THE BIRTH OF AN ALTERNATE REALITY
Part One of this series, covered the political and social ‘alternate reality’ that the world finds itself in. Significant changes were already happening prior to the COVID-19 pandemic. These changes were supercharged during the COVID-19 pandemic, creating lasting shades of ‘new normal’. When the pandemic hit, further shades were added to our regular lexicon that were both directly related our efforts at reducing COVID-19 infections; and to our forced lifestyle changes. In all, 35 shades of ‘new normal’ were covered in Part One.
In this part, 9 further shades in what we will call the new normal of ‘Crazynomics’ will be covered.
Development of Macroeconomic Policy
In 2005 Stephen J. Dubner, a University of Chicago economist and Steven Levitt, New York Times journalist wrote a book called ‘Freakonomics’ which explores unintended consequences, both positive and negative, of various policies and business decisions.[i] Today we are observing the birth of a ‘new normal’ that can only be described as ‘Crazyian Economics’ or Crazynomics, as some of the most foundational principles of economics are being significantly challenged.
The application of macroeconomics policies began in 1936 with the publication of John Maynard Keynes’s “The General Theory of Employment, Interest and Money”. Keynes’ view was that Governments were supposed to run large deficits (i.e., spending more than they took in taxes) during downturns to prop up the economy, with the expectation that they would pay down the accumulated debt during the good times. By the 1970s, ‘Keynesian’ economics had encountered problems. The persistently high inflation and high unemployment of that decade (“stagflation”) baffled mainstream economists, who thought that the two variables almost always moved in opposite directions.
This resulted in the ‘Monetarist’ era in the 1980s, most commonly associated with the work of Milton Friedman, who’s critique of Keynesianism was that if policymakers tried to stimulate without tackling underlying structural deficiencies then they would raise inflation without bringing unemployment down. Thus, high inflation could then persist, just because it was what people came to expect. The monetarist ideas were implemented by the US Federal Reserve (The Fed), which enabled inflation to be crushed by constraining the money supply (interest rates at 18% were normal in that period); even though doing so also produced a recession that sent unemployment soaring. Many monetarists argued that policymakers before them had focused too much on equality of incomes and wealth to the detriment of economic efficiency. They argued that focusing on the basics—such as low and stable inflation—would, over the long run, create the conditions in which living standards would rise for everyone.
From ‘Keynesian’ to ‘Crazyian’ Economics
This dominant economic paradigm began to show strain after the global financial crisis of 2007-09, as policymakers were confronted by two big problems. The first was that the level of demand in the economy, i.e. the aggregate desire to spend relative to the aggregate desire to save seemed to have been permanently reduced by the crisis. To fight the downturn in spending, central banks slashed interest rates and launched quantitative easing (QE), (or printing money to buy bonds).[ii]
Printing more money does not increase economic output – it only increases the amount of cash circulating in the economy. If more money is printed, consumers are able to demand more goods, but if firms still have the same amount of goods, they will respond by putting up prices. Thus, in a classical economic supply-demand model, ‘printing money’ should cause rampant inflation. However, this did not happen in the USA. Eventually, labour markets boomed, but inflation remained muted. Inflation and unemployment were once again not behaving as expected, though this time they were both surprisingly low.
This was not the only signal of the start of ‘Crazyian’ economics. Between March 2008 and December 2019, the US Fed’s balance sheet in terms of its total assets, ballooned from US$900 billion to US$4.5 trillion. This should also have meant that with such an oversupply of dollars, the exchange rate of the US dollars vis-à-vis other global currencies should have depreciated significantly. However, against all economic theory, even as the supply of the dollar increased 5-fold, the global demand US dollar also increased, thus strengthen it against most currencies.
