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Tuesday, November 24, 2009

Looking over the precipice with Niall Ferguson

The V-shaped recovery seems to have been about a two-day thing. Economic historian Niall Ferguson does a good job of suggesting why. Demand Side suggests that since the policy actions of the Fed and Treasury have done nothing to address the root problems, we might expect another flowering of those problems. Soon.

Interview with Niall Ferguson
Brian Milner
Globe and Mail
Nov. 23, 2009

Does the recovery we've seen in fits and starts have any legs at all, outside of the major emerging markets? Or is it a mirage?

I don't think it's possible to infer from the stock market rally anything resembling a sustained recovery. The third quarter GDP number of 3.5% growth [subsequently revised down to 2.8%] was at least half due to one-off government measures. In any case, the U.S. consumer is constrained by horrible balance sheet problems – excessive leverage and severely reduced real estate values on the assets side. The stock market rally has been largely due to near-zero interest rates and a weaker dollar. In foreign currency terms there's been no rally.

What's your assessment of how the economic and financial crisis has played out this past year? Worse or better than you thought? Are markets headed for another big fall, or are they correctly predicting that the frail recovery will be sustainable?

I feared all summer that we might have another big banking crisis in Europe just as happened in 1931. Well, the European governments turned a blind eye to their big banks' problems and we avoided a repeat of Creditanstalt. So things are better than they might have been. But I don't think you can have any faith in markets ‘predicting' anything. First, the bond market isn't predicting anything resembling what you might infer from the stock market, where the price/trailing earnings ratio is now pretty high. Secondly, how well did markets predict the crisis? Enough said.

Let's address your famous “Blood in the streets” comment to The Globe and Mail last February. Still feel that way?

I wasn't saying there would be blood in the streets of Toronto, remember. My first point was that the crisis would likely destabilize about a dozen relatively weak states and that this ‘axis of upheaval' would become more violent. That's happening already – just look at the escalation of violence in Afghanistan and Pakistan, and the signs of a deterioration of security in Iraq, not to mention Somalia.

The other point I had in mind was that, after previous big financial crises, insecure governments have been tempted to rattle sabres for the sake of promoting their own domestic legitimacy. My prime suspect here is Russia, which of all the big powers stands to gain the most from geopolitical instability, since [for example] a major attack on Iranian nuclear installations would double the price of oil and greatly enrich the denizens of the Kremlin. The probability of such a war is currently being underestimated by many people.

You have said projections about the economy are wrong because they're based on models that don't correspond to real life. Do you feel they have by now been well and truly discredited, along with the efficient market theory and other dearly held views of so many academic economists?

No, I think they are putting up a heroic resistance. And I don't want to caricature the process whereby economists try to model the complex thing that is the economy. These exercises have their uses. And the efficient market hypothesis is not all wrong. Most of the time, stock prices do seem to follow a random walk, as the theory states. But the key phrase is ‘most of the time.' We need to use history and psychology to understand what makes seemingly irrational manias and panics happen so frequently in financial markets. Too many economists thought they didn't need to stoop to incorporate such lowly disciplines. The discipline succumbed to hubris, because mathematical elegance took precedence over the real world.

Please give your outlook for the U.S. dollar, inflation and long-term interest rates?

My outlook? After what I just said about models? The most we can say, drawing on what we know about past financial crises, is that over a five-year time frame, the dollar is likely to weaken some more, inflation is likely to pick up after another year or two of pretty low prices and long-term interest rates could move up sooner than that, in anticipation of a revival of inflation. Add, say, 50 to150 basis points to the U.S. federal government's 10-year Treasury yield and the effect could be quite painful for the economy as a whole.

What are the biggest surprises in the unfolding story so far? Would the quick response by central banks be one? And have they done the right thing by turning on the taps and bringing rates down to record low levels?

I was truly surprised by some of the things Ben Bernanke did, especially in late 2008. He was buying up securities that previously would have been considered totally unacceptable on a central bank balance sheet. Full marks to him, however, for realizing the gravity of the crisis and moving to avert a second ‘great contraction.'

But what surprised me even more was the readiness of Treasury officials to accept the nakedly self-interested arguments of the ‘Too Big To Fail' institutions.

Any concern about the lack of a clear exit strategy for the fiscal stimulus programs? Will we be looking at higher taxes soon, despite the protestations of the politicians?

I am very alarmed by the prospect of trillion-dollar deficits as far as the eye can see – though for this year and next year they make sense. My bet is that Obama will eventually be forced to introduce a value-added tax on the European model.

You've been lumped in with Nouriel Roubini and some others with strongly bearish sentiments as doom-spreaders making a lot of hay out of the crisis. Is that an unfair criticism?

