Jan 8, 2018

Mike Bird on the Eurozone, Abenomics, and the Fed Balance Sheet

Abenomics was an ambitious economic plan enacted in Japan, and its results may be greater than its critics give credit for.
David Beckworth Senior Research Fellow , Mike Bird

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Mike Bird is a reporter for The Wall Street Journal and covers global economics and markets from the Journal’s London office. Today, he joins the show to discuss recent developments in central banking across the world. David and Mike discuss how the Eurozone has dealt with some of the serious turmoil it has faced in recent years as well as Japan’s “Abenomics” program geared toward raising inflation and implementing structural reforms. Finally, Mike shares his thoughts on the Fed’s plan to reduce its balance sheet and what impact that will have on the global economy.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Mike, welcome to the show.

Mike Bird: Hi, David. Thanks very much for having me.

Beckworth: Well, thanks for coming on. We have engaged on Twitter and the blogosphere before so it's great to chat with you in-person. So tell me, how did you get into economic and business journalism?

Bird: That's a good question. It was very much by accident. I think most of the people I know there's basically two ways into economic and financial journalism generally, which is either a strong interest in economics and finance or a strong interest in journalism, and then slowly finding your way to finance. For me I actually did history at university, and very slowly became more interested in economic history during the time that I was there. Thankfully, we had some great economic historians at our university and to be honest, it was a very fertile time. So this was the very early 2010s. Obviously, a lot going on in terms of economic debate in the public sphere then. I became increasingly interested and somebody pointed out to me, just as I was finishing university a job working for a free London based business newspaper called City A.M as their economics correspondent. I didn't think I'd get it because I had no experience. I hadn't really [inaudible] journalism before, but I got it. And yeah, I haven't looked back really. It's an enormously enjoyable job.

Beckworth: Yeah. And you've written for Business Insider as well. Along the way.

Bird: Yes.

Beckworth: Okay.

Bird: Yeah.

Beckworth: So you've hopped along some different media outlets, and now you're at The Wall Street Journal and a very prestigious publication and you write from London and you have, is it one or two columns a week you put out?

Bird: It varies.

Beckworth: Okay.

Bird: I think, generally about two. But it really depends on what's happening. I mean, one of the great things about working here is that we don't have much pressure to churn a specific number of pieces. If you have something interesting to say, there's nothing stopping you writing five a week, if you don't, you take a week out whatever. Yeah, which is one of the really good things about the Journal.

Beckworth: Yeah. And I love following your work, because you seem to cover topics that I find very interesting. And that's why I have you on the show. I have you on the show, for that reason. So very selfish motives here. But no, we're going to have a fun conversation, for sure. So what I want to do is take a tour around the world because you know this topic well and take a look at central banking, where we are here at the end of 2017. This show will probably come out in early 2018. So this is maybe a state of central banking end of the year 2017.

Bird: Cool.

Beckworth: And I want to begin first in Japan, because you've written a lot and even in your own personal tweets and stuff, you've had a lot of interest and focus on Japan. And Japan has been great for anyone who cares about monetary policy or just economic conditions because they soon will-

Bird: Yeah.

Beckworth: ... be the leader of the experiences and problems that the rest of the advanced economies soon will be facing. They were the first ones to get to zero lower bound on interest rates. They were the first one to try quantitative easing so back in 2001 to 2006. First I should say recent experience with quantitative easing large scale asset purchases, there's some early historical experiences. But that's the first modern one and now we're in the current period and they're doing something called Abenomics. So tell us what Abenomics is and what is your sense of what it's accomplished and where it's going.

Abenomics and its Accomplishments

Bird: Sure. So Abenomics is just the very basics of it. Shinzo Abe, Japanese Prime Minister was elected in a pretty big victory towards the end of 2012. Slightly later, the next year he brought in Haruhiko Kuroda, who's the governor of the Bank of Japan. Abenomics is very aggressive even by Japanese standards reflationary and expansionary economic policy. And a huge part of that is the monetary policy arm. I think in an interesting way, Japan has somewhat less central bank independence. It was very clear when Kuroda came in that it was to exercise Shinzo Abe's vision which obviously, Kuroda shares. But the two don't operate very independently from each other in the way that some people might think of it if they're British or American. It's very much intertwined.

Bird: I guess the basic way to look at it is the three arrows, which is how they started off. I'll get round to this in a minute. But I think one of those arrows is a bit of a red herring, the three arrows are monetary policy stimulus, fiscal policy stimulus, and structural reform, effectively designed to all be done at the same time. Yeah. And that was the basis of it. It's been running since 2012. Shinzo Abe has since won two additional elections, so secured himself a mandate really, it's actually not too long until he'll be the longest serving Prime Minister of Japan in I think something like 120 years.

Beckworth: Interesting.

Bird: Yeah, yeah.

Beckworth: So this is a big deal over there, because they have for at least a decade, they've been wrestling with deflation, sluggish growth. I mean, your whole point that they're trying to reflate the economy, and many people in Europe and in the US might be bothered by that notion. But they literally have been fighting the opposite of the 1970s that we've experienced in the rest of the world. They've had to wrestle with that. And it's not just low prices with good growth, it's been low prices, low growth, just a very stagnant experience. And so they've wrestled with it, and what is your sense of what Abenomics has accomplished? Well, actually, before we get to that, let me step back. Let's put some perspective on what they've done. So they've done large scale asset purchases, right?

