Nov 7, 2022

Megan Greene on the UK’s Recent Market Turmoil and What it Means for the Future of the Global Economy

After a perfect storm of factors recently plunged the UK in economic disarray, central banks across the globe should be taking notes on how to avoid a similar fate.
David Beckworth Senior Research Fellow , Megan Greene

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.

Megan Greene is a senior fellow at the Watson Institute for International and Public Affairs at Brown University and is the global chief economist at Kroll. Megan is also a contributing editor and columnist for the Financial Times and is a returning guest to the podcast. She rejoins David on Macro Musings to talk about a recent article she has written titled, *UK Market Turmoil is a Harbinger of Global Events to Come.* David and Megan also discuss the basics of what caused the UK’s recent crisis, how persistent inflation continues to impact the global economy, the current outlook for international energy production, and a lot more.

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 [email protected].

David Beckworth: Megan, welcome back to the show.

Megan Greene: Thanks for having me. It's nice to talk to you again.

Beckworth: Okay, Megan, you have this new article titled *UK Market Terminal is a Harbinger of Global Events to Come.* That sounds pretty ominous, very serious at a minimum. Walk us through this and start with what happened in the UK because I still think there's a lot of confusion, including myself, as to what exactly happened. What's your take of that event?

An Overview of the UK’s Recent Economic Crisis

Greene: Yeah, sure. I'll point out first that I published that article right before the IMF World Bank meetings and had a number of policymakers from Europe and the US pull me aside and ask the same thing. Also pointing out how ominous it sounded and how they were worried about it too, so that actually made me feel a bit better that they're also concerned about this. But the idea is just that the market blow up that we saw, particularly in the LDI markets in the UK, is just the first mine in a big mine field that we're starting to walk through now that the era of cheap and easy money is ending as we've got a global central bank tightening cycle happening. The developed world is almost certainly going into recession and fiscal and monetary policymakers are going to be acting at cross purposes.

Greene: In this environment, I think we're going to have market blowups. I think, generally, we can assume that everyone is going to have to spend more in the face of this cost of living crisis, energy crisis, a downturn. Markets are going to be the disciplining factor and it's going to be central banks who are going to have to step in and paper over market dislocations. What we saw in the UK was a huge move in gilt yields and also the pound off the back of the announcement of a so-called mini-budget that really wasn't mini at all. In my view, the mini-budget was really just the straw that broke the camel's back. It's not the only thing that's going wrong with the UK economy right now, but off the back of Brexit, a pandemic, an energy crisis that's just as bad if not worse than what we're seeing in the Eurozone, even though the UK's not very reliant on Russia for energy, general mismanagement of the economy.

Greene: We had this new government come in and announce not only huge amounts of money to address higher energy costs, but then on top of that, a whole bunch of unfunded tax cuts that were regressive, arguably would've benefited wealthy people at the expense of poorer people. That last mini-budget was the straw that broke the camel’s back. There's a lot that's idiosyncratic about the UK here, I should point out, I just listed a whole bunch of crises the UK is facing. The communication of the mini-budget was pretty bad. The Treasury Department didn't talk to other departments or the central bank before they announced it. They sacked a top civil servant. It wasn't subjected to their version of the Office of Budget Management. There was no accosting of this. It was handled pretty poorly, but I think with the moves that we saw, the big jump in gilt yields in particular, wasn't really a reflection of concerns about the economy.

In this environment, I think we're going to have market blowups. I think, generally, we can assume that everyone is going to have to spend more in the face of this cost of living crisis, energy crisis, a downturn. Markets are going to be the disciplining factor and it's going to be central banks who are going to have to step in and paper over market dislocations.

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Greene: I think it was really a moron premium that got built into the market. It was just a complete evaporation of confidence in this government, and so investors absolutely went on a strike, didn't want to hold long-term government bond yields anymore, didn't want to hold the pound either. Government bond yield spiked in the UK and that kicked off this whole doom loop in the pension industry, where you had LDI, liability driven initiative, pensions that had forced selling of gilts and a whole bunch of other things in order to raise collateral for margin calls. You had these pensions dumping their gilts in order to get cash to hedge against higher yields than gilts, but that of course just pushed yields up further, and so it became this endless doom loop until the central bank, the Bank of England, had to step in and be the market maker of last resort and they provided the liquidity operation that's being broadly called QE, even though they're trying to lean against inflation by withdrawing accommodation. They engaged in QE in this industry, in particular for a short period of time to help the pension funds unwind their positions.

Greene: What we see now is that the gilt yields have actually come back down off the back of the Bank of England's intervention. The Bank of England is going to start quantitative tightening as they had originally planned anyhow. But actually, the pound hasn't recovered, which suggests that investors are still pretty skeptical about some of the structural problems that I mentioned in the UK economy. Now, I say all of this is a harbinger of things to come for the rest of the world because what we saw was the fiscal authority in the UK trying to spend a lot while the monetary authority is trying to withdraw accommodation. Investors weren't convinced at all by this additional spending. They didn't think it was being done in a smart way, and so they went on a strike and the central bank had to step in. We're going to see that repeated, in my view, across Europe as we go into winter in the face of an energy crisis sparked by a war in Europe's backyard, the cost of living crisis. A lot of European governments are going to have to spend more and I think investors are going to be the ones who are going to discipline governments doing that. Then it makes it really tricky when governments are operating at cross purposes with central banks. It just makes the central bank's job that much harder.

