendix
Understanding aggregate sectoral balance sheet accounting and the implications from types of fiscal financing.
To analyze the potential implications of monetized fiscal expansion, one must first ascertain how components within the aggregate sectoral balance sheets are likely to shift. Note the premise that the government sector – given its status as the monopoly issuer of a fiat currency – can undertake money creation and inject net financial assets into the economy. We compare various types of financing for monetized fiscal expansion, i) bond-financed fiscal expansion, ii) bond-financed fiscal expansion coupled with CB quantitative easing (QE), and iii) QE alone. On a side note, Professor Steve Keen provides a more detailed treatment of various monetary operations.
For our purposes, the different scenarios encompassing the above fiscal-monetary policy choices can be summed up below:
As shown above, a money-financed fiscal expansion will largely resemble that of a debt-financed fiscal expansion coupled with QE (no material difference in sectoral balance sheet component shifts). The only difference is the nature of liabilities and assets in the government sector (as opposed to bills/government bonds in a debt-financed fiscal expansion, net liabilities built up by the treasury can be in the form of IOU to the central bank). On a consolidated basis, the government sector will run an identical net liabilities position in the form of banking system reserves under both scenarios.
On a side note, the above also illustrates why QE has had limited impact on aggregate spending/income. QE does not directly inject income into private sector balance sheets, but simply represents an asset swap within the banking system (government debt to reserves), coupled with the balance sheet expansion at the central bank. There is essentially no stimulus provided to the economy (outside of purported second order impact via wealth effects from portfolio rebalancing and enhanced forward guidance).
Monetized fiscal expansion can be executed in various forms (degrees of fiscal-monetary coordination; net injection of liquidity/sterilization; duration/liquidity of government liabilities). This is more a matter of choice and depends on the treasury’s financing strategy.
The continuation/evolution of US foreign policy will have a meaningful impact on the shape of the new world order in the coming years. The Trump electoral victory was able to seize upon popular anger against the “globalists”, though policies enacted lack strategic direction and clear objectives. Meanwhile, Biden’s foreign policy ideas remain ambiguous at this juncture. Policies are always circumstantial to an extent, the willingness and ability for the US to assume leadership/maintain hegemony in global finance and military security will also evolve as underlying conditions shift.
Many neoliberalists long for a return to the “post-war international liberal order” (some believe can be partially restored under a Biden administration) but benefits to the US are no longer obvious. Global security and trade architecture depend largely on the US which consumes both military and economic resources. Globalisation required US leadership in creating the institutional infrastructure and gaining global acceptance of this shift. The Cold War provided US the commitment and motivation in safeguarding this arrangement.
In recent years, Allies have played a diminishing role in its own security, focusing instead on their own economic development (some developed export-oriented models ultimately reliant on US demand). Post-Cold War and into the “end of history”, the ascendancy of neo-liberal and neo-conservative (globalists/ interventionists) ideals and their dominance in US policy-making led to a period where the US continues to play its global security role (albeit with many mishaps) without a clear raison d’etre. The US security arrangement and the accompanying global economic structure enabled conditions for surplus economies to tap into global demand, while deficit economies were able to attract financial capital. Large corporations gained (trade liberalisation/regional stability/security of sea-routes), Wall Street enlarged its global financial footprint (global financialization).
However, following the ascendancy of a popular “revolt” reflecting poor socio-economic outcomes, the US are likely to turn towards addressing domestic grievances no matter the election outcome. These will include i) the international trade architecture which led to large/persistent external imbalances and the distributional effects for US industries and communities, ii) the international security architecture and its inherent burden-sharing with regards to costs (finances, military resources and lost economic opportunities), iii) reforming global institutions based on shared principles (rather than legalistic rules-setting) and enforcement mechanisms, and iv) minimising wastage of resources (foreign military campaigns not aligned to US welfare and lacks burden sharing).
Global rebalancing requires a strategic rethink of global economic growth models rather than just reflecting circumstances. We think much of the “improvement” in external balances post-GFC is “forced” rather than “structural”. The sharp re-widening of global imbalances YTD reflects the difference in the immediate economic policy response to the pandemic amongst major economies – whether this represents a continued rigidness/reluctance to change depends a lot on the political will to rebalance towards domestic demand within surplus countries.
We have previously highlighted the lack of direct FX intervention by the PBoC (FX intervention is no longer done via the accumulation of official FX reserves). RMB’s relative stability amidst external surpluses in Q2/Q3 likely reflects indirect intervention via other economic agents. For example, banks’ net foreign assets accumulation amounted to >USD 250bn across Q2-Q3.