Bird: Yes, yes.

Beckworth: And they've done a lot, right?

Bird: It's been, as I say, extremely aggressive. The asset purchases are not really comparable in scale to anything that has been done in another major economy. I think that the closest comparison is probably Switzerland, which you wouldn't really call a major systemically important global economy. In terms of comparing it to the ECB or the Fed, the asset purchases are considerably larger, to the extent that now the Bank of Japan's balance sheet is about 520 trillion yen, or 4.6 trillion US dollars, so slightly larger than the Fed's. And when you remember that the Japanese economy is considerably smaller than the US economy as a proportion of GDP, you're talking about over 90% of GDP, the size of the Bank of Japan balance sheet, in comparison to I think something like 23 or 24% for the Fed. So it really is much larger.

Bird: To be honest, they started their post crisis policies much later, in a way. They didn't have as bad an experience in 2008, nine, ten. And really, as you say, Abe came in, not with an effort to revive the economy from a post 2008 slump, but really to revive it from what was by then a couple of decades of stagnation. Yeah. So in a way, it's a slightly different effort than the one that's been made in the US or the UK or the Eurozone, which is very much about recovering from 2008. And it's more designed to combat a deep and seated problem that Japan has, as you were saying, they've had either no inflation or deflation for a very long time. They've had a very low economic growth. And as you may be able to tell, I'm much more optimistic and positive about the prospects for Abenomics and what it's done so far than I think the general narrative has been.

Beckworth: Yeah, that helps answer a question I had, in the US, there's been a lot of political pushback against the Fed's efforts. So Ben Bernanke, the former Fed chair had a hard time doing QE two, QE three. And there's still this desire to shrink the balance sheet. What's been interesting to observe Mike, about this is that in the US, QE was often very unpopular. And I can just imagine if you had upped the scale tremendously like it was in Japan, it would be even more hated by some individuals. But my sense is in Japan, it's been well received overall, is that your sense as well?

Bird: I think it's to some extent, well received. There's a few different moving parts here. I don't attest to being an expert in Japanese politics, by any stretch of the imagination. But I do wonder whether some of the progress that Abe has made on making his economic policy program mainstream and accepted has been from the fact that he's a conservative, he comes from the political right, rather than the political left, which is slightly different to the way a lot of this has gone in the Western world, where people on the left are somewhat more associated with expansionary economic policy. And though you do get resistance in Japan. You can imagine there are places where, for example, the price of everyday household goods I think it's often things like junk food, almost, where the prices of certain things haven't risen for maybe 20, 25 years, and they're starting to see price rises, and no one likes the additional small price rise to something that they know that's been fixed for a very long time.

Bird: And this gets to the deep seated problem in Japan in that you didn't just have deflation, you had a deflationary mindset. Unions had stopped asking for wage hikes, people did not expect wage growth, and in many ways did not require wage growth, because their living costs were not rising. Property prices didn't rise dramatically, land prices didn't rise dramatically. And so really what they're combating is somewhat different from the experience in the Western world.

Beckworth: Yeah. So it was a different problem, as you mentioned. And I want to be clear to my listeners, I personally I'm not against deflation, per se, if it's associated with rapid growth, but Japan didn't have that. Japan was stagnant on all measures. So it's not just a fear of deflation, it's a fear of a number of symptoms that were associated with deflation, the bad form of deflation. Now they're also in addition to doing massive amounts of asset purchases that dwarf what the Fed has done, they're also aiming to pin down interest rates as well. Is that correct?

Bird: Yes, this has been a really interesting shift in the Bank of Japan that I think has been under discussed, which is in 2016 they moved towards what they call yield curve control. Effectively, they established that just to give a bit of background to this, the Bank of Japan cut their benchmark interest rate into negative territory. And what they've realized I think, relatively shortly after doing that, is that the expansionary impact that you might get from a lower interest rate wasn't necessarily enough to offset the potentially negative effects on the way banks operate. Banks really seem to struggle with negative interest rates. These are places where they've got fairly low margins anyway and have for a very long time in Japan, and they struggle to make money basically.

Bird: What the Bank of Japan moved to is yield curve control, which essentially fixes the 10 year Japanese government bond yield at zero percent. In reality, it ranges between minus naught point 1% and plus naught point 1%. Anywhere above or below those levels, the Bank of Japan will effectively intervene, either by cutting or raising its asset purchases to meet that goal. It allows the yield curve to be a little bit steeper further out. So you don't have the incredible flatness or negativity that you had in parts of 2016.

Bird: And the really interesting thing, I think about this, and it's something for the economics nerds among us, is that the Bank of Japan from 2013 to 2016 had the most overtly monetarist policy in that it was based on expanding the Bank of Japan's balance sheet and really the monetary base by a certain number of trillion yen per year, it was an explicit monetary target. And what they moved to with yield curve control is really quite a credit test target. They've aimed essentially to track financial conditions to fix financial conditions as measured through the 10 year JGB at a specific level, and they will now and they have been varying their asset purchases, depending on whether they're hitting that target or not. So I think there's a really interesting step change there in that you had something that would have been recognizable to Milton Friedman, in the first place the targeting of monetary aggregate, changed to something that's really very much focused on financial conditions.