Beckworth: There's a lot to unpack there, a lot of interesting angles. Let me start with first just saying it sounds like a perfect storm. A lot of things coming together and creating this environment that made the UK susceptible to what you called the moron risk premium. Did I hear that right? Is that the term?

Greene: That's right.

Beckworth: Okay.

Greene: Yeah.

Beckworth: The lack of confidence. Yeah, okay.

Greene: Not my term, the FT has written a piece on the moron risk premium.

Beckworth: Okay.

Greene: Yeah.

Beckworth: Very clever. A lack of confidence in leadership, as you mentioned, demonstrated by the lack of communication among the different agencies in the UK government and not communicating, thinking through how it might sound, the timing of the delivery, all those things came together to make this perfect storm. That's important, leadership matters. I guess one big takeaway is thinking through how you present your packages and your spending. Another question I want to ask is, you noted what the Bank of England did was like QE or buying up these longer term bonds to bring down these yields, so that pension balance sheets wouldn't be blowing up, so it lowered the yields, the prices of their securities go back up and things are better. What's interesting to me is at the same time, they're pushing up short term rates. They were, at least for a while, lowering long-term rates, pushing up short-term rates, and typically, we say that's a sign of bad things to come, an inverted yield curve.

Beckworth: I know it was a temporary arrangement, but if you think through, at least for me, think through the implications, you're inverting the yield curve, you're reducing your net income spreads, it seemed like a lose-lose situation no matter which way you were going. Any thoughts on that? On the cross purposes that might have accomplished?

Yield Curve Inversion and the Question of Fiscal Space

Greene: Yeah. I think that's right, although it was temporary and it's hard to overstate the swiftness in which government bond yields moved. I do think that the Bank of England stepped in and did the right thing. To my mind, it's a risk, yes, that they're setting up an environment in which the yield curve would naturally invert. The UK is probably going into recession, but in my view, there's a bigger risk out there about this and that's around this whole idea of QE, because I think QE is now this huge bucket into which we throw all kinds of different types of operations, and I think that was done quite intentionally by central banks because it's a complex concept and trying to delineate between them wasn't necessarily going to help central banks communicate what they were really doing. But now, I think it's tricky because QE can be restoring market functioning or it can be trying to push investors out along the yield curve to longer maturities.

Greene: Those are very different types of operations. I guess I bring this up because the Bank of England engaged in QE, even though the day before that they were talking about QT, the very opposite, that's what they wanted to be doing. They stepped in with QE and they lucked out in that investors didn't look at that and think, "Well that's going to boost asset prices all across the board. That's going to be inflationary and that's just going to make the central bank's job more difficult," and I think that's because it was a one-off. If we have central banks having to repeatedly step in to paper over these market dislocations, I think there is a real risk that that gets baked into everybody's inflation expectations and that undermines what the central banks are all trying to do in terms of leaning against inflation.

Beckworth: Okay. Risk management there, even though there may have been some potentially bad outcomes, it was a one-off thing and in terms of risk management, it was the right decision. Let me ask another question related to this, and this is the question of fiscal space. Again, it sounds like we're saying this is a question of the moron risk premium, timing, delivery, appearances, it wasn't that the UK government was out of fiscal space per se, they could have potentially done this or not?

If we have central banks having to repeatedly step in to paper over these market dislocations, I think there is a real risk that that gets baked into everybody's inflation expectations and that undermines what the central banks are all trying to do in terms of leaning against inflation.

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Greene: Well, no, I think there are big questions about how much fiscal space the UK really has. There wasn't a concern that the UK is turning into an emerging market style sovereign debt crisis. I don't think that that was really a risk, just because the UK issues its own currency, has an independent central bank, most of its assets are in pounds, so I don't think it risks becoming a sovereign debt crisis. But given the scale of the unfunded tax liabilities and the utter absence of any kind of plan to reduce the UK's debt stock going forward or its deficit, I think there were concerns that this government was just going to be fiscally irresponsible, was going to spend massively… that could be inflationary. I think that was a piece of the gilt yields rising. I just don't think it was the main piece.

Greene: Baked into the risk premium and embedded in this total loss of confidence in the government, I think, was this idea that, what are they doing spending right now? That's not what they need and it's very irresponsible. If I were Rishi Sunak now, I would come out with a budget, but also, and more importantly, a 3 to 5-year plan showing how exactly the UK would expect to reduce its debt stock over time.

Beckworth: Signaling is important here. Sending the message, managing expectations, forward guidance by the UK, their government's own form of forward guidance.

Greene: That's right.

Beckworth: Yeah, I was joking the other day on Twitter that Secretary Janet Yellen's doing her own version of forward guidance by suggesting a bond buyback program in the near future for treasuries to add liquidity. We always think of forward guidance with the central bank, but governments themselves can do that and affect bond markets. Let me move ahead to something I was going to talk about later, but I think is very useful now we're on this, and that's the question of the Fed and central banks raising rates. It's a part of this mix that created this perfect storm. Your colleague at the FT, Edward Luce, had an article titled *The World is Starting to Hate The Fed,* came out a few weeks ago and he goes through these emerging markets, other parts of the world, even the ECB, the Bank of England to some extent have to follow what the Fed is doing or they will import higher inflation.

