Chris Crowe on Hedge Fund Perspectives and the Economic Implications of Brexit

David Beckworth: Our guest today is Chris Crowe. Chris is head of economic and flow research at Capula Investment Management, a London based hedge fund, where he covers global economics, primarily the G10 countries plus China. He was previously UK economist at Barclays for two years and prior to that worked at the International Monetary Fund for five years. He has also published in top economic journals. Chris joins us today to give us a perspective of a macroeconomist from inside a hedge fund on markets, Brexit and other current events as well as some of his own research. Chris, welcome to the show.

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

Chris Crowe: Hey David, thank you very much for having me.

Beckworth: It's great to have you on. And I have to give a disclaimer for you. Your views represent yours alone and not your firm or any entity related to your firm, so this is Chris talking. And I have to give a second disclaimer that we are two time co-authors, so we've written together, so I am bringing on a friend of the show and a co-author. Chris, tell us, how did you get into macroeconomics?

Crowe: I guess I was drawn to economics indirectly in the sense that, as a child, I was always interested in politics and I felt like you had to understand economics to understand politics and policy, and constraints on what you could do politically. And I guess I was also good at subjects like history at school, but also good at physics. And so, I felt if there was one subject which would allow me to combine the two, looking at society but also using quantitative skills and techniques, that economics would offer me that opportunity. But it was a bit of a gamble because I didn't study economics at high school.

Crowe: But I enjoyed studying it at university and the macro side was the one that appealed to me most. It seemed most relevant to the real world, most related to those political and policy issues that I was interested in when I was younger. In the UK as well in the 1990s, there was a lot going on in terms of macroeconomics. We had a number of different efforts of putting together a credible monetary policy regime, most of which ended in ignominious failure until the mid ‘90s when we had a new regime of central bank independence in the Bank of England which turned things around.

Crowe: But prior to that we'd made an effort at shadowing the Deutschmark in the late 1980s and then late ‘80s, early 90s, a failed effort to join the exchange rate mechanism which was a kind of early precursor of the euro and like many of our escapades with the European Union didn't go so well. We'll talk about Brexit later, I think. There was lots going on from a macro point of view in the UK and lots of interesting issues and so I think I was drawn to the subject for that reason.

Beckworth: Chris, you were probably just a kid during this time, but the early ‘90s when the UK broke free from the exchange rate mechanism, or it had been tied previously to the Bundesbank as you mentioned, was that a formidable experience for you in getting you interested in macroeconomics?

Crowe: Very much so, yeah. Break free is a slightly euphemistic term. It was a more of a ignominious exit. The UK very much wanted to stay in the ERM and the Bank of England spent quite a large proportion of their reserves trying to stay in. I think the bank felt maybe not as much support from the Bundesbank and the rest of the Europeans as they might have received. But, yeah, it was a very formative experience. At the time, it was seen as a total disaster. It was called Black Wednesday and it eventually cost the job of the Chancellor of the Exchequer and arguably, probably, was the final nail in the coffin for the conservative government at the time.

Crowe: But it was certainly a formative event in terms of my economics education and becoming interested in the subject. It was such a huge a deal at the time. And it was interesting because, as I say, although it was viewed as a disaster at the time actually it kicked off one of the best periods of economic growth to the general economic outlook in the UK, arguably for a generation. We had a period of relatively strong growth. Inflation didn't take off as many people had feared when the pound exited at the ERM so it was a kind of interesting experience. And I think, certainly for me, it drew me towards the subject and I think it was also an important issue for UK policymakers as well and framed much of the debate on issues like the Euro that followed.

Beckworth: Yeah, so was this experience important in the UK not joining the Euro?

Crowe: Absolutely, I think. Yes. I think there are two elements to the UK's decision not to join the Euro. One was purely political and reflects the fact, as we've seen from Brexit, that there's always been a fairly substantial proportion of UK population who are not really into Europe, to put it mildly. And the euro was seen as a typical European grand protégé, sort of French style project, of trying to achieve too much through political diktat and not a British type of product of gradualist reform and incrementalism. I know that's a bit of a cliché but that's, I think, how the British view the Europeans. They have a tendency to go in for these big projects.

Crowe: Those are always going to set them to be a skepticism about the Euro in the UK But then coupled to it, the experience of the ERM was that the UK would do much better with a floating exchange rate that our economy, although close to Europe, wasn't sufficiently in sync with the economies of continental Europe to make the Euro a sustainable proposition for us. I think other countries in Europe took the opposite lesson, which was that a system of pegged exchange rates wasn't a hard enough arrangement that the markets, with sufficient fire power, could always push you off that fixed exchange rate and the only way to really achieve that stability was to have a single currency. It's interesting that UK and Continental Europe took two very different lessons from the experience.

Beckworth: And in my view, the past decade has vindicated the UK view. That would be my take away.