Beckworth: Yeah. It's almost mind blowing from my perspective over here. They are targeting the 10 year government bond yield at zero percent.

Bird: Yeah.

Beckworth: Just think about what that means over the next 10 years. People who buy these bonds are effectively paying the government in real terms to take theirs, "Here's my money, please give me less back in 10 years." But apparently people are more concerned about preserving principle than getting the positive return. So that's the mindset. I mean, that's what they're facing really. Those low yields are a symptom of I think the deeper problem they're wrestling with.

Bird: Yes.

Beckworth: But it is fascinating. You're right, the Japanese have always been more monetarist in spirit when they've done their large scale asset purchases. The first QE they did from 2001 to 2006, they were very explicit. They were trying to expand... They were thinking about the liability side of their balance sheet, expanding the amount of reserves, the monetary base. And Ben Bernanke had some speeches where he mentioned what the Fed was doing was very different. The Fed was doing the credit approach, they were more concerned about the asset side of the bank's balance sheet, their central bank's balance sheet. They were trying to affect credit spreads, interest rates. And now what you're saying is that they've shifted to that direction as well. They're much more concerned about yields, credit spreads and those financial market issues.

Bird: Yes, absolutely. It's been a really interesting shift to watch. And I think we'll probably get on to this, if we talk about the ECB a little bit later. But part of the issue here, I think, is the semi political constraints on the central bank in terms of there are only so many JGBs in the world, and the Bank of Japan doesn't really want to be seen to buy up the entire government debt market. One of the reasons that they changed policies was because they were buying something to the tune of 80 trillion yen a year in Japanese government bonds and the yield curve control policy means that they're really now, even though they technically still have a target to buy about 80 trillion yen, they're only really now buying more like 50 trillion yen. It extends the potential lifetime of the policy, somewhat. They don't hit those constraints as early on.

Beckworth: Yeah. So again, another mind blowing observation, they're buying up most of the government debt over there. And at some point, they would have all the government debt if they kept doing this. And so the yield curve targeting allows them to get to a similar objective without having to buy as much. But I guess it then raises another interesting question, aren't they also buying ETFs, exchange-traded funds?

Bird: They are. They are. Which has been a really interesting thing. And I think it's something that... There's a way of looking at it as an interesting thing, and there's a way of saying there's no need to overplay the importance of this. Now it's always seemed more acceptable for central banks to buy government issued assets rather than private sector assets, even though you could look at the Fed, the ECB and the Bank of Japan and say, "Okay, well, the Bank of Japan is buying ETFs but the ECB buys corporate bonds, the Fed bought MBS." And you could meaningfully say all of these, to some extent are private sector assets.

Bird: I think the issue specifically with the Bank of Japan and ETFs, it's not that important from a macro perspective, it's relatively small in terms of the proportion of what they buy. I do think it probably has an effect in those Japanese equity markets in that knowing psychologically that the central bank is now effectively the buyer of last resort in the equity markets has some power to, and I know there are some concerns about there are major Japanese stocks where the Bank of Japan is now a considerable holder via its ETFs. And one of the largest owners in several big Japanese stocks. And you've got to think to yourself, how does the Bank of Japan act as a corporate steward? Are they're going to be an active investor, are they're going to be turning up at corporate meetings and exercising their shareholders rights? It's an interesting step change. But as I say, I think it doesn't have a huge macro impact, and I'm not sure whether it's too different from the private sector asset purchases that have gone on in Europe and the US.

Beckworth: Okay. And just for the listeners who aren't clear these ETF, these exchange-traded funds, can you explain to them why it means that the Central Bank of Japan is effectively buying up the stock market of Japan? Explained what they are here.

The Bank of Japan’s ETF Purchases in Context

Bird: Sure. So the exchange-traded funds are effectively a vehicle that will buy a basket of stocks. So you or I could buy a Japanese stock ETF and you can put any amount of money into it basically, and it will buy a proportional number of Japanese shares across say the topics or the Nikkei 225 index. The thing is when the Bank of Japan continues buying these and eventually owns enough ETFs that it owns large parts of corporate equity in the Japanese market, it becomes a major shareholder in some of the big Japanese manufacturers, some of the big banks. And it's not immediately clear how that works in the long run.

Beckworth: Okay. So I guess my question is, how aggressively are they buying up the ETFs?

Bird: They're buying them up fairly rapid clip. To be honest, I wouldn't be surprised if they change the ETF policy in relatively short order. I don't know whether they'd go into corporate bonds, or they'd just continue buying JGBs. But I think there may be an element there. I think there was a signaling effort behind it. But that they actually can't buy that many ETFs. And I don't think the Bank of Japan wants to be a majority shareholder in major Japanese companies…

Beckworth: Right. So that's-

Bird: Yeah.