Beckworth: But I want to read a quick excerpt here from what he wrote. He goes, "Africa was neither responsible for the pandemic nor the war in Ukraine. The first is undoing years of human development gains. The second has unleashed a wave of food and energy inflation. Now, the Fed is adding a potential debt servicing crisis to the cocktail." He goes through examples like that, and I guess this raises the question, could this part of the perfect storm been avoided had the Fed raised rates sooner, say mid to late 2021? Now, again, this is hindsight and Monday morning quarterbacking, but let's just say they could have seen all this coming. Would it have made enough difference to avoid some of these challenges today?

The Macroeconomic Hindsight of Earlier Fed Rate Hikes

Greene: I'm not sure it would've made a difference. When Chair Powell said, I think at the Jackson Hole Fed Conference, "Look, if we had hiked rates a few months earlier, it probably wouldn't have made any difference at all," I was pretty sympathetic to that view. I think it's important to consider what the Fed is responding to in trying to figure out whether they've acted appropriately or not or if they had done something differently, if it might have helped. They were clearly responding to inflation, but the nature of inflation in the US is very different from the nature of inflation elsewhere, primarily because it's got a big demand component to it. Whereas, in Europe in particular, inflation is mostly supply-driven. If the Fed had hiked earlier, maybe it could have headed off that demand spike a bit, but I'm pretty skeptical that it would've made a big difference and the Fed would've been the only major central bank in the developed world hiking at that point, so in terms of currency impacts, I still think the dollar would've been driven higher.

Beckworth: That's a good point.

Greene: That's the reason that other economies are effectively importing inflationary pressures. I don't think it would've helped out much. What has helped other economies, in emerging markets in particular, is that a number of emerging central banks started hiking really proactively and pretty aggressively, and so their currencies haven't had as big a shift relative to the dollar. But for the major developed economies, they wouldn't have been hiking earlier and they weren't facing the same demand side driven inflation anyhow, so I think the currency moves would probably have been pretty similar.

If the Fed had hiked earlier, maybe it could have headed off that demand spike a bit, but I'm pretty skeptical that it would've made a big difference and the Fed would've been the only major central bank in the developed world hiking at that point, so in terms of currency impacts, I still think the dollar would've been driven higher...That's the reason that other economies are effectively importing inflationary pressures. I don't think it would've helped out much.

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Beckworth: That's a great point. We just maybe could have brought forward some of the currency issues we're experiencing today, which could have created similar problems in late 2021.

Greene: Yeah, and no other central bank would ever admit that they're hiking because of their currency, but of course that's a huge, huge input into their reaction function. They just don't talk about it publicly.

Beckworth: Well, let me ask a question on that because I have found that at times, [it is] hard to follow what the ECB is doing, for example, my love is with nominal GDP targeting and just in general looking at total spending, total nominal demand in an economy. In the US, it's easy to see the excess demand that's accelerated above trend growth. In the Eurozone, it's less clear, and I know there's other indicators, wages, the exchange rate, things like that, where you're worried about pass through and maybe unanchoring inflation expectations. But in terms of just the current state of the economy, as you alluded to, there's really more supply side-driven inflation. Is there any conversation over there with policymakers and commentators that maybe the ECB is getting ahead of itself and might do more damage than good?

Is the ECB Getting Ahead of Itself?

Greene: There isn't really, though the ECB at its last meeting had a pretty dovish turn, I think. Insofar as the president, Christine Lagarde, said that they were considering that a recession is disinflationary and they know that they're headed for a recession, so they were considering the implications, en gros, of their moves on their reaction function for rates. I think while the hawks had pretty much dominated at the ECB for the past couple of months, particularly at Jackson Hole, where Isabel Schnabel gave a pretty hawkish speech, the doves are finding their footing again, and so maybe that debate is just starting. I think it's really likely that Germany and Italy are already in contraction. If not, I think they'll go into contraction pretty soon. I think the Eurozone will be in a recession next year. Isabel Schnabel at Jackson Hole had said that she was committed to actually hiking into a recession because as the Fed has argued, it's better to act now and cause a downturn than to wait and have to act even more later and cause a much bigger downturn.

Greene: I do think that the ECB still subscribes to that. As you point out, their inflation is mostly supply-driven, so there's not a whole lot that the ECB can really do about it. They do have to respond to the weak euro, and so I think that's part of the reason that they're hiking. I think they're also worried about inflation expectations becoming de-anchored, and in their view, if you wait until they're de-anchored to do anything about it, you've already missed it, so that's a piece of it as well. When it comes to a wage price spiral, there's less evidence of that in the Eurozone than there is in the US, except for Belgium, which has wage indexation, so that's baked in… a wage price spiral. But Belgium's a pretty small economy, so that doesn't really move the needle in aggregate for the Eurozone. There are big German unions that are having their trade negotiations now. Usually, when they propose a wage growth, after negotiations, they come out at about half that, so the proposal for IG Metall was around 8%, which would be huge. I think consensus is that it'll come out around 4%, which is higher than historically has been the case, but much lower than the wage growth that we've seen in the US. There's little sign of a real wage price spiral in Europe.