Crowe: Yeah. I think that's probably right. Yeah. The Euros created problems for countries like Italy, which is not quite as semi-detached as the UK is but it is in a similar kind of position where the economy isn't quite as strong as the economies of France and particularly Germany. The country has relied on exchange rate flexibility which is often a euphemism for devaluing your exchange rates to gain competitiveness and achieve growth. And obviously inside the Euro it's much harder to achieve that. You have to undergo quite difficult processes of what you call an internal devaluation, in other words juicing wages and prices without the slightly easier way of doing it which is just to allow your exchange rate to devalue.

Beckworth: Yes, very interesting these experiences. They're formative for you. They helped put the UK on a better path, arguably. But going back to you, so you got into macroeconomics. You're now at a hedge fund but you've worked at the IMF, you've published in some good journals, you've written on central bank independence. And I thought it's just worth mentioning that macroeconomists do have lives outside of macroeconomics. You're also an actor and a writer in theater. Is that right?

Crowe: Yeah, very much an amateur and I've been working on a project with…

Beckworth: Okay. That's so fascinating. We have a macroeconomist who also has his hands in acting. And I'll just mention also, for our listeners' sakes, a little bit more about myself as well as Chris, we’re co-authors. We'll talk about some of our work later in the show. But we both met in a very strange way. We were both dabbling in the economics of religion. I was looking at the relationship between the business cycle and religiosity and explain briefly what you were working on at the IMF at the time. That also puts you in that camp.

Crowe: Yeah. I was working on a slightly strange paper, looking at whether people's religious views, and in particular views on the end of the world, which from a European perspective is a surprisingly prevalent philosophy in the US and whether that impacts people's behavior. And I tried to focus on local housing markets to get an insight into that issue. Yeah. It was a slightly strange paper. I'm not sure whether it really holds up, but… Actually, the empirical results were quite strong, but that's often the way where there are empirics. You might find an interesting correlation but then struggle to fully motivate it.

Beckworth: Yeah, I know. It was fun work. We both were involved in this economics of religion at an interesting time, right around 2008, so there's interest in it. And that's how we met. We would co-authored several papers that way.

Crowe: Yeah. To me, as an economist I've always been fond with the kind of homoeconomicus view of human nature a little bit limiting. I've always wanted to try and get beyond that. And there's been quite a lot of interesting work on behavioral economics, looking at people's motivations, and trying to look beyond the utility maximization view which is quite limiting, I think. I'll make no apology dabbling in this slightly strange esoteric kind of areas. And unfortunately I didn't get much time to do that sort of stuff now.

Beckworth: Yeah, yeah. But it was fun to dabble at the time for sure. But then…

Crowe: Definitely. And they gave us the opportunity to meet as well, so….

Beckworth: That's absolutely right.

Crowe: -It was opportune.

Beckworth: Yes, it was. Let's move on and talk about your day job. So, you work at a hedge fund. We've had many guests on the show who are academics, maybe they work at central banks, we've had a few market practitioners but I think you're the first person who's worked at a hedge fund we've had on the show so it's interesting to get your perspective on what it's like. What is a typical day like in your world? What do you do? How do you process news and information? How important are all these market developments? Walk us through all of that.

Crowe: Yeah. As an economist, I think the role of the economist tends to vary very much by firm depending on the focus of the firm or what exactly it is they want to get out of you. For me, my job is really to act as a filter for information through to risk-takers, so to follow the data, follow policy announcements and to pick out what's relevant, what the key themes are, some of the implications for markets and feed those through to my colleagues. And you're doing it across different time zones here. My role on this is very much a global one. One of the benefits of living in London is your ability to follow events right across the world.

Crowe: We get the end of the trading day in Asia, we get obviously the European trading hours and you get at least the morning of the US markets as well. My colleagues in London actually follow the US markets throughout the day in the US Eastern time zone. I have an ability really to follow those numbers and policy developments, following key policymakers, the ECB, the Fed, BOJ, Bank of England, understanding central banks, translating how central bankers think and translating their message to market participants. There is quite often a bit of a divergence between how central bankers communicate and the timelines central bankers work on and how people in the markets think.

Crowe: People in the markets tend to expect things to happen much more quickly. They assume that the Central Bank's primary focus in their communications is with market participants whereas, often, central banks view their primary role as communicating with the public at large. It's things like that, just acting as a bridge between policymakers and people trading in the markets and also following the data. Because people in the market tend to be very intelligent people, but they may not have the economic knowledge to understand quite what this number means, why does this number going up mean X, Y, or Z? It's acting like a bridge or a filter of information if you like.

Beckworth: Okay. Well, let's move on from what you do as a practitioner at the hedge fund and how you incorporate market data, how you incorporate what the Fed is saying, to an issue really close to home for you and that's Brexit.

Crowe: Yes.

Beckworth: You are in London, as you mentioned, and you have actually worked on this topic.

Crowe: Yes, I live and breathe Brexit, Indeed.

Beckworth: Yes.