Beckworth: ... the political issue that comes up. If they just put their monetary policy in autopilot, this is for the sake of argument, but they keep doing what they're doing, they put it on autopilot, they come back in six months, they own the entire Japanese stock market. The Government of Japan via its central bank owns the stock market. That would be pretty radical. Right?

Bird: It would be pretty radical, yeah. And it's an odd form, I guess of nationalization in that it's owned by the central bank, rather than the government. But I mean, the difficulty being that JCBs, you buy JGBs you just sit on them. It has a monetary policy impact, it has an impact on the economy, those eventually mature, you either sell them back to the market or you reinvest the proceeds, you do whatever you want. But effectively, the government and the monetary authority have a relationship with each other that's well understood and has been for a very long time. As you alluded to a little while ago, these are not the first asset purchases that have ever happened. There are a number of schemes during the Great Depression. In fact, Japan did some overt monetary financing during the Great Depression. This is a historical relationship that's well known.

Bird: What I think is somewhat less known is what business the central bank has buying up large sections of private companies and exercising ownership rights there. I don't think it's a problem that the Bank of Japan wants to have to be honest. I don't think the upside of buying lots and lots of Japanese equities is worth it to them for the downsides of working out what on earth they're going to do with them in the long run.

Beckworth: Yeah, I think this speaks to the fact that these policies are so radical, and yet they're being tolerated by the public over there, which means that the public understands the significance of the problem they're facing. The deflationary drag, the stagnation they have. That the central bank has resorted to these radical policies and there's not been a big backlash against them. So let's move on from the specifics of what and how they're doing it to the results. Do you see results from these policies?

The Results of Abenomics

Bird: Personally, just to lay out, there's a very strong narrative in terms of this. A large part of that comes from financial journalists, that Abenomics hasn't worked. That it doesn't work. I think that's slightly embedded around the fact that Japan has had a long period of deflation and the fact that there's a general perception that monetary policy, this is pushing on a string argument, I think is fairly popular among financial journalists. I disagree personally, in my career and the reporting that I've done and the economic analysis I've done personally, I do think it's worked. I think Japan has been going through its most impressive period of economic growth on a number of different metrics since the early 1990s, and this is in the period pretty much since Shinzo Abe took office, certainly since Haruhiko Kuroda was appointed in 2013.

Bird: I think if you look at nominal GDP growth, that's a very obvious place to start looking because it's what the central bank's effectively aiming to control. It's Japan's most impressive period of economic growth on that statistic in again, 25 years. If you look at real GDP growth, again, it's been consistently above what economists regard to be the potential output of Japan. If you dig into some other real economy metrics, particularly in the labor market, it's been very, very strong. Participation rates are extremely high, even by any historical standard, unemployment rates extremely low. You've got a job to applicant ratio in Japan now of over 1.5, which is basically unheard of in most of the developed world. Yeah, I think it's worked, is the basic answer.

Bird: I think it's really worked considerably better than a lot of the other reflationary policies around the world. I think that it's a fascinating playground for monetary policy, to be honest. Japan is so far ahead in many ways, from the rest of the developed world. And I think people should take note of the fact that actually, when you look at what's happened since 2012, the past four or five years, it does seem to have worked a lot better than the popular perception.

Beckworth: Okay. So there's been an inflection point in the economy that coincides with the adoption of these policies under Abenomics. So-

Bird: Yes.

Beckworth: ... one takeaway is it is working, it's radical, but it is working. Japan's on a better path than it was before. All right, very nice. Well, let's move on then to Europe, let's talk about the Eurozone and the European Central Bank or the ECB for short. How has the Eurozone economy been doing lately?

The State of the Eurozone Economy

Bird: Well, it's been a great year to be covering this. So I cover European financial markets, certainly more than anywhere else, and the European economy. It's been going pretty well, this year. It's been booming, I made a lot of jokes on social media about that booming is not quite technically correct. The growth is not quite strong enough for it to be a boom. But what it's done is it's broken out of the period that was, since about mid-2013, you had fairly reliable growth of around naught point three percentage points per quarter. And that's quarter on quarter growth. You had unemployment falling. But the growth wasn't stellar, it was slow.

Bird: In fact, what you've seen this year is growth pick up. The pace is more like double that. What you've also seen is fairly synchronized growth across different economies in the Eurozone. This is not a story about Germany accelerating very quickly, and everyone else trying to play catch up. French economic growth has been stronger than expected, Spanish economic growth has actually been strong for a few years now. Italian economic statistics have surprised the upside. You've seen a fairly broad based upswing, you've seen even more rapid falls in unemployment. There's some fascinating things happening in the German economy, particularly where unemployment is very low. And you're starting to see the, finally, you're starting see some prospects of the German economy potentially starting to overheat, produce some inflationary pressure, which is really what the Eurozone has been looking for, for a very long time.

Bird: But yeah, it's been actually a really good year. You've seen some of the political risks that people worried about earlier in the year abate. I would say it's probably been the strongest post crisis year for the Eurozone. In fact, I don't think that's really in contention. Yeah, so it's been a really interesting one to cover.

Beckworth: So this gives us hope for the Eurozone project then. There's still hope that it will survive.