Beckworth: You mentioned Germany, and that's one of the countries in your FT piece that you talk about, the “Harbinger of Things to Come,” Germany and then Italy, and you've already touched on Germany, but anything more you want to add about Germany? Susceptibilities it may have to this cycle?

Greene: Yeah. Germany announced a $200 billion package to subsidize energy. They've been pretty wise in how they've designed it so that it is pretty targeted and temporary and timely as all policy is supposed to be. It’s just one example of Germany, the pillar of fiscal responsibility, is unilaterally announcing massive spending packages. I just think that that's an example of what we're going to start seeing coming out of other Eurozone capitals given how difficult this winter's going to be. They've lucked out so far on the energy front in that it's been pretty mild. Europe has also really lucked out that China's been doing so poorly because then they haven't been competing with China for LNG. I think we'll see stimulus coming out of China, so China should accelerate from here on out, and who knows what will happen with the weather? The only forecasts that are more useless than economic forecasts is a weather forecast.

Beckworth: Yes.

Greene: If we're hanging all our hope on that, then I think we're in a pretty precarious position. I think it could get difficult this winter. Moreover, next winter is going to be much harder because, of course, Europe managed to refill its storage with Russian energy that was expensive, but at least available, it won't be available next winter, and so even if we get through this winter without having to spend a lot on energy subsidies, next winter, they're going to be necessary I think. Over the next year, there's going to be a lot of spending in Europe. There's going to be spending on the green transition, as well as on the cost of living crisis, and it's not clear that investors are going to be willing to stomach that. It really depends on how exactly it's targeted. We've heard rumors now that there's a new government in Italy, that they're putting together a budget which they'll have to produce pretty soon, and that it's actually more expansionary than the previous government under Mario Draghi's budget was, and that's not a surprise, but we don't know exactly what it contains yet.

Greene: But there is a risk that they'll come out with something and investors will say, "Well, that's just fiscally irresponsible. We're not willing to hold Italian government bonds," and already, Italian government bonds have been supported by the ECB in their PEPP re-investments. They've mostly been redirected towards Italy. We may end up having to see the use of this TPI tool that the ECB has set up to try to reduce spreads if they need to. Will that be enough? We're not really sure. I think there's a lot of uncertainty around it, but it's just another example of a European country that may end up spending a lot more.

Beckworth: Italy is particularly susceptible, right? Given all of its debt and the lack of good finances in the country. Can you talk more about that?

Greene: Yeah. Italy is not only highly reliant or has been highly reliant on Russia for energy, but also Italy doesn't grow when times are good. It's not growing now, right?

Beckworth: Right.

Greene: As I mentioned, I think it's one of the economies that's probably already in contraction. It has a pretty big debt burden already. It's got a center right government, the head of which is from the Brothers of Italy, a political party that has its roots in Mussolini's party, so there have been concerns about the responsibility of this party. Since the election, the now Prime Minister, Giorgia Meloni, has really moderated and she's moderated both in terms of what she's been saying, but also in terms of the ministers that she's chosen. Most importantly, she chose Giorgetti to be the finance minister. He was in Draghi's government, so he's actually seen budget creation and execution before, which I think will be helpful in trying to stick to a budget under Meloni.

Greene: That kind of continuity is a good sign, but Italy has very little room for maneuver. There's not a lot of extra cash lying around in Italy to be spent this winter. On top of which the only one buying Italian bonds right now is the ECB. There's no way the ECB is financing a flat tax or a reduction in retirement age or something like that in Italy. This government will have very little room for maneuver. If it decides to paint outside the lines because it feels it needs to support more vulnerability in the economy and it does it in a seemingly irresponsible way, we could end up with another blowout like what we saw in the UK.

Beckworth: Does the ECB have a lot of support still? This seems like a period where there could be some unhappy campers. Didn't the Italian prime minister come out with a speech recently which was critical of ECB's monetary policy? Then, just the flip side, the Germans might be upset that the ECB is providing this implicit support to Italy?

Greene: Yeah, what's interesting is during the Euro crisis, we saw that the Germans were often against any kind of solidarity with the rest of the Eurozone, particularly the weaker economies, largely because Germany didn't want to have to be bailing everybody else out. But right now, Germany is underperforming the rest of Europe in economic terms, and so now Germany's asking everybody else for some solidarity, and it's partly off the back of Germany's disastrous energy strategy, which was pretty much to just rely on Russia up until the invasion of Ukraine.

Greene: That has shifted a little bit, but that said, I don't think Germany's really on board for supporting peripheral countries even more so because Germany's struggling economically quite a lot now, so that would have political repercussions in Germany as well. If you look into the politics of Germany and in local elections, the finance minister's party has done really poorly and they tend to be pretty fiscally hawkish, and so that would suggest that the finance minister, to shore up his party's support, will double down on hawkishness. Even if the chancellor's willing to do some things, I doubt that Lindner, the finance minister, will be. I don't think we can expect any kind of solidarity coming anytime soon in terms of fiscal policy, but also in terms of monetary policy. We might see some schisms emerging on the governing council at the ECB.