Crowe: It's on the point, unfortunately, everyone wants to know about Brexit and it's at the top of the news every day. Brexit fatigue is happening in this country now or probably has been for a while.

Beckworth: Yeah. Well, tell us about it. What is it? What do you see happening in the UK with Brexit on a practical level, just as a UK resident? But then maybe also bring it back home to finance industry in general because one of the things you hear is that London is this great financial capitol but Brexit might do that industry harm. In fact, you see these articles, anecdotal I think at this point, but some firms are moving offices to Europe as opposed to keeping them in London. Maybe first tell us the general lay of the land, what's going to happen and what you see happening, and then maybe veer into the effects for financial industry.

Crowe: Mm-Hmm [Affirmative]. Maybe it'd be helpful just to, very briefly, give a timeline of what's been happening with Brexit because perhaps some of your listeners, particularly in the US, maybe they aren't quite as in the weeds on this issue as we unfortunately have to be. But we had these vote in June 2016 where we narrowly voted to leave the EU by a margin of 52 percent to 48 percent. In March 2017 the government triggered what's called Article 50. This is an article of the Lisbon Treaty, the EU treaty which is the article… It provides the rules for how you leave the EU and essentially triggering that article starts the clock ticking on two years so we were due to leave the EU on March 29th, 2019, this year.

Crowe: The UK and the EU negotiated what was called a withdrawal agreement, which essentially covered three issues. One was maintaining the rights of EU and UK citizens living in the other territory currently. The other was that the UK would have to pay its outstanding bills which amount to about a little bit below 50 billion dollars at current exchange rates. And the third and most contentious part dealt with the issue of the border on the island of Ireland between Northern Ireland, which is part of the UK, and the Republic of Ireland. That was the big sticking point, the way that the issue was dealt with. A lot of MPs, particularly on the conservative sides as well as the government side, felt that there were too many concessions to the EU.

Crowe: And as a result the prime minister, Theresa May, tried three times to get that withdrawal agreement passed in the UK parliament and failed three times. In fact, the last time was actually the biggest ever defeat that government has ever suffered in the House of Commons, so a pretty comprehensive defeat for her approach which is why she's currently on her way out. As a result, Brexit was delayed until the 31st of October and we're likely to choose May’s successor, elected in about a week's time. They're currently going for an internal party ballot. The likely successor, who's called Boris Johnson, has promised that we will leave, whatever it takes, on 31st of October even if that means leaving without a deal.

Crowe: The question being whether, (A), he would actually do it, a lot of people have big fears about what that would involve, and also whether we'll allowed to do it. And I sense the parliament will try and insert itself into that process and there's a decent chance we have a general election in the fall. In terms of what Brexit might involve, both broadly and for the financial sector… Maybe talk about finance to start with, obviously the UK has a huge financial sector. It's extremely large and extremely successful relative to the size of the country. The expectations are that we could potentially see a number of jobs in the banking sector go.

Crowe: There was a piece of analysis by the Financial Times that estimates that we may have lost about one, or are in the process of losing about one and a half thousand jobs in the banking sector directory thanks to a Brexit. That is small relative to the size of the banking sector, but also small relative to, I think, what people were expecting beforehand. I think a prior piece of that analysis by the FT a couple of years ago suggested we might've expected about three times the amount of job losses in the banking sector. Direct impact so far has been perhaps smaller than expected. There are issues going forward for finance if Brexit happens, particularly if we get Brexit without a deal.

Crowe: The issue there being that, under the withdrawal agreement if that had been passed, there would have been what was called the transition period which would have essentially kept current EU rules in place and allowed a soft transition rather than the overnight closing down of existing arrangements. In the financial sector, under the EU rules, you have a process called passporting and which essentially provides service providers in one country to sell its financial services in other countries within the EU, as long as they’re regulated in their home country.

Crowe: Outside of the EU, we'd have to rely on a process called equivalence which provides much more limited ability to provide services cross border. Now, for different parts of the UK financial sector that'll be a big issue or a small issue depending on whether they're primarily focused on EU market or more globally. In large parts, the financial sector's much more globally focused. The impact will be significant but it's not the end of the world for the financial sector by any means. And probably some other opportunities may be opened up in the process.

Crowe: For other sectors of the economy, I think Brexit is perhaps more of a worry, areas like the auto sector for instance, or other parts of manufacturing which are highly dependent on just-in-time production methods. You have car parts, which cross borders multiple times. If they're faced with long delays at the border, which is probably likely in the case of a no deal Brexit, for checking product standards for potentially imposing tariffs. This will materially impact the ability of those firms to do business. I think the auto sector is extremely worried. And the agricultural sector too faces big challenges in large. It's a big export area for the UK into Europe.