Bird: I think so. I wouldn't underestimate the challenges. I think when I speak to Eurozone policymakers, they are still keenly aware that what happened in 2010, 2011, 2012 was a half-finished political project encountered some extremely serious problems. And came out on the other side in one piece by the skin of its teeth. And I think a lot of them realize that the project is still incomplete, they're not sure whether the Eurozone could face another serious crisis, even though the ECB has done a great deal to give them some time, at the very least, to sort these things out. But I think it's certainly more hopeful. There are a number of years where journalists in the UK and the US were very, very negative about the Eurozone, or I think they were slow to realize from about 2015 or so that actually the predictions of its immediate demise were not coming about. I think this has been the year that people have realized there's more prospects to the Eurozone surviving, making its way through than they'd thought certainly during the Eurocrisis.

Beckworth: Yeah. I mean, from an economic perspective, and I'm guilty of being one of those people who thought its future was doomed. But from an economic perspective, it does seem to have a lot of things going against it. It doesn't seem to be, at least on paper, an optimal currency area, where it doesn't seem to make sense to have a one size fits all monetary policy for these countries. They have very different business cycles and structurally different. There's not a unified, large fiscal policy transferring resources across regions. So on paper, it looked troubling. But I think what we've seen or learned, what I've learned, is that the political commitment to preserve the Eurozone is much stronger, or it's been strong enough to persevere this long, and maybe even further.

Bird: Absolutely. I would agree with that entirely. And I would never say that oh, I knew this all along. I'm also one of the people that thought the Eurozone did not have a future as a political or economic project. What I do think is that for a couple of years... What changed my mind particularly was the Greek crisis in 2015. The economic situation in Greece is still relatively dire, unemployment is extremely high, they've gone through something that in reality was probably on the scale or if not, in the terms of the headline figures, slightly worse than the Great Depression was for the US, truly terrible stuff. And they feel like this has been imposed on them by other Europeans, particularly by Germany.

Bird:  But when you go to Greece, you realize that the political appetite to return to a national currency and national economic policy is also extremely low. And that's true across much of southern Europe, even in the countries that really struggled economically. So it does give you the impression that there is life in the political project, even if only because the level of trust in national politics is so low, that even that low levels of trust in the European project are somewhat higher.

Beckworth: Yeah. It is truly amazing that a group of people would be willing to tolerate a great depression just to hang on to the hope of the Eurozone project. They're willing to endure the pain of a great recession, the Greek people, in order to be a part of the Eurozone project. So that does tell you how much they want it. Well, let's talk about the ECB a little bit more, the central bank. They have the Eurozone. You've written some recent articles you have one titled *ECB Taper Promises to Set Off Ripples Across Many Nations.* You also have one titled The ECB and The Fed are growing apart moving market. So is the ECB gearing up to taper and what does it mean for the world economy?

The ECB’s Tapering and Its Effect on Exchange Rates

Bird: I mean, the ECB is really, they've been very clever in vocalizing their tapering intentions in a way that hasn't upset financial markets particularly. They were very keen to avoid what happened in 2013 in the US, the Bernanke Taper tantrum. For those not aware, then Fed Chairman, Ben Bernanke signaled the tapering of quantitative easing, the purchases would fall in size and then stop, financial markets reacted fairly sharply. They wanted to avoid doing that, but the ECB has now twice cut the size of its monthly purchases. And everyone knows. Everyone who works in European financial markets in European economics knows that the European Central Bank has set some fairly strict limits on itself in terms of the proportion of debt that it can buy, the proportion of the government debt market and they can only buy so much debt for example, from Germany if they buy a certain amount from France. They're nearing the limits on some major countries in terms of what they can do. So they're tapering house, regardless of what happens to the economy, the tapering has to happen, really.

Bird: But they've done very well in terms of not provoking negative market reactions this year, despite the fact that they've effectively had to come out and admit that quantitative easing will come to an end or will slow down dramatically, probably into next year and potentially ending towards the end of next year or potentially beginning of 2019.

Beckworth: And does this have effect on exchange rates, other countries that are linked to the Euro? Can you talk about that a little bit?

Bird: Absolutely. Yeah, it does. It does. One of the really interesting things this year has been, and this is, in some ways how you can see it's been a clever tapering, the spread in yields between Germany and the US, I was looking at the spread between the two year German bond yield and the two year Treasury yield this morning, it's at about 2.5 percentage points, which is extremely large and shows what a gap there is between the prospects for the Federal Reserve raising interest rates and the ECB raising interest rates. A lot of people personally, I think, rightly expect the ECB to wait until at least 2019, before raising benchmark interest rates. If the Federal Reserve's dot plot is accurate, they'll raise rates several times before then.

Bird: What you would expect and one of the interesting developments in markets this year, what you would expect is for that to weaken the euro against the dollar, which hasn't happened this year. The euro is actually considerably stronger. We came into 2017, with a lot of people expecting the euro to test dollar parity. Goldman Sachs, for example, their FX guys who are great, but they expected the euro to fall below parity against the dollar. Obviously, it's up more like 118 now, maybe even higher or hopefully not much lower at the time that this is played. But you'd expect the euro to weaken on this divergence. And one of the really interesting things is that it hasn't, it's actually strengthened, and that's in large part on the back of those political risks. So we were talking about earlier abating.

