John Pattullo, Co-Head of Strategic Fixed Income, explains how after the failure of QE to generate any sustainable growth or inflation the dial has turned to various forms of fiscal policy. But as he argues, a successful formula has to combine fiscal and monetary policies with structural reform.
"Do you remember the Great Financial Crisis?“ Ahh — you mean the one we are still in…
It is rather amusing that we sometimes get asked the above question. We need to remind some clients that we are very much still in the crisis.
The crisis happened for a number of reasons but primarily because of the enormous amounts of debt raised by households, corporations and governments. Hence, a lot of the economic ‘growth’ was financed by increasing debt in an unsustainable way. Remember the ‘Great Moderation’?1 Hmm…
Eleven years on, as the chart demonstrates, the vast majority of countries have more debt than before the crisis began — a few have managed to partially reduce their debt. So, how on earth can the crisis be over?
Debt loads higher than pre-crisis
Source: Thomson Reuters Datastream, BIS, Janus Henderson Investors, change in aggregate debt, 2008 versus 2018, annual, as at 31 December 2018
Note: Aggregates for household, corporate and government
There are no easy solutions to reducing too much debt. A number of options are available, such as growth and inflation (which are hard to come by), austerity, default and/or financial repression2 (more on this later). But the not so distant past may have lessons that can help.
It was back in 2011 that we started talking about Richard Koo’s balance sheet recession3 thesis. It is extraordinary how reading one book (The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, 2009) can completely change your view on economics and the bond markets.
In 2009, he prophetically forecast that Europe would turn Japanese. We have talked about this for years but it is only recently that our inbox has become full of ‘Japanification’ articles on Europe. This backdrop explains why we have maintained a much longer duration in our portfolios for much of the time compared to many in our peer group, given our rejection of mainstream conventional economics.
Rather bizarrely, we are pleased to still get some push back on our views from the (older) part of our client base, which means there is still money to be made in bonds. Some of our clients remain short of duration or have tried their luck diversifying into alternatives, away from quality, long duration bonds. Most though, who are younger than me (49 in May — urgh!), agree with our disinflationary outlook.
We feel that the long-term secular drivers such as demographics, technology, excessive debt and low productivity, will dominate and lead to lower global bond yields. We doubt whether we can sustainably breakout into higher inflation and growth but it does not mean that politicians, with a democratic mandate, could try something completely different (more on this later).
Wot no growth, wot no inflation?
Here’s the title slide from our 2013 UK New Year Conference presentation.
Our 2013 presentation cover — still relevant today?
Source: Janus Henderson Investors, January 2013
In the presentation we highlighted how small the money multiplier could be compared to the fiscal multiplier in a severely depressed economy. Our message was that fiscal policy tools should be employed to restore growth but there was no political will at the time for such measures.
The Global Financial Crisis was no ordinary recession; this was a ‘balance sheet’ recession whereby individuals and corporates changed their behaviour towards borrowing and spending after the trauma of experiencing negative equity. In such circumstances, lowering interest rates does no good and policies focusing heavily on the monetary side may not be effective, as we have seen.
Monetary policy broadly became independent in the 1990s (in many countries) with the aim of taking politics out of the business cycle. Keynesian fiscal expansion was pretty much dismissed by conventional economists during this period as being ineffective. As the dogmatic Maastricht Treaty removed the possibility of fiscal expansion in Europe, the ‘one-clubbed golfer’ of independent interest rates seemed to be the only policy tool.
While it is true that quantitative easing (QE) has massively expanded the monetary base, as Mr Koo demonstrates, it completely decoupled from the growth in bank lending and money supply. We have definitely created asset price inflation in Wall Street with no ‘trickle down’ effect into Main Street. The palliative needed was something along the Koo Theory.
In ‘Koo Theory’, the government needs to borrow all the private sector surplus and redistribute via fiscal policy to stop the economy shrinking into oblivion. This very much chimes with the secular stagnation4/excessive savings hypothesis of American economist, Larry Summers. Unfortunately, our policymakers do not subscribe to the Koo thesis. If all this surplus is not redistributed you get a deficit of demand and deflation — anyone mention Europe?
Why then was monetary policy not combined with fiscal policy? Surely, they should be complementary and not treated as substitutes. Italy, for example, would have welcomed (still welcomes) a massive fiscal expansion (even though the Maastricht Treaty prevents it). As Koo points out, you need structural reform before a fiscal expansion otherwise it will fail. Indeed, he said that 80% of the necessary change is structural reform, followed by fiscal expansion. Note that this third arrow of structural reform was never delivered in Japan.
Somewhat ironically, the inequality brought about by QE has led to the populist backlash in developed economies as well as calls for Modern Monetary Theory (MMT)5/fiscal expansion — but let’s not confuse the two for now.
Anyway, what’s all this MMT chat?
Modern Monetary Theory is really just a politicisation of fiscal spending with unlimited constraint. No one constrained the British and the American fiscal expansion in World War II (WW2); tanks and warships were needed, so they were made. The idea was that governments spend as much as needed to achieve the desired outcome and worry about financing the deficit at a later stage.
So, after the abject failure of QE to generate any sustainable growth or inflation, the political dial has now turned to fiscal policy. Now, governments are always keen to inflate away their debt — by running inflation higher than the nominal yield on the debt that they issue. This policy is called financial repression and is one way to deleverage an economy (reduce debt). Interestingly, the reduction in debt generally happens via growth in the economy (ie, higher GDP), which reduces the debt as a percentage of GDP but rarely a reduction in the absolute level of debt.