Crowe: And food obviously, fresh food, has big implications if it's kept waiting at the border for long periods of time. The impact on the UK economy will be material, my expectation would be that in the event of a no deal Brexit we'll probably end up in recession. It's not certain but it seems very possible to me. Suddenly already you can see a decline in business investment. We've gone from a situation where the UK business investment was amongst the highest growth rates in the G7 to where it's now the lowest. There's clearly been an impact on business investment. And in general, business surveys show a gradual deterioration of business sentiment.

Crowe: Economic growth has slowed even though we haven't actually left. Initially, growth held up quite well after the Brexit vote but over time it's fallen back and currently GDP is more or less at the level the Bank of England predicted in the immediate aftermath of the Brexit vote. Initially it outperformed but over time it's slipped back and it's now at that level, which was materially lower than the Bank of England had forecast just prior to the vote. You can see that. I think that certainly has been an impact on the economy. The exchange rate devalued fairly sharply in the initial aftermath of the vote. It devalued again subsequently once…

Crowe: …It appeared clear that the UK was going to follow a relatively instant hard Brexit. Since then, it's gone on a bit of a roller coaster. Initially people hoped, with the withdrawal agreement, that we'd get this transition period and the economic impact would be softened. As those hopes have evaporated somewhat, the exchange rate has started heading down again. And now with the other likely next prime minister apparently being willing to countenance leaving without a deal seems to be impacting sterling again, sending it lower in the last few days.

Beckworth: Given all these developments, given there's a growing awareness of the cost of Brexit, are there voters who now would vote differently? Do you think there's a lot of voter remorse about the votes that were made in 2016?

Crowe: There's a bit. There's a bit, yes. There's not as much as perhaps you might have expected. The depressing thing about Brexit is that it's opened a door to a kind of US style culture war in this country in which positions become extremely entrenched and it becomes just almost a matter of identity for people. And so there has been something of a change in public opinion and partly that just reflects the demographics as well. It may not be people changing their minds necessarily but the vote for Brexit was very heavily skewed towards older people. And you know older people do have a tendency to die more than younger people and the younger people who couldn't vote in 2016 and now are old enough to vote.

Crowe: There's been a kind of natural evolution in views just simply because of passage of time. And it has been. I think a limited number of people changed their mind, but it's not as much as you'd think. If we did have a second referendum on Brexit, my best guess is that it will probably be won by remain this time around but then I expected remain to win the last referendum. I think it's by no means guaranteed.

Beckworth: Well, I wonder if you get to the point where you do leave the EU without a deal and you have this recession that you suggested may occur. I wonder if people will really begin to connect the dots, Brexit leads to lower standard of living, and they'd really be remorseful and regret that vote they made. Maybe they need a little more pain.

Crowe: Well, it's possible. It's a slightly depressing thought. I think that until it happens that the risk is people will just dismiss it. They'll call it ‘Project Fear’. They'll say economists might be predicting this but economists are not necessarily very good at predicting things. They'll believe it when they'll see it. And also you've got to bear in mind a lot of people who voted for Brexit, some of them lived in economically depressed places, perhaps had personally had been not in a great place economically. A lot of the people felt like things couldn't get much worse for them and so even if the economy as a whole takes a hit they won't be affected. A lot of older people, of course, are retired so then it's not like they're going to lose their job.

Beckworth: Yeah. Let me ask this question. Let's say we do get to that point, so there's withdrawal from the EU, there's no arrangement so you have this recession. Let's say it's a painful experience. Let's say people do change their minds in large numbers so if they did a second referendum it would be overwhelming support for “remain.” What could the UK get after it has left the EU and then it wants to come back in without a deal? Will the UK be so far gone that it would be hopeless to try to get back in at that point?

Crowe: Well, the issue is that the EU is based on rules and laws and under the rules once you leave you can't just rejoin on a ‘sorry guys I was wrong' kind of basis. You have to rejoin as a new member and I think the EU would go out of its way to make that process as easy as possible for the UK. It would be the return of the prodigal son kind of situation. But they can't bend the rules completely. And so for instance, the UK has negotiated a fairly generous financial arrangement with the EU where they would actually get a rebate on some of their membership fees and that will be gone.

Crowe: The UK negotiated an exemption from the requirement to join the euro and if the UK joins as a new member, it would be under obligation to join the euro; which, as we've already discussed, might not be particularly easy for the UK. The issue is once you're out, getting back in again doesn't provide you with all the goodies you necessarily had in the first place. The UK was in a fairly good place with the EU before the Brexit vote actually, where we were outside of some of the stuff that we didn't like about the EU but benefited with those we did like. A lot of people in the EU weren't particularly too keen on that. And, indeed, you can make the case that being a semi-detached member of the EU is perhaps the reason why we ended up leaving.

Crowe: You should be either in or out and as a country we never quite embraced the EU as wholeheartedly as perhaps we should have done or as much as we should have done if we wanted to remain a member, perhaps.

Beckworth: Okay, so the next important deadline is when?