The debate surrounding MMT intensifies. Most arguments, however, fail to comprehensively lay out the underlying conditions upon which money-based fiscal expansion may be more/less appropriate. Money-based fiscal expansion or fiscal-monetary coordination can take place in many different forms – whether they can help support sustainable growth (before hitting real economic constraints) depend essentially on i) how assets/liabilities shift between economic agents, ii) socio-political-economic structures which determine the quality of spending and income distribution, iii) an economy’s inherent capacity to adequately absorb a larger wealth stock, iv) the global economic structure/financial architecture, and v) the political mechanisms through which such policies are implemented.
We expect fiscal-monetary policy coordination to be increasingly common globally in the coming years; and will seek to explain further in future posts.
What is clear is the dominance of the US and China on both sides of the global balance sheet. We think this reflects the contrast in the proportion of supply vs demand-side based stimulus provided by both countries (with other important drivers including commodity prices and employment schemes in EU contributing to the erosion of surpluses). We touched upon how BoP dynamics are part of PBoC’s inherent considerations behind its policy stance.
New World Order
Beware the long arms of American and Chinese law (Financial Times)
Navigating the new world order requires one to fully understand its strengths and weaknesses, trade-offs in policymaking while making efforts to make one more robust. Hence the importance of self-sufficiency in the coming years. The previous model where one can leverage on global demand amid a stable geo-political and security environment have seen its days.
Germany is being forced to take a leadership role it never wanted (The Economist)
The world needs a united EU, which requires Germany to increasingly fill its role as the political-economic hegemon of Europe. We continue to monitor closely how the debate evolves, especially heading into a critical election cycle.
Atlanticism will remain in retreat, whoever wins the US election (Financial Times)
The world’s geo-political relationships are in flux in times of a change in the world order as competing and symbiotic objectives clashes and are brought to the surface.
Limits of current growth model and need for reforms.
Recent years’ performance to an extent reflects the cushion provided by monetary policies. However, the negative side-effects will increasingly weigh on future expansion with cycles shortening. This reflects the adverse impact of the reversal rate and the ossification of the economic structure due to accommodative monetary policies. The need for a rethink in the economic growth models pursued everywhere and the importance of new economic growth strategies will determine economic, political and market outcomes in the near future.
On China.
Xi’s Dual Circulation Strategy: Can it succeed? (George Magnus)
China’s dual-circulation strategy (“DCS”) entails an inevitable recognition of the need to address deficient domestic demand, to achieve self-sufficiency in key sectors, and advancements in critical technologies (these reflect the rapidly shifting dynamics in the global order as argued before). Hence, ‘domestic circulation’ is very much placed at the forefront of DCS (“国内大循环为主体”). ‘International circulation’ re-emphasises China’s openness to trade/selective opening up of markets, but only if the above pre-conditions are met. As opposed to the author, we think it may not necessarily imply an inherent fixation on widening its external surplus (i.e. a shrinking external surplus should not be seen as contradictory to DCS); nor should it necessarily be non-conducive for growth dynamics in the longer run.
The China Dashboard – Summer 2020 (D.Rosen & L.Gloudeman, Rhodium Group)
While domestic circulation is deemed to be at the forefront of DCS, stimulus during the Covid-19 pandemic has focused almost exclusively on supply-side measures. China’s recovery since has been driven predominantly by infrastructure, property construction and exports while consumption detracted. Debt burdens have also worsened.
While policy flexibility provides future options, it at the same time causes confusion. This is especially so considering that different Committee and market participants are interpreting policies differently. See too.
The lack of PBoC balance sheet expansion since the Covid-19 pandemic stands in contrast with that of advanced economies and has garnered increasing attention recently. We think, however, that conceptually there need not be a direct relationship between the size of the central bank’s balance sheet and its policy stance. This is especially the case for China, where the largely state-owned financing system enables the PBoC to have much more direct control over the economy’s money supply/credit growth (price, quantity, administrative/regulatory – both over supply and target of money/credit flows) vs. other jurisdictions.
source: Bloomberg
The relatively unchanged size of the PBoC’s balance sheet in recent years reflect other factors (some of which are within balance of payments dynamics), such as: a) shrinkage of the current account surplus (hence less need/space for FX reserve accumulation), b) the recycling of external surplus towards the Belt-Road-Initiative (this is done largely through policy/state banks and thus outside of PBoC’s balance sheet), 3) the channeling of FX intervention through the large state banks, 4) higher inherent capital outflows found in E&O, and 5) the shifting of liquidity injections to shorter-term OMO operations, and 6) only a modest increase in claims on banks (relending/rediscount programmes/various credit facilities), amongst others. Movements (or lack thereof) in such balance sheet components should not be taken as definitive indications of PBoC’s policy stance. This is notwithstanding the institutional illegality to purchase government bonds in primary markets, and a seemingly sustained philosophical leaning against QE-like asset purchases from the PBoC.