Since only very low inflation could be generated, interest rates had to go even lower to try to reflate the economies but also to enable negative real interest rates (to repress you and I!). Rest assured, further financial repression is both required and necessary to reduce global debt levels but the current rate of progress is too slow.
Times are different now?
The economic downturn that we are in is not going to recover to previously normal levels. Given poor demographics and productivity, the future trend rate of growth in both the US and UK is around 1.5-1.75%. We are in a different regime after the ‘heart attack’ of 2008 — one of low growth, low inflation and increasing financial repression. As mentioned earlier, Richard Koo has called for a wartime response on the fiscal side as this is wartime economics but currently nobody has the political mandate to justify such a response, although things are changing fast.
So this brings us back to MMT
The theory that a government cannot default on its debts if those debts were issued in its own currency is not new. There is also a vast amount of economic literature on whether fiscal deficits matter. Still, this is certainty getting a big (political) push nowadays.
It is hard to argue that significant expansion in infrastructure, housing, technology, transport and education would not boost the economy and, would surely have a much bigger multiplier effect than QE. The tricky bit is how it is financed and the potential repression (redistribution) of wealth that goes with it. Could such a stimulus offset the long-term secular drivers? Possibly, but we are not convinced.
In Koo’s words, “MMT proponents are correct in arguing we need enough fiscal stimuli to absorb the private sector savings surplus. However, this does not necessarily mean we need the central bank to directly finance the stimulus”*. This is a key point in the MMT debate, which many people confuse — the stimulus should be funded from a private sector savings surplus not by the central bank.
*Nomura, Richard Koo, research paper titled: “MMT and the EU’s growing sense of crisis”, 23 April 2019
MMT fears — UK to be a test case?
What if the UK tried a massive Corbyn’s ‘People’s QE’6 programme? Well, it depends on its credibility and how it is financed. This could be accompanied by rising gilt yields, inflation and a sterling crisis — or possibly not. Bondholders would be repressed as inflation took off. Yield curves could steepen aggressively while the rich would be taxed heavily. Could the Bank of England lose its independence? We feel this scenario is less likely, but that does not mean we are not worried about markets worrying about it.
A more subtle, more palatable, approach could involve the central bank anchoring bond yields at a low (repressing) level set by law. The government could then issue endless bonds to the central bank to finance the fiscal expansion. This would be a more controlled expansion with some repression. It would probably involve capital controls (to stop capital escaping overseas) and financial regulation, eventually forcing financial institutions to be forced buyers of gilts once the central bank is full!
Neither sounds great for bondholders; but again, and as always, we turn to Japan where they still have not conjured up any meaningful or sustainable growth or inflation. One of their main impediments is the combination of abysmal demographics and lack of structural reform.
America and China have had some success with fiscal expansions, whereas Greece, Cyprus and Iceland have already had several degrees of repression and indeed capital controls. Many forget that UK citizens were repressed for decades post WW2 under varying forms of legislation. France, also massively reduced large government borrowing levels after WW2 by running inflation (at times over 20%) but keeping bond yields at around 6% by law. UK citizens are currently being repressed with bond yields at 1% but inflation at 2%.
So what will work?
We have sympathy for fiscal, monetary and structural reform — working together — but say no to MMT if badly financed. It is the combination of these factors that is key.
Fiscal policy can be effective if credibly financed and used at the right time in the cycle. Further, it must be invested and not consumed. Debate continues about the financing angle with regards to MMT, much of which is political and highly ideological (the heterodox school of economics), to which this is no definitive answer. Politics may also throw a spanner in the works as to the effectiveness (or credible financing) of a fiscal expansion.
Approach and positioning
We remain flexible in our approach but are mindful of MMT risk and hence remain very selective by company, and by country when we invest our clients’ money. Living in the UK, having studied the Japanese experience but investing in developed world bond markets, may not be a bad position to assess the scene and provide sensible bond returns going forwards.
Though forecasting is tricky, today we actually think US bond yields are cheap and, as real yields are positive, there is still capital to be made in US bond markets while that economy slowly turns Japanese. The UK and parts of Europe already have negative real yields (we are being repressed slowly). Our portfolios are barely exposed to UK corporate bonds for good reason and we prefer US corporate (and government) bonds as well as Australian sovereign bonds.
We invest thematically in a secular sense — you will get shorter term cyclical swings such as the two-year Trump reflation trade, which can confuse the narrative — but we continue to believe that most developed world bond yields are heading lower.
- The Great Moderation: a period of economic stability characterised by low inflation, positive economic growth and the belief that the boom and bust cycles had been overcome. In the UK it generally refers to the period between 1993 and 2007.
- Financial repression: in simple terms, using regulations and policies to force down interest rates below the rate of inflation; also known as a ‘stealth tax’ that rewards debtors but punishes savers.
- Balance sheet recession: said to occur when high levels of private sector debt cause individuals and/or companies to focus on saving by paying down debt rather than spending or investing, which in turn results in slow economic growth or even decline. The term is attributed to the economist, Richard Koo.
- Secular stagnation: a prolonged period of low or no economic growth within an economy (excessive savings act as a drag on demand, reducing economic growth and inflation).
- Modern Monetary Theory (MMT): an unorthodox approach to economic management, which in simple terms argues that countries that issue their own currencies can ‘never run out of money’ the way people or businesses can. In other words, governments that have control of the monetary policy are not constrained by tax revenues for their spending. Developed in the 1990s, it has recently become a major topic of debate among US Democrats and economists.
- People’s quantitative easing: a policy proposed by the UK Labour Party leader, Jeremy Corbyn, which would require the Treasury (Debt Management Office) to create money to finance government investments on infrastructure via a public investment bank.