Crowe: The big deadline is October 31st. That's when we are on the obligation to leave. We can request an extension. The EU would probably only give us an extension at this stage if it was for a purpose, i.e., if we were going to have a general election to try and come up with a different policy or perhaps in order to facilitate a second referendum. But just to give us another opportunity to argue amongst ourselves, which is essentially what we've been doing since 29th of March, I think is not anyone's interest. It's probably not even in the UK's interests ultimately.

Crowe: That 31st October should be a big deadline. The question is will we have a government in place that would actually request an extension? Under the current prime minister, it will be in place for another week. I think she sort of stared into the abyss and decided that for a number of reasons, she wasn't willing to countenance leaving without a deal. Now the current frontrunner to replace her, Boris Johnson, has said quite forcefully that he would countenance leaving without a deal. The question is, is he being serious, and also will parliament let him? Because the government's majority in House of Commons is wafer-thin.

Crowe: A number of conservative MPs have suggested that they would do whatever it takes to prevent [the UK] leaving without a deal, even if that includes voting against the government in what would be called a confidence motion, which would basically be an invitation to dissolve parliament and have an election.

Beckworth: Wow. Very interesting times there in the UK, something for us to continue to watch.

Crowe: Extremely volatile, yeah.

Beckworth: Yes. And I'm sure you obviously care deeply about this. You have a family there, your career is there. And so we will follow up, maybe in a later show when things do become clear, what has happened with Brexit.

Crowe: Yeah. You'll reach out to me in this little post-Brexit apocalypse. I'll be eating out of bins and in sort of wastelands.

Beckworth: Right. Right. Right. Now I'm sure things won't get that bad. At least I hope that they don’t.

Crowe: Yeah. No, I am joking.

Beckworth: But, yeah, it is interesting to see, though, a country inflict what appears to be policies, choices that are going to lower the trend real growth rate moving forward. Now I understand the concerns that you mentioned, some people who live outside London who did not have the opportunities. Maybe they were left behind by globalization. I understand that those are issues that needed to be dealt with, but effectively Brexit is going to lower the trend real growth rate for the UK moving forward. It's a very fascinating story to see a country inflict this pain upon itself.

Crowe: Yeah, it's frustrating. I'll be quite open, I don't think Brexit is a good idea. It's frustrating for me as someone who would like to find a way to deal with these issues because I don't think Brexit will actually make dealing with those issues any easier. In fact, in most ways, it'll make it harder as you say it. It'll probably reduce the growth rate and provide less government revenue to come up with programs of education or investments or infrastructure which might actually help people deal with these problems. I think, especially post financial crisis, this is an issue which doesn't just affect the UK, it shows up in lots of countries.

Crowe: Economic growth has disappointed, perhaps people's faith in institutions has been diminished and I think as economists we've failed to come up with a message that can resonate with people. Simply saying, “Oh, there'll be less growth,” doesn't hold water for people who don't feel they're benefiting from the economy as it is, or perhaps feel like economists missed all the warning signs pre-2008 and so can their judgment be trusted this time around. A politician in the UK said the people were sick of experts around the Brexit campaign.

Crowe: I think although he was denigrated for that comment, and in a lot of ways it is awful comment, but in other ways you can see what he's getting at. Right? I think people, they're sick of self-appointed experts telling them how things are going to be when they feel disconnected from the description of reality that these experts come up with. In fact, I feel the economy is delivering for them.

Beckworth: Yes. Fair enough. Well, some of the same forces that have driven Brexit, globalization, some of the people being left behind, the uneven benefits from globalization, can also be traced to development. This is where I want to move to next and discuss with you, and this is the phenomenon of these really low interest rates we're seeing all around the world. Part of what we're seeing is a consequence of globalization, particularly financial globalization, opening up global capital markets so credit flows across borders effortlessly. And I believe the latest numbers show approximately 13 trillion dollars in public debt globally now trade at negative yields, negative interest rates.

Crowe: That's right.

Beckworth: People are paying their governments to take the money and then give it back to them. I believe even France with all its issues recently touched on negative yields. Germany has been negative. Switzerland has been very negative. Even here in the US our 10 year treasury yield is bouncing around two percent, which is really low. And if you think in terms of inflation adjusted, it's pretty close to zero in real terms itself. There's this huge sea of really low yielding government debt out there. Now, this is for safer places typically. Though it's surprising that even Italy has seen their government bond yields drop as well.

Crowe: Yes.

Beckworth: But this is part of what I would call the safe asset shortage. There's this growing appetite for government debt. People are effectively standing at the door of the Treasuries, the Finance Ministries. They're knocking, “Hey, give us more.” Which is a hard story to sell, to explain to people. Here in the US, at least, we still hear people complain about the size of our public debt and it's often something that politicians will bring up in one breath. And at the same time we see yields continually staying low.

Beckworth: Under president Trump, the national debt has grown dramatically and yet we have 10 year treasury yields at historic lows. Which again is a signal that the demand for these treasuries are really elevated. And now we've written about this, and we will get to this in a minute, but just generally speaking what is your take on this? What do you see going on and does it really matter?