Beckworth: It'll be exciting to watch and we hope for the best for Europe. Now, let's move on to some other potential institutions or markets or assets that could be susceptible or part of this wave of things that could be affected by what we saw in the UK. Let's start with European banks. How do they look?

The Macroeconomic Ripple Effect of the UK Crisis

Greene: They don't look as great as American banks, I'd say, just in terms of having to build up capital. European banks have been massively subsidized for the past few years by TLTROs, the targeted long-term refinancing operations. That's been even more the case since the ECB started hiking rates. Now, the ECB at its most recent meeting changed the terms of the TLTROs so that they're not such a huge subsidy to the banks. But the banks have made quite a lot of money off of that, and so for that reason in the short term, I'm not particularly worried about European banks. What we saw with share prices of Credit Suisse though was that actually, even if the fundamentals seem sound enough, you can have a loss of confidence in banks, and so that is a concern and will remain a concern over the next couple of years, particularly as Europe is going into recession.

Beckworth: What about corporate debt?

Greene: Yeah. Corporate debt is a worry in the US, I think. Corporate debt is about 80% of GDP, so that's a pretty big stock. A third of that is BBB-rated, which is the lowest rung of investment grade. As profits are going down and rates are going up, we can expect some of that to be downgraded. If that happens, there will be a bunch of forced selling of those corporate bonds just because some portfolios can't hold junk, and so they'll end up selling it. That could push up yields even more. You could get a UK LDI type doom loop that the Fed might have to step in and fix. It's worth pointing out that before the pandemic hit, a lot of economists thought it was corporate debt that was going to cause the next recession in the US.

Greene: That went away as a concern because corporates amassed this huge cash buffer over the course of the pandemic thanks to the pandemic response measures. But they're slowly burning through that cash buffer and it's these BBB-rated companies that I'm mostly worried about. It's a pretty liquid asset class, and so that doesn't necessarily mean it's safe, as we saw with the LDI blow up, gilts are also incredibly liquid, and so it's just really difficult to figure out where the next blow up is going to happen, but I think corporate debt in the US could be a contender.

Before the pandemic hit, a lot of economists thought it was corporate debt that was going to cause the next recession in the US. That went away as a concern because corporates amassed this huge cash buffer over the course of the pandemic thanks to the pandemic response measures. But they're slowly burning through that cash buffer and it's these BBB-rated companies that I'm mostly worried about...and so it's just really difficult to figure out where the next blow up is going to happen, but I think corporate debt in the US could be a contender.

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Beckworth: The Fed did open up the corporate bond facilities or several of them, received a lot of criticism for it, but I wonder to what extent these corporate bond markets are expecting that to be turned on again should push come to shove and something awful happen.

Greene: There is a moral hazard issue potentially with this, and it happened with the Bank of England as well. Andrew Bailey, the governor, came out and he said, "We'll provide this liquidity," and there's a deadline and everyone assumed that that deadline would be extended, and so Bailey, again, at the IMF meeting said, "You've got three days, that's it. You need to unwind these positions to the pensions." In my mind, that was because he understood that the pensions were effectively trying to call his bluff. They figured the Bank of England's not going to let us go bust, so we'll just hand this stuff over to the Bank of England and then they can take the losses and Andrew Bailey had no interest in doing that. You could see something analogous in the US with the Fed and corporate debt, where companies assume that the Fed's going to step in.

Greene: We now have a precedent for how to try to avoid that with a deadline, but depending on what's happening in the markets, that deadline might not work, that could really blow up. I do think that's risky, though you're right to point out, we have the plumbing in place to do this and actually, the Fed didn't end up buying much corporate debt at all as part of those programs. What may end up happening this time around, too, is that it just needs to announce that it's willing to and that will unfreeze the market, so it won't actually have to use it. If you're going to announce that, you have to be willing to use it.

Beckworth: Yeah. It would be crazy if we begin to see these facilities used again so soon after the 2020 use of it. The Swiss National Bank, I believe, is already tapping into the swap lines, currency swap lines, from the Fed. At least one of these facilities is being used currently, and if things get bad enough, we could see some of the other ones as well. Well, let's move to private equity. I think you touched on that on your article as well. What are the challenges there?

Greene: I think the main challenge in private equity is we just don't really know what's under the hood there. Private equity and private debt, we know that both have grown massively since the global financial crisis. I think they've roughly doubled in size. We also know that they've taken some losses this year, paper losses, but they're much less than what the public markets have taken, and so you could look at that and just conclude that private markets have better investment strategies or you could consider that maybe they just haven't taken all the losses yet and it portends future losses to come. The problem with all of this is that off the back of the global financial crisis and Dodd-Frank and regulation elsewhere, I think we've figured out how to regulate our banks much better, but we've shifted a lot of activity out of banking into shadow banking and the private markets are a great example of this, so we just don't have great visibility on what's actually happening there.

Greene: I also don't think we'll have much of a warning signal when there is a blow up, much like with the LDI crisis in the UK. No one was looking at that two weeks in advance or even two days in advance. The LDI market is a pretty sleepy, considered a safe market that no one was really worried about until all of a sudden it was at risk of creating this global Lehman-like moment. I think that's what's going to happen going forward in the shadow banking sector, because we just don't have canaries in the coal mine in shadow banking. We'll know it when it hits us, but not much before that.