PBoC’s Restraint and its Inherent Considerations
The PBoC’s monetary policy restraint since the Covid-19 outbreak is instead more apparent through other channels as we consider its wide-ranging toolkit. For example, net OMO operations have largely shown neutral/negative liquidity injection over the course of Jul-Aug (following a complete halt from Apr-late-May), while usage of the MLF is rising but still muted. Price-based stimulus is also limited, with the OMO/MLF rates left unchanged since the 30bps cuts in February-March. Both M2 growth and TSF flow have also peaked in recent months, and at levels far below advanced economies. Onshore markets have since interpreted a pivot in PBoC policy via the rise in onshore bond yields since the peak of the crisis. Since May, the CGB curve bear-flattened and year-to-date moves contrast with those in developed rates markets (this is also compounded by the rise in local-government bond issuances).
source: Bloomberg
source: Bloomberg
In our view, PBoC’s policy restraint thus far stems from three main considerations:
(1) Authorities are cognizant of risks surrounding another significant rise in leverage from here; given that much of policy ammunition have cumulatively been exhausted between 2008 and 2019. Beyond absolute levels of debt, the economy’s ability to take on ever-higher levels of leverage within its current institutional framework has clearly weakened, evident by the much lower return on capital in recent years.
(2) The financing system architecture domestically (via its embedded incentive structures/high concentration in both lending sources and destinations/deeper financial innovation) has also impeded monetary policy transmission previously. In this instance, the loosening in credit policy in the immediate aftermath of the virus outbreak resulted in a buildup of banking system structured deposits placed by corporates (these products typically combine traditional deposits with higher-return investment products; and provide a positive carry relative to onshore funding costs for large corporates/SOEs, essentially allowing them to run a financial arbitrage trade). Structured deposits contributed over 25% of the new banking system deposits from January to April. The re-emergence of financial arbitrage opportunities led to renewed concerns on financial system instability, and the inability of credit creation to be fully channeled into real economic activity.
(3) Another argument behind PBoC’s monetary conservatism – articulated in this particular FT article – pertains to CN’s balance of payments. The article highlighted the linkage between a deteriorating US-China relationship and the subsequent incentive to maintain/rebuild economic buffers. Indeed, we have noted the tendency for Chinese authorities to shore up balance of payments defences during periods of increased vulnerabilities (supply-side stimulus/tightened capital controls etc.). Considering the global response to the pandemic, we expect CN’s current account surplus to further widen going forward, with the drivers including lower commodity prices and the lack of travel (recall capital outflows being disguised as tourist services outflows as flagged out earlier). The focus on supply-side stimulus (geared towards production rather than demand) so far is also juxtaposed with a higher proportion of demand-side stimulus in advanced economies (e.g.UE benefits in the US/furlough or ST employment schemes in EU). At the same time, we expect capital outflows to continue to remain very restrained – SOEs/large corporates are likely to be dis-incentivized to pursue large-scale M&A or asset purchases overseas. Measures pertaining to the capital account will likely be concentrated on driving portfolio inflows. The irony is that, while balance of payments pressures will be less of a constraint/concern for China going forward, a corresponding wider external deficit (likely borne by the US again) for the rest of the world risks worsening US-China relations – back to the central theme of the article. The impact on the rest of the world is also likely to be dis-inflationary.
Considerations (ii) and (iii) will be more temporary in nature. Recently, CBIRC has tightened the regulation on structured deposits, and has required all banks to reduce the size of such products. We do not see balance of payments pressures building to an extent which threatens China’s reserve position as well. As such, developments thus far may not represent a prolonged hawkish monetary policy stance. As financial arbitrage/leverage mechanisms are partially nullified, and the widening of external surpluses become more apparent/prolonged, conditions will likely be more conducive for PBoC to resume a net easing stance before year-end; albeit limited in degree and targeted in nature. The pressure to ease policy should also intensify as higher CGB yields are counter-productive to cope with the economic downturn (instead, we think the domestic economy will benefit from lower risk-free rates but more differentiation in risk-based credit spreads).