Crowe: Yeah, I think it's an absolutely first order issue in terms of both financial markets and the broader economy and policy environment. As you say, remarkably low interest rates, significant amounts of governments issuing debt even out the 10 year … beyond negative rates bond yields, I think, today minus 26 basis points on the 10 year points. As you said, even French RATs are marginally negative as well. Really remarkably low yields even for countries with pretty elevated debt ratios compared to pre-crisis. Before the crisis in Europe there was sense that debt to GDP ratios would be maintained at some 60 percent or below.

Crowe: Post-crisis many of these debt ratios blew out. Italy are currently running about 130 percent of GDP. Elevated levels, as you say, even in the US with current high levels of high deficits translating into renewed increase and yet yields are remarkably low levels. Which I think tells you that there is this strong demand for safety, for relatively safe assets. People are not looking for return on capital. They're looking for return of capital. They want to make sure they're getting their money back even if you want to take a little bit off them for the privilege. And I've worked on this with you, but also subsequently. Safe assets are in limited supply.

Crowe: My estimate is… and obviously people have different definitions of what constitutes a safe asset. But looking across the range of both government paper and other highly rated fixed income assets, I would estimate that we're looking at about 65 trillion dollars of safe assets globally which government bonds are maybe a little bit over 40 trillion. That's relative to a world GDP of 80 trillion dollars so it's not a huge amount really in terms of people's demand for this stuff. And some of that demand is eaten up by governments themselves either directly through central bank purchases. QE by major central banks has taken about 11 trillion dollars of those safe assets off the table for the use by private sector.

Crowe: Emerging market economies primarily holds significant amounts in international reserves. That's probably another 8 trillion dollars. And then under international financial rules, banks and other institutions are required to hold a certain amount of their assets in high quality liquid assets form. Some of that is met through bank reserves which have expanded through these asset purchase programs. But even taking that into account, these financial rules requiring financial institutions to hold these liquid assets has also added to demand. As a result, around about a third of total safe assets which are out there are being used for these official purposes which obviously leaves less available for the private sector.

Crowe: And if you just look at how the net supply of safe assets has evolved over time, that has gone down in recent years relative to global GDP. It peaked at about 70 percent of global GDP, around about 2009 and 2010, and it's currently running about 45 percent of global GDP. As the amount has increased with growth of the global economy, the net supply of those safe assets has not kept up. Partly that was related to posterity policies after the financial crisis, which meant that governments at that point at least were not issuing paper to the same degree. Then you had QE policies which reduced the net supply available to the private sector.

Crowe: And some of these post-crisis policies ended up securing the financial sector, which meant that some of the assets had to be held within the financial system of advanced economies. And so, I think there has been a certain amount of, inadequate supply of these assets and as a result that's put fairly relentless downward pressure on yields. To draw a chart of, say, the term premium on a 10 year US Treasuries against that net supply, they're pretty well correlated actually. The pattern and the two match up quite well. And it does suggest that the term premium will remain low in subsequent years as net supply of safe assets will probably be more or less flat over the next few years.

Crowe: Which is an improvement action, up to now, where it's been on the downward trajectory because for the time being at least central banks are no longer buying significant quantities of assets under asset purchase programs because there's been a little bit of an easing up on fiscal policy. The subnet supply of those assets is holding up relative to global GDP. But I think the underlying issue and the main driver of this imbalance between supply and demand is really the fact that the economies which are capable or judged capable of producing safe assets are not growing as fast as the economies which are not. And so you have growth in emerging markets consistently running ahead of growth in advanced economies.

Crowe: But advanced economies are not able to issue enough of this paper because their economies not growing and if it would to issue paper in enough quantities that would meet the demand from emerging markets, then, they would require their debt ratios to expand. And we saw when that happened in 2008.

Beckworth: Yeah, that's very interesting. Now, you mentioned the number for your measure, your net supply of... I would say global safe assets went from roughly 70 percent to mid 40 percent. That's pretty staggering. Again, just knowing that, I think, is an important fact because you ask many if not most politicians here in the US, they would have no sense of that. I didn't realize these numbers that you've calculated, 70 percent to 45 percent, so the net supply of global safe assets has been declining now. You said the good news is it's going to flat line, which is great, but the point is it probably should be going up a little bit.

Beckworth: What's interesting is you have that issue, you put that point to the side, is that this problem may create its own future problem in the following sense. It pushes rates really low. And then what's going to happen next time we have a recession? Well, central banks are going to revert to QE is my guess because rates are low. Typically, the US central bank, the Federal Reserve, typically cuts interest rates about 500 basis points or five percentage points. We're about half that right now in terms of where the short term rate actually is. And they're probably going to lower it, which means the Fed doesn't have a lot of ammunition so it's going to quickly resort to QE.