This resulted in the following crazy scenarios. The US purchased billions of dollars of goods from China, and paid for them via quantitative easing (printing money). China used this money to not only improve its infrastructure, but also loan the money for infrastructure projects in its ‘Belt and Road Initiative’. It also used the money to purchase assets around the world, from real-estate to listed companies, some of them in highly sensitive industries. After all this spending, China still had money left over to send their US dollars back to USA and buy its Treasury Bonds, which the US Fed printed and sold to China!
The second post-financial-crisis problem related to the distribution of wealth. While concerns about the costs of globalisation and automation helped boost populist politics (e.g. “Make America Great Again”), economists asked in whose interests’ capitalism had lately been working. Some worried that big firms had become too powerful[iii]; others, that a globalised society was too sharp-edged or that social mobility was declining.
Negative Interest Rates – The Brave New World of Finance
By 2014 Crazyian economics was gathering pace; with economists much divided on the perceived wisdom of how to manage the economy. Central bankers were of the opinion that only an interest rate below zero would force a release of savings and generate enough demand to stimulate the economy. That was a point they could not easily reach, since if banks tried to charge negative interest rates, their customers might simply withdraw their cash and stuff it under the mattress, rather than spending it. The countries that have already felt the effects of negative interest rates are: Denmark (2012); Eurozone (2014); Switzerland (2015); Sweden (2015) and Japan (2016). In such countries and economic zones, the central banks usually charge about 0.1% interest on a portion of excess reserves financial institutions park with them.
The concept of ‘Negative Interest Rates’ turns the world of finance and investing on its head. For example:
Time has no Value in Money: A fundamental tenant of Finance is that there is a ‘Time Value of Money’. Money now is worth more than money later as, as you can invest the money today at an interest rate and get a higher compounded value later. If interest rates are negative, theoretically, companies can borrow money from banks and get paid by the bank for taking the loan. Interest will no longer be an expense but a revenue source; i.e. the more a company borrows from the bank, the more profit it can make!
Capital Budgeting Decision Rules Reversed: The weighted average cost-of-capital (WACC) is the hurdle-rate that drives all investment decisions. The WACC is a composite of the cost of debt and the cost of equity. One component of the cost of equity is the risk-free interest rate (such as the Treasury Bond rate) and another is the market rate of return. With negative interest rates the risk-free return will higher than the market return; thus, reversing traditional Capital Budgeting Decision Rules!
COVID-19 – Back to Keynesian Economics?
The coronavirus finally destroyed the ‘monetarist’ economic policies with the force of a nuclear bomb. Supply chains and production was disrupted simultaneously, resulting in both raw materials and finished goods becoming harder to come by in every country. This should have caused prices to surge, but notwithstanding some short-term profiteering in essential goods, prices have remained stable. The bigger impact of the pandemic has been on the demand side, causing expectations for future inflation and interest rates to fall even further. The desire to invest has plunged, while people across the rich world are now saving much of their income.[iv]
Even before COVID-19, policymakers were starting to focus once again on the greater effect of the bust and boom of the business cycle on the poor. But since the economy has been hit with a crisis that hurts the poorest hardest, a new sense of urgency has emerged. That is behind the shift in macroeconomics. Devising new ways of getting back to full employment is once again the top priority for economists.
But how to go about it? It appears that many rich countries have reverted to Keynesian economics by jointly providing fiscal stimuli worth some US$4.2 Trillion; proving wrong that policymakers cannot fight downturns. It also created a ‘new normal’ that was unimaginable prior to COVID-19; i.e. that most governments would actually place the health and safety of its citizens above politics, and close their economies down despite significant resistance from its populace – many of whom lost their sources of income. This enormous stimulus has calmed markets, stopped businesses from collapsing and protected household incomes. But for how long?
Policymakers now have to weigh up the risks to choose from in the post-COVID-19 world. There are many choices: widespread central-bank intervention in asset markets, ongoing increases in public debt or a shake-up of the financial system. However, an increasing number of economists’ fear that even these radical changes are not enough. They argue that deeper problems exist which can only be solved by structural reform.[v]
A Booming Stock Market in a Recession: WTF is Happening?