Beckworth: Okay. So there's more hope in the Eurozone project long-term, which has increased the attractiveness of investing in Europe and has kept the euro higher than expected?

Bird: I think so. I think so.

Beckworth: Okay.

Bird: Particularly that French election earlier in the year did a huge amount to assuage international investors that there wouldn't be populist governments in large systemically important Eurozone economies, which was really important.

Beckworth: And this speaks to the question now, where is the Eurozone going? So one of the big critiques of the Eurozone is that they haven't had one fiscal policy or very coordinated fiscal policy across the different parts of the country. I know there's been talk about getting a bond backed by different government bonds within the Eurozone, kind of a safe asset over the Eurozone. Has there been any meaningful movement toward further fiscal integration in the Eurozone?

Bird: There's been, I think... Well, Emmanuel Macron elected in France earlier this year, he's an open advocate of fiscal integration of Eurobonds, of a common Eurozone budget. That said, the answer to that question is very little.

Beckworth: Okay.

Bird: The instrument I think you're referring to there, the safe asset, that's been a really interesting idea that's cropped up across a number of European institutions. The systemic risk board, the European Commission, the European Central Bank, there's been some very senior people buying into the idea of what was referred to by some academics as an SB. So it's a structured vehicle backed by the bonds of various Eurozone countries. That said, what all of these proposals are still missing is the buying of the German political system. Germans do not like the idea of sharing political policy with other countries in Europe, particularly France, particularly the countries on the southern rim of Europe. They don't want to and as long as they don't want to do this is going to be extremely difficult to achieve. And it's one of the big problems that the Eurozone still has.

Beckworth: But if the Germans do eventually buy into this idea, we would see a bond debt instrument from Europe that was backed by other government bonds throughout including Germany. So the SB would be a competitor to the US Treasury bond?

Bird: Basically, yes. The idea would be, I believe they'd tweak the idea, a bunch of academics that work on it, but you'd have a junior and a senior SB. You'd have a senior SB which is judged to be the safe asset, the equivalent of in the Eurozone, a German bond or in the US, the Treasury. And the junior one would be the high yield equivalent, with the basic idea being that if any Eurozone country defaulted, you can think of the SB as a CDO filled with European government bonds. And if any individual government defaulted, it will be the junior tranche of the bond that would default, and the senior will be protected. That's the basic idea behind it. I can certainly see the advantages for that in terms of the European banking system having a stable and common safe asset. But as I say, you really, really need the buy-in of the German government for this and I'm not sure they're yet particularly close to agreeing to.

Beckworth: Okay. Well, let's now move to your home, the United Kingdom. You're in London.

Bird: Yes.

Beckworth: So let's talk about the hot topic there, and that's Brexit. What is going on with Brexit?

Updates on Brexit and the British Economy

Bird: Well, it's always fun to talk about. Just to give a bit of background, at the moment the UK triggered what's called Article 50. It's the provision in the Treaty of Lisbon, which is the last major European Union treaty for leaving the European Union, which sets in place a two-year process of negotiating to leave. The stage that we are currently at in the negotiations is still negotiating the financial terms of the UK's exit from the European Union. So the UK needs to agree to a certain size payment to settle things like pension liabilities, obligations that we made before we left the European Union, things of that nature.

Bird:  We're not yet on to the bit where we hopefully talk about our future trading relationship with the European Union. We need to get past this bit first. It has been very much the only topic of conversation in British politics for a very long time. Everything for the past couple of years has revolved almost entirely around Brexit, the consequences or lack of them, how this affects British politics. It is absolutely everywhere, all the time. Yeah, we very much live in Brexit land now.

Beckworth: Okay. In a best case scenario, what do you see happening to the British economy because of Brexit?

Bird: I think it's still very much depends on the deal that the UK gets. I think it's reasonable and objective to say that there would be a serious short-term issue for the UK economy in the case that the UK left without a meaningful trade deal agreed. I think that the problem for the UK is that financial services are a huge part of the cross border trade that the UK does with the rest of the European Union. London is the wholesale banking center for large parts of the EU. And there are no meaningful trade deals in existence that allow the seamless access to cross border financial services that the European Union single market does. And the EU doesn't have that trade deal with Switzerland, it doesn't have that trade deal with Canada. They don't really exist.

Bird:  So I think the best possible outcome for the UK is that there is a trade deal that fairly closely resembles what we have at the moment, although the difficulty of that is that the UK did vote to leave the European Union and the European Union's rules on who can have that market access require applying the judicial control, the European Court justice, some political elements like free movement of people, which are redlines, it seems the UK politics surrounding them.

Beckworth: So in order for London to keep its advantages, this wholesale banking center, this financial capital for Europe, it would be an unusually generous treaty from the European Union to an outside political entity.

Bird: I think so. There's a couple of things on the European Union side that makes sense in that what they really don't want to do is incentivize any countries to also consider leaving.

Beckworth: Okay.

Bird: There's a bit of using the UK as an example because if you offer the UK a generous trade deal where nothing really changes, but you don't apply the laws and directions of the European Union, then what happens when Hungary or Italy or Malta turn around and say, "Well, we want that too. We don't want any of what's going on in Brussels, but we will have the trade deal. Thank you very much."? That's the difficulty that they face.