Beckworth: The saying that the Fed will keep raising rates until something breaks, one of these markets may be the thing that breaks and forces their hand.

Greene: Yeah. I think that's right, but that doesn't mean that the Fed's going to stop raising rates then. I think that, again, the UK is a good example of what might happen where the Fed continues to hike rates but just steps in with liquidity operations to be the market maker of last resort.

Beckworth: You mentioned earlier that you were visiting with government officials, central bank officials at the IMF World Bank meetings, and I'm wondering if any of them talked to you about what this means for the future of central banking. Maybe they're too caught up in the moment, they have current crisis, current stress to be thinking about this, but I'm just wondering, as someone who thinks about this a lot myself, 2024, 2025, the Fed's going to have a new look at its framework, and I believe other central banks will be doing that as well, and the Fed has received a lot of criticism for allowing inflation to get out of control, and inflation's been an issue in advanced economies across the world. Your colleague, Martin Sandbu, in the FT, had a recent column out where he also raised this question, are central banks well-equipped, well-designed to handle crisis like we're going through? He's argued, "No, they're not, we need something better." I'm just wondering, is there anyone talking about this? Are they right now too worried about the current challenges they're facing?

Implications for the Future of Central Banking and Inflation

Greene: Yeah, I think the outlook for the next year was so incredibly grim at the IMF meetings that that is what took everybody's attention. But there's one exception, everybody's talking about inflation, right? But there was some discussion about whether we shouldn't consider just having a higher inflation target in the US of 3% instead of 2%. That did come up but it didn't come up as a logical or forecasted solution. I think the idea was it would be nice if we could start from scratch right now, why wouldn't we choose 3% instead of 2%? But even those who were in support of it didn't seem to think that there was much political support for this. There's a risk in terms of central bank independence as well in that you'd have to change the mandate to do that and then would you have the mandate flip flopping depending on who's in the White House? That's a big concern. I think the impediment is more political than economic or financial.

Beckworth: We will have to get to the other side of this crisis before we can really start thinking long and hard about framework reviews that may be coming up in the future.

Greene: I think that's right. Just quickly, I think I have a lot of sympathy for the idea that we just don't know what the economy will look like when the dust has settled. Very few people are talking about that. It's easy to pretend that we're not in a pandemic anymore, but we actually are. China reinforcing a zero COVID policy at the Communist Party Congress should hit that message home, because we'll have repercussions from COVID for the next year for sure, if not longer. Then, on top of that, we just keep having successive supply shocks. We don't really know what our economy will look like on the other side of this, but some of the structural drivers of secular stagnation, things like demography and digitalization, automation, that stuff hasn't abated. I do think there is an argument that maybe, actually, on the other side of this, the inflation picture will look much more like it did before the pandemic than it does now. I think we genuinely just don't know yet, so it's worth waiting maybe to have that debate until we have a better sense.

I do think there is an argument that maybe, actually, on the other side of this, the inflation picture will look much more like it did before the pandemic than it does now. I think we genuinely just don't know yet, so it's worth waiting maybe to have that debate until we have a better sense.

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Beckworth: Yeah, I share your view on that. I suspect we will go back to a world that looks a lot like 2019, on the other side, with a lot more public debt along the way, but we'll return to low inflation. The other thing that's been interesting through this past year or so, the high inflation surge, is that you're seeing advanced economy central banks act a lot like emerging market central banks in the following sense; historically, the way I was taught it, is that you look through supply shocks if you're a central banker, and the only reason you would pay attention is if you're worried that those supply shocks create inflation that de-anchors inflation expectations.

Beckworth: In advanced economies, that was not a problem. That's not something you'd worry, but only those emerging markets got to worry about that when they have some term or trade shock or the exchange rate moves rapidly. But we're seeing it right in advanced economies, and that's really surprising for me at least to see that the ECB, an economy that large, thinking in those terms that normally would be something an emerging market would do. Has it struck you too that we've reached this point where this is becoming an issue for the advanced economies as well?

Greene: Yeah, and I think it's related to credibility. The idea was that in advanced economies you didn't need to worry about the credibility of central banks, so of course, inflation expectations would be anchored. Central banks said they were committed to it. But now, I think central banks have lost a lot of credibility, particularly as they've been caught surprised by inflation. I think that's fair enough, I was also caught by surprise by some of this inflation, and so I think the concern is that if they're viewed to be seen to not really understand what's causing this inflation, they've given up on their models, I think. That goes for the Fed as well as the ECB and the Bank of England. Their models just haven't been predicting this stuff very well. It's fair enough, we put the economy on a deep freeze and then defrosted it and then had a war. It's no surprise that our models don't know how to input that very easily, but it does undermine the credibility of central banks. If you don't believe that they understand what's going on with inflation or what to do about it, then you might also not believe their guidance on where they expect inflation will be.

Beckworth: One of the implications of this experience is how it's going to affect the energy industry, also, what it means for climate change in dealing with that, the transformation to a cleaner economy, other technologies. In previous shows, we've talked about this, you've been thinking about those issues a lot. I'm just wondering if you've thought through what this means for climate change and for the adoption of alternative energy sources. For example, we see this demand for fossil fuels and governments accommodating that. I imagine Joe Biden never imagined that he would be encouraging more drilling during his administration. In fact, when he came in, he was trying to push the other direction, and now he's kind of backpedaling. What are your thoughts on that as someone who's really in this space a lot?

