Policy Research in Macroeconomics

Negative yields, quantitative easing, currency wars, and reflexivity

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Compared to the 1930s, this deflationary crisis has played out much slower and more benignly. That doesn’t mean it isn’t a crisis. It is one, as evidenced by the beggar-thy-neighbour tactics like negative rates and quantitative easing that are being employed. In the 1930s, depreciation was the taboo. But when a country finally did devalue, this act alone led the suffering to an end. This time, fiscal expansion probably plays that role. Below, I have some comments on today’s currency wars in light of recent policy moves in Switzerland, Denmark and Canada.

What got me to thinking about this is two-fold. First, I feel fortunate in times like these to be able to read the press in lots of languages because I feel like, after you weed through the echo chamber stories that everyone is writing, there are those local nuggets that you just don’t see getting attention internationally. Yesterday, that nugget was in the Swedish newspaper Dagens Nyheter. The Swedish paper carried a conversation with the chief economist of SEB, a major Swedish bank, where he discussed the deflation problem besetting Europe. Now, Sweden has been in the news for being one of the economies in Western Europe expected to grow the most this year. But, earlier this week, Swedish finance minister Magdalena Andersson announced she was cutting growth forecasts to 2.4% from 3.0%, after 1.8% growth in 2014. “We will see a recovery, but a slow one,” she told reporters.

Now 2.4% is gangbusters for Western Europe. But it is slow. Even more problematic is the low nominal GDP growth due to deflation in Sweden. And so SEB’s Robert Bergqvist told Dagens Nyheter he believes the Swedish central bank, the Riksbank, can do more to spur on NGDP growth, first by cutting rates into negative territory and then by engaging in quantitative easing. This is a country whose currency is falling against the euro, whose currency is also falling. Frankly, I think his solution is preposterous. But this is what people are saying everywhere. Reading this exchange clued me into how much the shrinking pie mentality of the currency wars has taken hold. (link in Swedish)

Another piece that got my attention was one at Value Walk about Michael Pettis talking about George Soros’ reflexivity market paradigm. Here’s what Value Walk quote:

George Soros made what I think is an important contribution to economic thinking by working out a process in financial markets he called “reflexivity”, which in mathematics describes a feedback relationship between two variables in which each variable’s output reinforces the other’s input. It turns out that Soros’s reflexivity, which among other things explains the way in which markets substantially overshoot when a constraint that has come under significant fundamental pressure is relaxed, is itself a consequence of balance sheet inversions that have evolved within the investor base.

Before Mexico was forced to devalue in December 1994, for example, or South Korea in November 1997, economists believed that their currencies were overvalued by roughly 20% relative to the dollar. When the peg was eliminated, their currencies did indeed drop, but the dollar’s rise against these currencies was not limited to the roughly 25% that would have restored fundamentals, but rather it shot up by 100-150%, mainly because of the reflexive process in which a depreciating currency forced borrowers in dollars to buy dollars to hedge themselves against further depreciation. But with so much dollar debt outstanding, the very act of hedging forced the local currency to depreciate even further. Each variable in the reflexive relationship, in other words, created a reaction that reinforced the other.


If Spain were to leave the euro, the same balance-sheet structure – in this case the bulk of debt being denominated in euros – that caused the peso and the won to collapse would cause Spain’s new currency to drop by far more than the 15-20% by which most economists believe Spanish costs are overvalued. Spain’s new currency would almost certainly collapse under the pressure of so much external debt were it to devalue. This process would be reinforced by yet another reflexive relationship – as the value of euro debt soared relative to Spain’s newly-denominated GDP, the increasing likelihood of a default and forced write-down would cause bondholders to sell bonds, driving down the price, and the currency, even further.

It shows how poorly understood debt and balance sheets are among orthodox economists that Soros’s reflexivity is largely marginal to macroeconomics, even when it is clearly useful in explaining why economies so often behave in “surprising” ways .

In the context of what’s happening today, reflexivity means a strong dollar could overshoot a-la 1985 Plaza Accord overshoot. So when we talk about currency wars due to extreme positions on negative yields and quantitative easing, either everyone is going to have to play the game or the policy divergence could create reflexivity that leads to tail risk in unexpected ways. This is my takeaway from the Pettis piece.