Beckworth: Okay. What about monetary policy? So what is the Bank of England been doing and where is it going?

The Direction of England’s Monetary Policy

Bird: Well, the Bank of England has been an on interesting journey since the EU referendum. Around a month after the EU referendum, the Bank of England did what it had been signaling and it cut interest rates, cut UK base rate by naught point two five percentage point. And just a couple of months ago, they raised bank rate again back to where it was before. What's happening in the UK now is actually quite different to what was happening for a number of years before. And the economic concerns in the UK have diverged quite sharply from a lot of the rest of the world. The UK's inflation is not only currently above target, but it's above target even at the three year forecast of the Bank of England, which is why they've started raising interest rates.

Bird: It's very rare these days to find an advanced economy where inflation is a meaningful concern. But the UK is now there. Yeah. And that's interesting for a couple of reasons. The reason that inflation is above target at the moment currently is really just related to the fall in the pound. Exports, sorry, imports have become more expensive, and the UK imposed a lot. And so inflation goes up almost mechanically. The reason that they think inflation, at the Bank of England, is going to continue to stay above target is partly because they believe that the supply potential of the UK economy is somewhat lower. That's partly due to Brexit, that's partly due to the UK's now extended run of very, very poor productivity growth. All of which together means generally with the labor market, as it is now in the UK, unemployment is now very low. Participation is very high, you're likely to see inflationary pressures if you don't see productivity pickup. And if you start, for example, effectively erecting protectionist barriers with parts of the world that you previously had free trade with.

Beckworth: Very interesting. Okay. We've taken a tour of central banking in the major advanced economies around the world, the Eurozone, the United, well, we haven't touched on the United States, we've skipped that one. But all the others, the ECB, Bank of Japan. And our listeners know the US experience from our other podcasts and from their own understanding if they follow this discussion. What lessons can we draw from these experiences with unconventional policies? There's been negative interest rates, we've had large scale asset purchases, there's been new ideas floated, Japan has tried yield curve targeting. What is the takeaway or takeaways from these experiences?

Lessons From Unconventional Monetary Policy

Bird: That's a good question. I think the most obvious takeaway, at least in the past couple of years has been that negative interest rates seem relatively unlikely as things stand to be employed in the future as a major policy tool of central banks. I don't think any major central bank has particularly had a particularly happy experience of employing them. They've been a tool or most of desperation of not knowing what else to do.

Bird: On the other hand, I think as we discussed earlier, the experience of Japan suggests that, suggests to me in any case, that quantitative easing probably works somewhat better than the popular narrative suggests. I think that that's very likely to be a tool in future. I think that the assets purchased in any future crisis are likely to be broader. You've seen that recently, anyway in the fact that the European Central Bank now buys corporate debt, and we've talked about Japan's buying of ETFs. Yeah, I think that quantitative easing is likely to be one of them. And potentially, to be honest, if there were another crisis tomorrow, I think you'd probably see quite a lot of outright monetary fiscal coordination, effectively the central bank directly funding fiscal stimulus. I think that's extremely unlikely, it's extremely likely rather.

Bird: One of the interesting idea that's been floated in the US recently is price level targeting. That's been really interesting and I think, I hope actually, we're going to see more discussion about that. Because the relative flaws with inflation targeting that have popped up since the crisis have become increasingly obvious. Price level targeting, I know you're a fan of nominal GDP targeting. And I think these are likely to crop up increasingly as potential answers that central banks need.

Beckworth: Okay. Well, I hope you're right in the level targeting front. I think all these other policies become more effective when you've got a level target to guide and anchor them.

Bird: Yeah.

Beckworth: Let's talk about some of the developments in the financial markets because you also cover those.

Financial Market Developments

Bird: Yes.

Beckworth: And you've talked about, one of your most recent articles about the stock market boom, a global stock market boom, global earnings have hit record highs. What all is going on there? Why is the stock markets so happy?

Bird: That's a good question. I think one of the things, and we've spoken about this a little bit when it came to Europe is this has really been the first year of synchronized global recovery. There are very hardly in recessionary territory. Emerging markets are doing relatively well. The Chinese economy hasn't slowed down by as much as some people feared that it would. And the Eurozone is growing, Japan is growing. US growth still seems to be strong, despite perpetual worries that the US is late cycle, that it's on the edge of a potential recession. That doesn't seem to materialize.

Bird:  Trade growth has picked up this year, something that's been lacking since 2008, which is really great for a lot of emerging market economies. And it's really good actually for the Eurozone and Japan. Yeah, I think that's a large part of it. The commodity price volatility that we've seen in recent years has dissipated a little bit, you had an earnings problem simply because so many large equities are commodity focused that when commodity prices crashed, a lot of those stocks did really badly. That seems to be out of the way. Even though there's a huge amount of discussion in politics, if you were just looking at economic statistics, economic metrics, this is one of the most... I was speaking to someone the other day who put it this way. They said that it's the most normal post crisis year so far, just in terms of the economy. And I think that sounds just about right to me. And that's been a major support for markets. And why you've seen such broad based improvements, certainly in equity markets around the world.