Beckworth: And I suspect other places will as well because there's not a lot of room for cutting interest rates, which means more of that supply of safe assets is going to be pulled on to central bank balance sheets further reducing the net supply. This problem is almost self-perpetuating. You create a low interest rate environment. Moreover, that loan shared environment increases, money demand broadly declines so demand for highly liquid safe assets increases. It self-perpetuates given the policy response to that. This is very problematic. And, I guess, what is a solution? Do you have a solution or a way to get us out of this hole?

Crowe: I think it's very difficult. And before I try to think of the solution, I'd mention one other channel as well which I think we discussed in the paper that we worked on together, which is this. Easing by global central banks, QE and other policies also creates looser monetary conditions globally which then encourages capital flows to emerging markets, which then leads them to try and offset the impact on their currencies by accumulating reserves which is another channel by which safe assets are used up. There's all kinds of channels by which this kind of vicious circle is created and it's a process which has different names. Some people call it second stagnation, some people talk about safe asset shortage. People talk about a global savings glut.

Crowe: I think, in a way, they're all similar symptoms which is of, as I say, a global economy where the parts of the world which demand safe assets are growing faster than the parts which supply it; and also a world where things like demographics and the aging population are creating greater demand for these kinds of assets. And so I think it is a kind of self-perpetuating cycle which is difficult to break out of. People have come up with a number of potential ways out, perhaps, to, for instance, target a high level of inflation in order to, at least, if you can't affect the low real yields you can affect the rate of nominal yields. Which potentially buys you a bit more space to cut rates before you get to a lower bound.

Crowe: People have come up with policies like negative interest rates, trying to make changes to financial system to make it easier to push rates further into negative territory. I know in the US right now it's impossible to imagine the Fed adopting a negative interest rate policy but there are people advocating for some changes to the financial system to make that easier. Other parts of the world obviously have gone to negative rates. I think all these policies have negative side effects and so it's not clear. It's not clear that these are policies which should be followed. But far from anything else, you say you want central banks to target higher levels of inflation, they actually seem to be struggling to create any inflation at all, even to hit their relatively low inflation targets right now. And so to be honest, I'm not sure what the way out is.

Beckworth: Well, I'll give you my radical solution but let me lead up to that by making some observations. First, I think this problem speaks to what's called the Triffin dilemma, which I believe in the 1960s the economist, his last name is Triffin, he outlined this issue that the main reserve currency producer of the world is going to have a demand for its assets that's greater than is needed domestically. And I think he was talking about money or currency back then but this is true for the safe assets story as well, that the world wants more US debt. I mean one way to solve this problem is to create more US debt. And if you think of it in terms of seeing us debt it sounds awful.

Beckworth: But when you think of it in terms of this Triffin dilemma, the US government is providing a much needed financial asset to the world which would ease this strain, which would raise interest rates. I think you can view it in a different light. Now, there is a limit to this. I want to be clear. The US could issue so much debt that it wouldn't be a risk free asset anymore. But this, going back to the paper we wrote together, Banker to the World, the US is effectively a banker to the world. If you look at the consolidated balance sheet of the entire US economy, so you've to take the public sector, the private sector, put them together, and you look at the various sides of the balance sheet it looks a lot like a bank.

Beckworth: On the liability side of the consolidated US economy, it tends to be weighted more towards short term liquid assets. And these are the liabilities to the rest of the world. The world, they come to us. They want our Treasury bills, they want commercial paper, they want deposit accounts. They want those very safe assets that can be easily turned into purchasing power. And if you look on the assets side we tend to have riskier assets, not entirely but weighted more towards riskier. We're going out into the world investing in assets that have a higher return. And so we're providing this service to the world and I guess one solution is we need to do more banking to the world.

Beckworth: And how do you do that? Really radical proposals, one would be setting up a sovereign wealth fund where US Treasuries are issued to fund it. And, again, this wouldn't be so much to help the US domestic economy. Because there were talks about a sovereign wealth fund during the crisis setting something up in the US but I think there's more of a global demand dimension to this story. Now, I don't think this will ever see the light of day but it is one potential solution.

Crowe: Yeah. If you have a supply and demand to balance, you have to either reduce demand or increase the supply. Right? I guess the problem is that the efforts to increase the supply can create problems. Countries can print too much government debt and get into difficulties. You can see that clearly in Europe with some economies. The private sector has at different times tried to create safe assets and has run into problems with the famous CDOs and CDO squares and that kind of stuff in the run up to the financial crisis.

Crowe: And part of the reason why the supply of safe assets went down was simply because people figured out that actually some of these assets weren't as nearly as safe as they were meant to be; which suggests that actually it's much easier for governments to producer this stuff than for the private sector. There are ways of increasing the supply but I think it's challenging.

Beckworth: There is no easy solution. Yeah, there is no easy way out. Every solution is going to have some kind of costs. All right, we are running low on time but I want to ask you about your research. You've published in some really top journals on the issue of central bank independence. Quickly summarize your findings and then maybe tie that into recent events such as President Trump chipping away at the Fed's independence.