Now, I started this piece by saying that the deflationary we are witnessing is proceeding apace much more benignly and slower than the Great Depression. And this is because policy makers have been more aggressive on monetary policy but they have been very weak on fiscal policy, meaning the monetary policy offset has had to be aggressive to maintain any modicum of growth. And I do not see us with a robust growth future unless we see greater fiscal transfers to the private sector that result both in larger wage gains and lower private debt levels. Until policy makers accept this fact, we will be in a currency war.

Moreover, the negative rates are a tax on saving and suck interest income out of the private sector just the way an income tax does. So the concept that this is a benefit to Europe is flawed. But of course, everyone is doing it: Switzerland, the ECB and Danmarks Nationalbank. In the press conference announcing the ECB’s QE asset purchase program, ECB head Mario Draghi was frank about the two main channels he believes QE acts through in order to boost economic growth and inflation.

Draghi mentioned what he called the portfolio rebalance effect, saying that banks which sell bonds to the ECB will find themselves with reserve deposits that are now taxed at a 0.20% rate. He believes this will give banks “an incentive” to increase lending. Draghi also said that the QE program will push up inflation expectations, which in turn will pull actual inflation toward the 2% target over time. While the validity of each of these explanations of how quantitative easing are debatable, it is nice to know what is driving ECB policy decisions. My sense is that these actions will not have their intended effect except to the degree they signal risk-on for investors who can shift portfolio preferences, knowing that policy will remain loose for the foreseeable future. In the meantime, I expect the deflationary trend to continue, putting pressure on monetary policy, and furthering the currency wars.

Right now, the crux of the war is policy divergence, meaning the U.S. has been left as the last man standing on the tightening side of the rubicon. Bank of Canada governor Stephen Poloz said early Wednesday that the drop in oil prices is unambiguously negative for Canadian economy. As a result, the BoC unexpectedly cut interest rates by a quarter-percentage point to 0.75%, sending the Canadian dollar to a six-year low against the U.S. dollar. The press release from the BoC also stated that “Oil’s sharp decline in the past six months is expected to boost global economic growth, especially in the United States, while widening the divergences among economies.” In effect the Bank of Canada was following the lead of the Swiss National Bank in making an unannounced and unexpected policy decision while noting that it expects US growth and US interest rates to remain higher than elsewhere in the developed world.

The ECB policy announcement yesterday just adds to the isolation of the U.S. on this score, especially given the climb down we have seen on tightening at the Bank of England this week as well. Could the euro go to parity with the U.S. dollar? I think yes. The strong dollar trade has become crowded. However, if the U.S. continues on this divergent path we are going to get reflexivity and overshoot versus the Canadian Dollar, the Euro, and emerging market currencies. China cannot possibly hold its peg to the U.S. dollar under that circumstance. And they will be forced to widen their band and attempt to force depreciation. When China joins the currency wars, it will export deflation and change the whole tenor of the discussion.

In sum, we are living in dangerous times because a shrinking pie mentality borne out of weak domestic demand and a lack of fiscal policy options has caused policy makers to turn to monetary policies that have currency and trade balance implications. These currency wars are dominated by surprising and unilateral actions in order to maximize the policy effect for single currency areas, creating a tension which leads to market volatility, negative external repercussions and “retaliation”. We saw this most vividly with Switzerland, the eurozone and Denmark over the past week.

But because of the shale boom, the U.S. economy has outperformed other economies, leaving it in a tightening position just as the shale boom has bust. Unless growth slows materially from here, we could see rate hikes that cause euro-dollar parity and force the Chinese to devalue. These two events will have negative external consequences and increase tail risk.

At the same time, I am not hopeful that we are going to see more on the fiscal front out of Europe. All of the recent wrangling over Greece tells you fiscal leeway is off the table as the Germans themselves have moved to a balanced budget. Deflationary forces will remain potent in Europe as a result, weakening the euro in anticipation of more robust monetary offset. The U.S&. may be slowing, however. Capital expenditures in the oil patch are getting cut in a major way. And we see job cuts popping up in a lot of places not connected to the oil sector like eBay and American Express. With jobless claims trending up, this weakness may be just enough to bring the Fed back into line with other central banks. We’ll just have to wait and see.

Originally published on Jan 23 2015 at Credit Writedowns 

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