PBoC’s Policy Stance and ‘Dual-Circulation’
We continue to see PBoC’s overall policy stance as a key component in relation to the broader economy; previously we have highlighted the need – both domestically, and from a global re-balancing standpoint – for the Chinese economy to rebalance towards domestic consumption. It remains far from clear if the recent public emphasis on 双循环理论 (dual-circulation/feedback) would indicate such a policy shift in the near term (we suspect that it would resemble more a sectoral shift in industrial policies, prioritizing self-sufficiency in strategic segments/markets and focusing on broader technological innovation).
Ultimately, a healthy re-balancing will require a higher income share for households. This can come directly via improved wages or enhanced social security. Income distribution may also occur indirectly via elements such as strength/weakness of the currency, the degree of speculative activity in residential property, the extent of the credit cycle, and which segments of the economy do credit flow to/from, amongst others. All these elements will continue to be heavily influenced by PBoC’s overall policy stance going forward, regardless of its balance sheet size.
Moreover, income shifts can occur via inherent cost attribution, this is especially pertinent as credit risks/bad debt inevitably rise (beyond reported NPL ratios in the banking system) amidst the economic slowdown. CN’s inherent credit costs have historically been funded by financial repression of the masses (via deeply negative real deposit rates on captive savings), that has contributed to the low consumption share of income previously. A rebalance to domestic consumption will require inherent credit costs to be attributed to other economic agents this time round. We have seen initial signs of costs shifting to the banking system – authorities have ‘encouraged’ banks to sacrifice up to RMB 1.5trn in profits. The headline figure (>70% of banking system’s 2019 net profits) appears significant, although details suggest the majority are likely to come in the form of forgone opportunity costs (via rate cuts, reduced service fees, and loan repayment deferments) which will be amortized over a prolonged period of time.
Even as PBoC’s balance sheet (as a proportion of GDP) declines – especially relative to other central banks – its overall policy stance and its inherent intentions/trade-offs will continue to play a critical role in China’s economic trajectory.
1. Negative real rates essentially becomes an explicit policy objective.
2. The new policy introduces an element of a ‘make-up’ strategy to inflation but characterizes the approach as “flexible”. There is no formulaic commitment (both in terms of the extent of ‘tolerable’ inflation overshoot and the length of time the overshoot can be ‘tolerated’). We think this preserves optionality for the Fed, as one would expect different degrees of tolerance depending on the sustainability and nature of inflation (demand/supply-led for example).
3. Retaining this optionality comes with its inherent trade-off. We think this complicates forward guidance (essentially both a calendar-based/outcome-based forward guidance may be less relevant/useful) as it leaves the framework open to interpretation, alongside a very high degree of subjectivity. The new policy framework may entail different policy considerations for FOMC members with differing views and a clearly-communicated context underlying future policy decisions will be needed – notwithstanding the lack of consensus even within the Committee.
4. The relationship between UE and inflation has been re-assessed. This is partly an acknowledgement that the 2015 rates hikes were, on hindsight, premature. Policy response towards the UE rate – and its relationship with the un-observable NAIRU – will change. The FOMC now defines the “maximum level of employment” as ‘a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market.’ Through that statement, the Fed explicitly recognizes that a focus on headline inflation fails to account for higher unemployment among disadvantaged populations. It also means a low UE rate, by itself, will be insufficient to justify tighter policy without sustained inflationary pressures. Technically, the change embeds an asymmetric policy response to the labor market, changing the policy rule term within Taylor Rule from (u* – u) to min(u* – u, 0). Unemployment higher than NAIRU leads to policy accommodation while the term drops off once it falls below without any corresponding policy tightening post recovery into expansions.
5. The formalization of the framework review will soon be followed up by an update of the Fed’s toolkit. The recent Fed minutes suggest that the addition of some form of Yield Curve Control/Targeting (YCC/YCT) into the toolkit is not imminent (understandably so given the lack of incremental benefits at this juncture). We note that adding YCC to the toolkit ≠ utilization. That said, YCC may be inevitable at some point should underlying conditions force further sustained balance sheet expansion – given the inherent technical constraints of QE (such as the proportion of excess reserves in the banking system’s balance sheet). YCC, we believe, is highly likely to come before negative policy rates is even contemplated.