We put the economy on a deep freeze and then defrosted it and then had a war. It's no surprise that our models don't know how to input that very easily, but it does undermine the credibility of central banks. If you don't believe that they understand what's going on with inflation or what to do about it, then you might also not believe their guidance on where they expect inflation will be.

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The Outlook for Global Energy Production

Greene: Yeah. I think it looks different in Europe and the US, so it's worth splitting them out. I think in Europe they are much more committed to this green transition. In the same way that Joe Biden's had to try to encourage fossil fuel production, the Europeans have reopened coal plants, so in the very short term, I think we've all taken a massive step back in terms of the green transition. But the intention in Europe, I think, is much more firmly in trying to accelerate this transition and it's baked into some of their programs. The next gen EU funds, for example, which were created, it's jointly issued debt at the EU level to be provided in the form of loans and grants to EU countries, but a pretty big proportion of that has to be earmarked for the green transition, has to be earmarked to shift away from fossil fuels. It is baked into some of their funding plans.

Greene: Now, there's talk of trying to come up with some European-level approach to energy, both in terms of a different approach to pricing energy, but also in terms of trying to reduce the cost burden for regular citizens and also there's some talk of reigniting the next gen EU funds creating a new program to try to fund the green transition. I don't think it's going to happen, it's not my base case, but the fact that it's being discussed I think is encouraging. Olaf Scholz, the German chancellor, actually said he was up for it, which he then walked back from really quickly, but that was a surprising moment. We're not there yet for sure. It doesn't mean we'll never get there, but it all does suggest that the Europeans are pretty serious about this transition.

Greene: That's less the case in the US. When Russia invaded Ukraine, the first question investors asked me was, “Biden's going to reopen the keystone pipeline, right?” Which I think is just a knee jerk reaction that suggests how committed to the green transition we might be in the private sector at least, if not in the public sector. I do think that it's less clear that this is really going to accelerate the green transition in the US. Our energy costs haven't risen nearly as quickly, we're much further from the war. We're not reliant on Russia at all, even though we are affected by the invasion of Ukraine, because the oil market is a global one, for example. But the implications for the Europeans have been much harsher, and so I think that they're much more committed to it.

Beckworth: One of the areas that was contested in terms of this green transition was nuclear energy. Some people were for it, some were against it. Do you think this crisis we're going through right now has convinced more people that nuclear is a viable option and that it's not just a temporary fix, but something that we need to invest more in and look at that as a part of the future?

Greene: I think the jury is still out on whether we're considering it a viable option going forward. But Germany did agree to delay the decommissioning of three of its nuclear reactors, which before Russia invaded Ukraine, already made sense for Germany to do. It made no sense for them to these nuclear reactors down, really in economic terms at least, and even in my view, at least, in environmental terms. It was a complete non-starter. There was no way that the political class was even going to discuss it. This U-turn that the German government has made, I think is maybe indicative that there's definitely more tolerance for nuclear energy in Europe, but also elsewhere. I'm just not sure that we're going to consider it one of the real solutions to fill the gap is we try to develop other renewable energies. I'm not sure that we've gone that far yet.

Beckworth: Well, Megan, I'm hopeful that in addition to nuclear energy being more accepted and eventually becoming a viable option, that geothermal energy and more hydro, more existing technologies that are alternatives we could use as well as renewables that have traditionally been promoted. It will be interesting to see where this conversation is going. So, Megan, walk us through the economic implications of this green transition and where we are today.

I do think that it's less clear that this is really going to accelerate the green transition in the US. Our energy costs haven't risen nearly as quickly, we're much further from the war. We're not reliant on Russia at all, even though we are affected by the invasion of Ukraine...But the implications for the Europeans have been much harsher, and so I think that they're much more committed to it.

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The Economic Implications of Green Energy Transition

Greene: I think the implications depend very much on how we decide to achieve it. You can use sticks, carrots, or both sticks and carrots. The Europeans, for the most part, are using sticks and carrots. Their sticks are carbon tax, for example, carbon pricing. Carrots are subsidies for renewables. In the US, we pretty much just go with carrots. The idea of pricing carbon is dead in the water in the US. There is some indirect pricing of carbon in terms of regulation, so you could argue there are some sticks there, but mostly we've been using subsidies. Most of what was in the Inflation Reduction Act that was related to energy was really a carrot. If you're using sticks to get through this green transition, then that will be very inflationary. It means that effectively you're taking the price of carbon, which you considered zero before and providing a price on it. That will push prices up. Inflation is a regressive tax, so that has distributional consequences as well.

Greene: If you use carrots and subsidies, though, it needn't be as inflationary in that you can find an alternative to fossil fuels, just subsidize the heck out of them to use a technical term. Then you can generate the green transition without actually pricing anything in. It does mean that you're providing some stimulus, so that could be a bit inflationary, but much less so than if you're just using sticks. Most economists would say you probably shouldn't address a negative externality by just using carrots. We shouldn't just reward off the back of poor behavior, effectively, as using fossil fuels.

