"A Herculean Task": You Don't Solve One Problem, You Create Two New Ones
By Michael Every of Rabobank
I loved the Greek myths growing up, and the older I get the more they frame the contemporary world better than most contemporary takes. Among the rich pantheon, I turn to the Hydra in particular, a giant serpent with many heads, where each time you cut off one, two grow back in its place. That’s how the real world works: you don’t solve problems, but create two new ones.
Yesterday’s US consumer confidence data were better than expected at 104.2 post-SVB vs. 103.4 in February. So, less fear of the recession some see looming. However, the survey saw 12-month inflation expectations rise from 6.2% to 6.3%, and ‘jobs are plentiful’ minus ‘jobs are hard to get’ at a still-high 38.8, consistent with a tight labor market. Hence, the Fed need to do more on rates, which then places more potential stress on the banking sector and the economy.
Yesterday saw ECB regulators state that just one small Credit Default Swap (CDS) trade was, in their eyes, behind the recent panic at Deutsche Bank. So, all is well? Hardly, if that kind of market structure exists, says the regulator. After all, CDS allows markets to trade on insurance on somebody else, which we don’t allow for any other insurance for obvious reasons. This morning also sees news of regulators raiding French banks in a tax fraud probe.
On US banks, testimony from the Fed’s Barr underlined the points already released in his text the day before and added little new. The Wall Street Journal summarises it as: ‘How Bank Oversight Failed: The Economy Changed, Regulators Didn’t - Overseers paid insufficient heed to risks of falling bond values and fleeing deposits. Social media and selling by smartphone made that worse’, adding the quote: ““The supervisory process has not evolved for rapid decision making. It is focused on consistency over speed. In a fast-moving situation, the system is not as well-designed to force change quickly.” So, they aren’t even cutting off the right heads(?)
In the Financial Times, Martin Wolf defends central banks, arguing ‘Monetary policy is not solely to blame for this banking crisis.’ Which is true, even though it arguably played the largest single role. He then adds: ‘It’s a fallacy to suppose there is a simple solution to the failings of our financial systems and economies’. Which is also true - thus the Hydra. At least he admits there are systemic failings – how much of that do you see in other financial media and market commentary?
The IMF understand things are changing. They just released ‘RETHINKING MONETARY POLICY IN A CHANGING WORLD’ (all caps, so it must be important!) that argues: “after decades of quiescence, inflation is back; to fight it central banks must change their approach. Monetary theory in economics has consisted of various schools of thought rather than a single unified model. Each of these schools emphasizes different forces that drive inflation and recommends a distinct policy response. Different times have raised different challenges -and each required its own policy approach.” It’s nice that the IMF finally recognises multiple schools of monetary theory. However, the paper lists our current problems before concluding that to address them, “central banks should return to a monetary approach in which stabilizing inflation expectations is a central priority” - without saying *how*. So, ‘Go slay the Hydra, Heracles!’
As Aussie CPI data today showed a downside surprise at 6.8% y-o-y vs. 7.2% expected --so, might the RBA sheath its sword in April?-- the new message is that central banks will keep hiking if the data back it, and use acronymic liquidity support to prevent a banking crisis at the same time. In other words, hybrid policy to deal with a Hydra.
Yet that creates all kinds of problems too, as central banks inexorably start getting involved in either deeper moral hazard or capital allocation decisions at a time when they can’t even get rates or financial supervision right. Those political-economy choices are likely to between guns and butter (or cat videos), as China, whose ruling ideology understands both financialisation and ‘fictitious capital’, is leading the way on.
On which, Congress yesterday heard another testimony as consequential as Barr’s. The Joint Armed Services Committee learned US naval logistics have atrophied and are a generation behind on sealift readiness, the entire end-to-end fuel system in question, US ship-building too slow, and buying new ships on the open market not an option. Congress was sympathetic. The potential bill could be astronomic. Without it, the US cannot permanently remain hegemonic.
Coincidentally, today’s Financial Times also sees Janan Ganesh argue that regardless of the geopolitical crisis we are experiencing, Western voters --or at least European-- won’t give up their peace dividend because electorates prefer guns to butter. He concludes, “Governments have to decide between a retirement age here and a naval fleet there. Or rather, voters do. If they go the way I fear, it will be a legitimate and understandable democratic choice. But then so was the inward turn of the interwar years. The second world war happened, in part, because Germany and Japan didn’t believe a US that had lets its hard power run down for a generation could counter them….Weakness is provocative, goes the cliché. But so, at home, is paying for strength.” Of course, we have plenty of talking heads who point out that even Western strength is also provocative.
These issues flow back to markets even if most won’t join the dots. For example, as oil markets swing wildly (on which, see the latest energy outlook ‘Energy Security in a Walled World’ from our Joe DeLaura, which urges “Focus on the future!”) FinTwit is still, wrongly, echoing with cries of ‘the end of US dollar hegemony’, which implies market chaos on a scale few grasp.
Again, let me stake out the view that the US dollar will remain unchallenged as the global reserve currency. Again, however, let me also stress that if we keep seeing large emerging markets and commodity producers switch to de facto barter for trade settlement priced in US dollars, then there might over time be a growing imbalance between the supply of global dollars and the actual physical demand for them. The dollar could, hypothetically, become like Latin in Europe – still there as lingua franca, but never used in day-to-day interactions. The US recourse would logically *not* be lower rates and QE, as pivot-happy punters are saying.
Yet even if one buys this longer-term scenario, it’s still a Hydra. In the near term, barter is highly inefficient. If ‘no dollars’ means Saudi Arabia building up assets in China or Kenya rather than the US, good luck to them with their US-pegged currency. If it all means a weaker dollar and higher Treasury yields, which is questionable, it also means higher global inflation and more financial turbulence, and so a collapse in demand for commodity exporters ‘protecting themselves’. Moreover, as the logical end game, Michael Pettis has long argued the US would be better off without its global reserve currency role, which allows every other economy to dump their excess savings on it, pushing up US debt or unemployment in kind. A US walk-away would mean Japan, China, Germany, etc., would not be able to save and export so much to it, directly or indirectly.
As Pettis also points out, the path to achieving this global rebalancing is through increased financial regulation, not tariffs: stop the capital flows, and the inverse trade flows halt too. Is that the way to slay our global Hydra, as in the Greek myths, where Heracles and his nephew Iolaus cut off each head and cauterised the wound with a burning torch before new ones could grow back?
Of course, applying a burning torch to our financial system does not seem to be on the cards, and would create epic market volatility. We are more likely to see a fusion of fiscal, monetary, regulatory, and industrial policy, i.e., a new mercantilism – but that path also means geopolitical and geoeconomic tensions, rippling back to markets.
In short, there are always two new heads to the international political economy Hydra for every one we cut off. Pretending there is a pre-2020, pre-2008, pre-1971, or pre-1913 way to simply resolve all our global issues is a giant myth.