Well, I like Nouriel a great deal and admire what he's achieved. But we've approached this in very different ways. Nouriel was predicting collapse from as early as 2002, if not before, and his focus was on the current account and the dollar more than the banks. I first raised the spectre of a massive liquidity crisis for highly leveraged U.S. financial institutions in 2006, so I think my timing and focus were a little better. But I was wrong in one respect: I thought a geopolitical event would be the trigger for a massive repricing of risk. Wrong. It happened all by itself, caused by endogenous forces within the financial system.

What's your outlook for 2010 for both the U.S. and global economies?

U.S. growth will likely be lower than the 3.2 per cent forecast by the administration earlier this year. Growth in the big Asian economies and their trading partners may beat expectations. But this is pure guesswork. Remember: The models used to make forecasts of this sort by the IMF have been largely discredited by the crisis, just like the ‘predictions' of the stock market.

What's the risk of new asset bubbles forming and what threat would they pose, if any, to global recovery?

Excessively loose monetary policy causes asset bubbles and excessively loose monetary policy is what we have now. It's a little early to start pointing figures and calling things ‘bubbles,' however. Many prices are simply returning to their trend growth line after the collapse that occurred a year ago.

You have said: “Default is not a scenario we can rule out.” Do you believe the U.S. government would ever renege on it obligations to foreign investors? What are the risks that the government would cut off funding domestically for programmed spending on Medicare et al?

At some point it is absolutely inevitable that the U.S. will have to ‘default' on part of its existing liabilities, since the long-run trajectory of government borrowing is clearly unsustainable. With the unfunded liabilities of the Social Security and Medicare systems now around $100-trillion, these look like the most vulnerable budget headings.

You said recently the biggest problem that anybody faces today is that their lifetime experience is no longer a reliable guide to the future. But some economists, including your Harvard colleague, Ken Rogoff, have been saying that we have seen this movie before.

Ken and I are of one mind. His book [ This Time is Different: Eight Centuries of Financial Folly ] goes back eight centuries, mine goes back four millennia. We need financial history to free us from the trap of our own personal experience which (unless you're Paul Volcker) is just too short to offer a reliable guide to the range of possible crises we may face.

You have talked about the “Chimerican era” coming to a close and that the 10/10 rule of 10 per cent Chinese growth and 10 per cent U.S. unemployment can't be maintained. Any time frame for the end of the Chinese-U.S. financial marriage?

I think Chimerica is a marriage on the rocks. The Chinese feel they have more than enough U.S. Treasury bills and bonds. They also know our consumer isn't coming back any time soon. But for the short run they gain from their currency's peg to the [U.S.] dollar. As the dollar weakens, do does the renminbi. So this has a few more years to run, after which the Chinese may allow their currency to appreciate.

Are you concerned about rising U.S. protectionism?

Protectionist measures by Congress don't worry me. I am more worried about a game of competitive devaluations.

In The Ascent of Money and subsequently in public comments, you have talked about the crippling U.S. debt and the lack of political will to fix it. Do Obama's comments [last week] in China that urgent steps must be taken to rein in public finances give you any hope that the government will be serious about tackling the problem?

I was very glad to hear him say that. The administration urgently needs to get serious about medium- to long-term fiscal stability, or the U.S. risks losing credibility as a borrower – and that generally translates into higher interest rates.

This is another debt-related question. You have argued that the only way out of this mess is to get the U.S. off its addiction to debt and for China to end its role as chief enabler, which you see already occurring. But foreign demand for U.S. bonds remains relatively strong and domestic purchases by financial institutions and institutional investors is picking up some of the slack. Do you see this changing any time soon?

I think it's much too early to conclude that the U.S. can count on foreigners to finance a cumulative $9-trillion of new bond issuance at the current low rates over a nine or 10-year time horizon. At some point, especially with the dollar weakening, the U.S. will need to offer higher real returns to sell all this stuff.

Does being an historian give you a better perspective on the future?

I think it has taught me that there is no such thing as the future, only multiple futures of varying degrees of probability.

How does it colour your advice to hedge fund investors?

‘History' is mostly what the statisticians call the ‘fat tails of the distribution.' I advise my financial friends to keep trying to imagine big ‘tail events' like wars, revolutions and of course financial crises.

How have the events of the past year affected your personal investment decisions?

I am out of U.S. stocks and currently have a modest cash pile. The commodity and stock market rally since March looks to me to be coming to an end. I am genuinely not sure what happens next. Having narrowly avoided a Great Depression by using massive fiscal and monetary stimulus, we are now in uncharted waters.

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