Greene: I think some combination is probably right, but the choreography of this is everything in terms of what the implications are on the economy. As long as there are some sticks, though, I think this will be inflationary, and so I've argued before that I think when the dust settles on the other side, when we stop having war and supply shocks and lockdowns and factory closures, I think inflation will come back down. The big risk to that call is the green transition, and if we use regulation and carbon pricing to achieve it, then that would push inflation up in a pretty structural way.

Beckworth: Let's tie together several strands in our conversation. We talked about inflation and central banks dealing with that. We've just talked about the green transition and let's throw in the midterm elections coming up, and I think they're all connected in this sense. The high inflation has become a number one issue among Americans in polls. You look at polling, it's number one above any other concern. There's other concerns in there, but this is number one, and it's likely to be a big issue in the midterm election. Right now, the polls are suggesting a red wave is coming, Republicans are going to take power, and so it will be interesting if this inflation experience brings Republicans to power and undermines President Biden's ability to implement and continue his green transition. I think that's part of the challenge in the US in general, it's hard to get the country together on the same page to pursue a common vision of a green transition.

Greene: Yeah, I think that's right, or on the same page to pursue much of anything for that matter.

Beckworth: Fair enough, yeah.

Greene: The Ukraine aside actually, support for Ukraine seems to be a bipartisan issue, something both sides can agree on. But no, I think if there is a red wave, then the result will be utter gridlock, so it'll be really difficult to implement anything, but also to pass anything else. I guess, if I had to come up with an optimistic result of that is that the markets love gridlock. Insofar as we've seen both equity and fixed income fall, that negative correlation between the two is completely broken down. We might see some abatement in that if there is gridlock in government, but I think the midterm elections could put a wrench in the plans towards a green transition and many others.

Beckworth: I think that's going to be a big deal and it's coming up here in a few weeks. By the time this show comes out, we may already have had that election, we'll see. I think it could have a huge bearing on what's possible going forward. Well, in the time we have left, Megan, I want to transition to this book you've been working on. I know we've talked about it before, but give us a review again, what you're covering, what are some of the issues in it, and maybe a sneak peek on its release date if you have that.

I think if there is a red wave, then the result will be utter gridlock, so it'll be really difficult to implement anything, but also to pass anything else. I guess, if I had to come up with an optimistic result of that is that the markets love gridlock.

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Information on Megan’s Upcoming Book

Greene: Yeah. It's a book on inequality, wealth and income inequality within countries, mostly looking at developed countries. I'm effectively writing about the drivers of inequality that you wouldn't have learned about if you took macro 30 years ago. Not only because they just weren't factors then, but also because our conversation and thinking around them has changed so much in the past couple of decades. It is things like looking at globalization versus technological advancement. I think our conversation around that has fundamentally changed over the past couple of decades, but also new things like a big jump in market concentration in the US, the dwindling down of worker power in the US as well, unionization, post-employment restrictions, how that's influencing workers' ability to negotiate for higher wages and feeding into income inequality, things like that that weren't really factors a number of decades ago.

Greene: Then, I'm trying to provide some policy prescriptions, mostly for governments, actually. I tried to come up with policy prescriptions for central banks and genuinely couldn't. I don't actually think that central banks have a huge role to play in terms of turning around many of these drivers, even as I'm a big fan of central banks addressing climate change, but inequality, I think is a different issue. I wish I had a release date for you. If you gave me a really hard deadline, I could give you one, but no one ever does. I always have other deadlines that are more imminent.

Beckworth: Sure. Well, let me throw another possibility into that mix of causes of inequality. I've had a number of guests on the show recently that have talked about this, but it's housing, housing in the US and the inability to build and meet demand. I just recently had Peter Ganong on the show. He has this paper with a co-author, they show that this incredible history of US income convergence across parts of the country has broken down in part because people cannot move to a city where they would have great opportunities because of the housing costs and the supply of housing is inelastic, and so as a result, we're not seeing people move from poor regions to richer regions like we used to. In the past, we saw that. We don't see that today.

Beckworth: And, for example, the famous China shock, I mentioned this in a previous episode that it's an interesting study, but for me, one of the more fascinating things that come out of it is, why didn't those people move from those towns that were hit hard by globalization? One of the answers is, well, because it's so expensive to move to San Francisco or New York, where they might have more opportunities to work. Do you think that's an important part of the story too?

Greene: Yeah. I think that's absolutely a piece of the story. For all of the US' bragging that we're the ultimate single market, particularly towards the Europeans… Actually, we're not as single a market as you might think. That goes for housing costs and the cost of trying to relocate, but it also goes for services and goods, particularly services. You can't just be a hairdresser in Kentucky and move to another state and pick up and practice the same thing. I think that there are these rigidities in the US that a lot of other economies don't quite understand about our country just because you wouldn't expect it, it's not supposed to be there. But to your point, I think housing cost is an issue. As someone who's moving from Boston, I can highlight that housing costs are an issue.

Beckworth: Well, our time is up. Our guest today has been Megan Greene. Megan, thank you again for coming back on the show.

Greene: Yeah, thanks, David. It's always a pleasure.

Photo by Ben Stansall via Getty Images

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