Crowe: Yeah. Sure. This was research work which I did with Ellen Meade who's currently at the Fed. We took a look at some issues around central bank independence, central bank transparency, measuring how these things have changed over time and what potential impact it had had. As perhaps one might expect, we found that central bank independence increased quite dramatically, at least in terms of de jure terms between the 1980s and late 1990s, early 2000s. This occurred through a number of channels to creation of the European Central Bank. And changes to legislation governing how central banks worked in Europe was a big part of that.

Crowe: Also, obviously the spread of new central banking institutions in transition economies in Eastern Europe played a big role. There was a lot of technical assistance from people like the IMF drawing up model legislation for these institutions. That's kind of the good news. We genuinely think central bank independence is a good thing. It produces better outcomes for monetary policy and destined to be more of it. When you actually look at the numbers demonstrating that central bank independence leads to lower inflation, which is a received wisdom…

Crowe: And I think partly reflects experiences of 1970s where in countries like Germany and the US, relatively independent central banks did a better job of avoiding the high inflation that followed the oil crisis than other economies. But when you actually do some serious empirical work on this, it's not that easy to demonstrate a robust relationship between central bank independence and inflation because inflation came down a lot everywhere. And it came down a lot in some countries where they made central banks more independent, but it also came down in countries which already had relatively independent central banks. And so demonstrating a kind of closer relationship there is difficult.

Crowe: Central banks also became more transparent and the ways the central banks communicate has become so much more complex. It's almost impossible to imagine this but until the early 1990s, the Fed didn't even tell people when they changed the interest rate. Now, the Feds can't stop talking. Right? You always want to tell some to be quiet sometimes because there is so much communication, not just by the Fed but all central banks. There are people always talking. And the market has a love-hate relationship with central bank communications. I think that there's always an appetite to hear from central bankers.

Crowe: But then when you start getting conflicting messages from different people, at the Fed or at the Bank of England or the ECB, then people start to say, “Well, they're communicating too much. They're confusing us. There's too much information.” I think it is a difficult challenge in central banks to know how much to communicate. There's always this sort of current controversy in central bank transparency and communications. It's whether a central bank should publish a path for interest rates. Bank of England, for instance, has been pretty adamant for a while that they don't want to do that. The central bank of England used to be very reluctant actually to communicate with markets on anything but their own terms.

Crowe: And to give you an example of that, the bank was quite an early adopter of fan charts showing forecasts for inflation, which is a good thing in terms of aiding transparency. But they wouldn't publish the numerical parameters of those forecasts because they didn't want people to focus on the central estimate for inflation. They wanted to emphasize the uncertainty by producing the fan charts. And so what that meant was that financial market participants would get printed inflation report out on a piece of paper, take a ruler and try and figure out what the central path for inflation was. And so in other words, the Bank of England, they tell us the path. It's just that we have to estimate it with an error which is probably suboptimal.

Crowe: Luckily, they now publish the numbers which then we can figure it out a bit more cleanly. But, they won't publish a forward path for interest rate even though a lot of central banks do. The Fed, obviously, has the famous dot plot. They won't publish the central path but they'll publish a range of numbers reflecting the different views of different people on the FOMC. I think at different points the Fed has found that a useful communication tool, but other times it's probably not so useful. Because I think the problem with the dots is that they don't allow for a central view.

Crowe: They don't allow the core of the FOMC, the Fed Chair and other people close to the Fed Chair, to provide a central view of what they expect in terms of rates. And so, there are these outstanding issues in terms of transparency practices. And even in central bank independence as you hinted, that is coming under fire and being questioned. And I think partly that reflects the experience of the financial crisis where central banks were seen, in some cases, to have not done a good job in terms of anticipating risks or responding quickly enough once those risks crystallized. Also the policy response, things like QE, has required a degree of coordination between central banks and government which was not necessary while central were simply setting interest rates.

Crowe: And that renewal of that relationship between central banks and the governmental authorities has created opportunities for some governments to start wanting to interfere more in what central banks do. And clearly the latest episodes in the US with President Trump putting pressure on the Fed to cut rates has just exacerbated those tensions. I think it created real problems there because now they're in a situation where even if they wanted to cut rates, which I think they do, they run the risk then of being accused of simply caving to political pressure.

Beckworth: Yeah. It is a complicated world out there for central bank independence.

Crowe: Yeah. Actually, I read an interesting paper just today actually on measuring political pressure on central banks. It's by somebody who I don't know called Professor Carola Binder, which is very interesting. She was using a narrative approach looking at analysts’ accounts of pressure on central banks usually to cut rates most of the time. Finding that central banks succumb to that pressure about 40 percent of the time and actually they seem to be succumbing to the pressure more often now than they had in the past. And so, I do think that this is an issue which is going to just keep growing and become an increasing issue of central banks.

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

Crowe: Thank you very much. It's been a real pleasure.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.