The coronavirus pandemic is producing some unusual developments in financial markets, challenging some historic correlations. Sharemarkets have surged since the trillion-dollar capital injections by the central banks; although the spread of the virus shows no signs of abating, especially in the USA due to the total mis-management of the pandemic by President Donald Trump.
Beyond the health crisis and its economic implications of a pending global recession, the upward trajectory of the sharemarkets continue. This is despite the escalation of political tensions between the world’s two largest economies – the US and China; China’s crackdown on civil liberties in Hong Kong – a key global financial centre; border conflicts between China and India; a potential collision between China and the West over issues as disparate as technology and the South China Sea and a looming election amid massive civil unrest in the US.
A surging sharemarket has historically been positively correlated to the copper price which has also spiked 38 per cent since March. Copper had historically been very sensitive to economic conditions. What is confusing however is that gold and silver prices – which traditionally have had an inverse correlation with the sharemarket, the copper prices and the state of the global economy – have also soared.[vi]
The unusual correlations between copper, sharemarkets, gold and silver encapsulate the confusion about the economic impacts of the coronavirus. Clearly, The Fed’s multi-trillion dollar infusions of liquidity and credit, and the initial $US2.9 trillion (A$4.1 trillion) US Congress stimulus (with more about to come imminently) – along with what are in real terms zero or negative interest rates around the world – are being regarded as contributing to a perceived potential debasement of the US currency; and hence the popularity of gold and silver as alternative investments. Traditionally, investors looking for “safe” investments have sought refuge in Treasury bonds; but with these now essentially yielding almost nothing – precious metals like gold and silver are seen as ‘stores of value’ that can also offer much higher yields.
Cash and Conquer: The Rise of Shadow Banks
Traditionally, commercial and investment banks held only a fraction of their assets as reserves and they borrowed short-term to make long-term loans or hold long-term securities. That exposed them to runs. Economic history is littered with the tombstones of banks that were felled when markets for illiquid securities seized up, or depositors rushed to withdraw their funds.
The subprime fiasco of 2007-09 inflicted severe economic pain for all banks, and the US Fed had to inject over 200 billion to bail them out. All types of banks have faced tighter regulation since then, which has made them more risk averse and blunted their competitive advantage.
As banks have grown risk-averse, tech-savvy non-banks, often called ‘shadow banks’, are stepping up with a new wave of innovation in capital markets that has changed securitisation and debt issuance and led to more direct lending. Technology has also facilitated this shift because it has promoted the growth of payments; and of bank-like activities outside the banking system.
The term ‘shadow banking’ could apply to a range of financial institutions and activities. It includes long-established institutions like pension, insurance, private-equity and hedge funds, as well as newer ones, like exchange-traded fixed-income funds, which provide a vehicle for savers to deposit cash that is then invested in government and corporate bonds.
Banks’ stagnation and their risk aversion has had consequences for how central banks respond to crises. In 2007-09, the Fed had to intervened mainly to prop up commercial and investment banks and AIG Insurance. When the coronavirus pandemic hit and capital markets seized up, rather than acting as a lender of last resort to banks, the Fed became market-maker of last resort, intervening in credit markets with massive capital injections. The scale of the Fed’s intervention surpasses any other in its history. As a result, both traditional and shadow banks went relatively unscathed.
The US Fed has intruded into a bewildering array of financial markets in the aftermath of the COVID-19 pandemic, including: the treasury market, the corporate-bond market, and the repo market (where Treasuries are swapped overnight for cash). It is providing liquidity to money-market mutual funds and it has bought up mortgage-backed securities.[vii] The US Fed, acting with the US Treasury, has bought up the bonds of AT&T, Apple and even Coca-Cola, and lending directly to everyone from bond dealers to non-profit hospitals. Together the Fed and Treasury are now supporting 11% of America’s entire stock of business debt. Across the rich world, governments and central banks are following suit.[viii] Australia’s second biggest airline, Virgin Australia, hampered by massive debt, asked the Australian government to buy it out. When this was rejected, it went into voluntary liquidation.