6. The promise to tolerate higher inflation vis-à-vis the ability to generate higher inflation are two separate issues. Current underlying conditions (higher debt stock -> debt deflation, lack of aggregate demand, no wage-driven inflation, the strengthening of big vs. small -> oligopolistic nature of economy etc., no meaningful global re-balancing) are significant impediments to generating sustainable demand-led inflation. Inflation, at best, will likely be sector-specific (sectors most meaningfully impacted by Covid-19 on the supply-side – staples/commods, or see one-off demand spike – healthcare, logistics, personal transport vehicles), and which will mostly be offset by weaker spending elsewhere. Unfortunately, AIT works best in a typical late-cycle expansion (when Fed’s credibility will be most critical) – this is not a valid consideration at this juncture, with employment/inflation way below target, and effective transmission of monetary policy suspect. Hence, less relevant considering current circumstances. Moreover, it allows a bear-steepener during better times, which helps restore profitability to the financial system (vs. a typical bear-flattener without AIT), but similarly less relevant considering current circumstances.
7. On a standalone basis, the formalization of the AIT framework resembles more an intensification of the current regime, rather than a regime shift, especially once we consider the overall policy mix both globally and domestically. Incrementally, it justifies a marginal higher move in breakevens, a steeper curve but at an un-stable/fragile equilibrium (we have previously argued here for why the current regime is unsustainable and a shift imminent/inevitable), but nothing much beyond.
8. We continue to expect a deeper state of financial repression. However, underlying conditions are unlikely to allow CB-engineered financial repression – on its own – to work this time round (which we define as the ability to generate higher demand-led income growth and subsequently deleveraging via ‘healthy inflation’). Instead, side effects will intensify – such as elevated leverage, wealth disparity, reversal rates, zombification, anti-competition – hence leading to shortened future cycles – with less/zero scope for monetary policy offset. Real rates can stay negative even as disinflationary pressures persist, but clearly only to a very limited extent.
9. The Fed put is, however, still operational, should the sell-off be driven by adverse market functioning and not economic downturn. The Fed can support markets by being the bidder-of-last-resort in thin markets. While its credit guarantee programs are extremely powerful (defers default driven by liquidity and protects FIs through risk transfer), insolvency driven by a prolonged downturn will still damage markets through spill-overs (limited Fed ability to short circuit solvency led sell-off). The Fed has limited space, if any, to support income – either through lower debt-servicing or by driving higher demand (broken policy transmission).
10. That said, it is now difficult to envisage an environment whereby the ground is more fertile for well-designed fiscal policies than the current one. Politics now favor income support to the consuming class, financing costs are low, there are high buffers to inflation constraints, and now a credible assurance that fiscal spend will not encounter a counteracting monetary policy from the Fed. The O/N move in rates on the day of the announcement suggested some optimism towards a post-election fiscal outcome.
Implications on Rates Markets
– The tightened control at the front-end of the curve – & assuming the ZLB stays – will increasingly limit the possibilities in which the spot curve can move. We expect the long-ends to increasingly lead any directional move from here on, with the curve only capable of meaningful bear-steepening/bull-flattening as conditions improve/deteriorate. A meaningful bull-steepener will require deeply negative rates (in this instance, the forward curve may remain stable via a much steeper curve which is negative in absolute terms, but clearly the hurdle is very high at the current juncture); whereas under the new framework, a meaningful bear-flattener will perhaps be years away.
– Clean positioning and low absolute levels pricing to near-perfection (suppressed term premia + positive odds for negative rates priced) suggests that the hurdle to higher rates is un-demanding. The extent, however, will be capped by the overwhelming dis-inflationary dynamics of the current regime.
– A much more meaningful move higher in our anchor levels for rates will require a shift in policy regime (confidence over a Treasury-Fed coordination needs to intensify, and subsequently, proven) – depending on political dynamics. The fiscal outlook will play an outsized role in determining the trajectory of markets, including rates, depending on the outcome of the Nov US elections. Should fiscal activism gain ascendency, the role of the Fed as either fiscal enabler or as a “responsible and independent” institute (which the new framework dilutes to an extent) counteracting fiscal authorities will be important in deciding the success of the fiscal program and the trajectory of rates.
– Higher rates will also require policy regime shifts beyond the US. We note the increasing recognition by major surplus countries to focus on generating more sustainable sources of domestic demand. Developments such as the EU Recovery Fund, the relatively quick and expansionary fiscal response in the EU and increased signaling by Chinese authorities on the need to close the income gap and rebalance towards domestic demand are the positive signs. The above are conditions necessary for a ‘Great Reset’, but only if they persist in a greater scale and highly dependent on a sustained shift in political-economic philosophy and policy execution.
– We will seek to explain policy regime shifts and their implications in future posts.
Our reaction to an intriguing debate held by the Jain Family Institute (twitter thread link below). Moreover, we do not think the idea of endogenous money or the focus on accounting identities (& their adjustment mechanisms) negate Pettis/Klein’s arguments in any way.
