247Bull.com Editor: In his latest Amphora Report John Butler has an interesting discussion with economist John Llewellyn. Some of the key macroeconomic areas they cover include: the troubling trend of financial repression, the survival of the euro, the debt and demographic issues in Japan, seeking safety away from the US dollar, the coming currency crisis, the valuation of assets, the increasing risks within the financial system and the “good life” after the great reset.
John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognises the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronised global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.
BY WAY OF BACKGROUND…
Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specialises in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.
I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.
We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.
When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.
John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.
THE GATHERING STORM
JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?
JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronised global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronised, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.
JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a nonissue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?
JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.
JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While countercyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?
JL: The central tenet of Keynesianism is subtler than the bastardised version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.
FINANCIAL REPRESSION PAST, PRESENT AND FUTURE
JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidise government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?
JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.
JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?
JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarised to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfil.
PRESENT AT THE CREATION
JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration. Given recent developments, this seems a bold view to some. Would you care to elaborate?
JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalisation: but you get the point.
JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?
JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realise that they could get rich also by selling to themselves. To this day, they have not learned that lesson.
JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalised the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?
JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. Butalternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.
JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?
JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.
Read part two of A Conversation With John Llewellyn here.
John Butler | Amphora Capital
Mr Butler is the author of The Golden Revolution: How to Prepare for the Coming Global Gold Standard