Such a broader and deeper reach by a State across all sectors of the economy creates some opportunities. Low rates make it cheaper for the government to borrow to build new infrastructure, from research labs to electricity grids, that will boost growth and tackle threats such as pandemics and climate change (i.e. a more Keynesian approach).
Yet this new normal of massive state spending also presents grave risks in that such policies are vulnerable to capture by lobbyists, unions and cronies. Sprawling macroeconomic management always leads to infinite opportunities for politicians to play favourites. Already they are deciding which firms get tax breaks and which workers should be paid by the state to wait for their old jobs to reappear. Soon some loans to the private sector will turn sour, leaving governments to choose which firms fail. When money is free, they will rescue distressed companies, protect obsolete jobs and save troubled investors with political clout, rather than economic necessity.
This has resulted in a perverse ‘new normal’ in that even as millions in the USA have lost their jobs and are worried about how to get food and pay the rent, banks and shadow banks are awash with cash. Such cash is finding its way to exotic investments; and ‘fire-sale’ purchases of companies distressed in the wake of pandemic. For example, Bain Capital an American private investment firm that specialises in private equity and venture capital recently made a bid to buy Virgin Australia, when a government bailout was not forthcoming.
The holy grail is for policymakers to create a framework that allows the business cycle to be managed and financial crises to be fought without a politicised takeover of the economy. There is no evidence that such a shade of ‘new normal’ will ever eventuate.
In this part, 9 further shades in the new normal of ‘Crazynomics’ were covered. These include: Massive Size of Government Borrowing; Quantitative Easing; Central Banks Buying Company Bonds; Negative Interest Rates; Money Printing vs. Low Inflation; Money Printing vs. High Exchange Rates; Booming Stock Market in a Recession; The Rise of Non-Banks; Private Equity Funds on Spending Sprees.
In the next concluding Part 3, the impact of COVID-19 on various global interconnections, from logistical supply chains that drive our commerce, to physical weather patterns that drive our climate are explored.
The opinions in this article reflect those of the author and not necessarily that of the organisation or its executive
[ii] Janek Ratnatunga (2020), “Pandemic Financing – Stealing Billions from Future Generations”, On Target, April 8. https://www.cmawebline.org/ontarget/pandemic-financing-stealing-billions-from-future-generations/
[iii] This resulted in the most powerful figures in USA Tech companies, including the CEOs of Amazon, Apple, Facebook and Google, being grilled by the US Congress about their competitive tactics during the high-profile antitrust hearing that commenced in late July 2020.
[iv] Economist (2020), “Starting over again: The covid-19 pandemic is forcing a rethink in macroeconomics”, Briefing, July 25. https://www.economist.com/briefing/2020/07/25/the-covid-19-pandemic-is-forcing-a-rethink-in-macroeconomics
[vi] Stephen Bartholomeusz (2020), “Bulls vs bears: The pandemic has the markets looking confused and divided”, The Age, July 28, pp.19-20.
[vii] Economist (2020), “Putting the capital into capitalism: Banks lose out to capital markets when it comes to credit provision, Finance & Economics, July 25. https://www.economist.com/finance-and-economics/2020/07/25/banks-lose-out-to-capital-markets-when-it-comes-to-credit-provision
[viii] Economist (2020), “Macroeconomics: Governments must beware the lure of free money”, Leaders, July 23. https://www.economist.com/leaders/2020/07/23/governments-must-beware-the-lure-of-free-money
Prof Janek Ratnatunga
Professor Janek Ratnatunga is CEO of the Institute of Certified Management Accountants. He has held appointments at the University of Melbourne, Monash University and the Australian National University in Australia; and the Universities of Washington, Richmond and Rhode Island in the USA. Prior to his academic career he worked with KPMG.