Beckworth: So the global economy is improving and this has been reflected in stock markets. This is a good thing. One of the issues you brought up in that conversation is the yield curve in the US has some potentially troubling signs coming from it. But there's been a different way to interpret it. And one interpretation is that it is pointing to a weakening of the US economy. Another interpretation is that maybe the long end of the yield curve is acting differently. Long-term interest rates in the US are acting differently because of all these developments in the world, the QE programs around the world, the shortage of safe assets around the world. How do you view the flattening US Treasury yield curve? Is it more benign? Or is it more troubling?

Bird: It's interesting. I think it's always worth paying attention to these metrics, because a really steep sharply flattening yield curve, as we have at the moment has been a decent recession indicator in the past. It's certainly worth keeping an eye on. But what you alluded to there, which is partly the large international buying of US Treasuries potentially wasn't quite as true at the time of the last US recession, and it really is true now. So I think you do have to look at it slightly differently. And actually, the UK is a good example here. The very, very long dated UK government debt, so thought of 40 and the 50 year maturity, they actually yield less a lot of the time than the 20 and 30 years.

Bird: And that is because in the UK, we have a large pension fund appetite for those very long dated UK government bonds. And it means that the yield curve is inverted at the medium to long and basically all of the time. It doesn't have any special economic signal. It doesn't offer any information. It really is just because there is a very large institutional buyer that has a perpetual appetite for that debt. It may very well be the case in the US that these are Japanese pension funds, Japanese insurers, Eurozone insurers, Eurozone pension funds, buying longer dated US debt. And that potentially, as you suggest, the yield curve doesn't offer as much explanatory information as to the state of the US economy than it did maybe 10 years ago.

Beckworth: Oh, I hope you're right. That's a very nice interpretation.

Bird: Fingers crossed. Fingers crossed.

Beckworth: Yeah, fingers crossed, for sure. Okay. In the few minutes we have left, I want to end on an article that you wrote on the dollar and the title of the article was, *A Decade After the Crisis, King Dollar Is the World's Tyrant.* And this actually does tie back into Fed policy, which we haven't discussed. So share with us what you covered in that piece.

The Dollar as the “World’s Tyrant”

Bird: Absolutely. Well, it's been a fairly popular narrative for a very long time now that the dollar's dominance of the global financial system might be at risk. It was popular before the Euro crisis, that the euro might supplant the dollar in a number of markets. It then became popular to imagine that the Chinese yuan would do the same thing. What we really wanted to explore in this story, and to explain is that the dollar's control, control is the wrong word. Because it's not the dollar controlling it. The dollar's influence in international markets is not only not diminished, but probably greater than it's ever been.

Bird:  We were looking at a number of different variables. But whatever you look at really, the dollar is still the overwhelmingly dominant global currency in terms of issuance of international debt, it's dominant almost completely in trade accounting. Banks in the rest of the world are still hungry for dollars to the extent that there are some markets for foreign exchange swaps that are extremely distorted and have been for a long time. Yeah, we really just wanted to look into this idea. And for me, it's one of the fascinating things to keep an eye on in terms of potential future crises, the dollar's grip is so strong, that any real shortage of dollars would pose a big problem for larger parts of the global economy.

Beckworth: So the dollar is still highly demanded across the world and dollar denominated assets, like treasuries we talked about a few minutes ago. And what was, meaning the pieces you tied this to the Fed tightening its policy, particularly the shrinking of its balance sheet.

Bird: Yeah, absolutely.

Beckworth: Speak to that.

Bird: So the Fed's shrinkage of its balance sheet, I think it's particularly interesting on this front, because private sector, or rather let's just say commercial bank lending, unsecured foreign exchange lending, has become increasingly difficult since the financial crisis, a number of regulatory efforts that have gone in, things like capital requirements, the requirement to hold a lot of high quality liquid assets have meant that US banks, for example, are fairly reticent to lend out a lot of dollars. Typically what they would do is lend a stream of dollars to say a Japanese or a European Bank in exchange for a stream of euro or yen. And the cost of doing that will effectively be the interest rate differential between the two countries.

Bird:  The higher capital requirements have made it much more difficult for them to do that. And in their place, what has happened is the reserves held at the Fed have become de facto the center of international dollar lending. It's very easy for those banks to exchange a reserve at the Fed for a reserve at the Bank of Japan, for example, without expanding their balance sheet and starting to hit those regulatory constraints. Now what happens when the Fed shrinks its balance sheet is a bit of a question mark from here. We spoke to a lot of analysts, a number of whom think that as the Fed shrinks its balance sheet, and they're shrinking the balance sheet at an increasing pace. So next year, they'll start reducing by $50 billion a month. They expect a fairly meaningful tightening in dollar funding as those US commercial banks become less willing to lend dollars to their international peers. That's particularly in Japan, the Eurozone and Canada. And so you might see some interesting things next year in those dollar funding markets. It's definitely one to keep an eye on.

Beckworth: Okay. Well, our time is up. Our guest today has been Mike Bird. Mike, thank you so much for coming on the show.

Bird: Thanks very much for having me. It's been great.

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