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The coming storm

Tensions in the global economy are near breaking point. The looming turmoil in stock markets, interest rates and currencies will affect us all.

1. Making sense of the mayhem

When does a stock-market slide become a crash? And when does a financial crash spark an economic crisis? At the end of last year, few investors were giving much thought to such nice distinctions. Less than two months into 2016, with the leading global equity indices having dropped between 10 and 25 per cent at their worst, these questions are on everyone’s lips.

The turmoil in the equity markets should not really come as a surprise: the warning signs have been there for some time. Haggard veterans returning from other financial fronts – oil and metals exchanges; the emerging markets, including China; corporate bond funds – have been reporting heavy losses and instances of extreme volatility for more than 18 months. Safe-haven flows flooding into the soundest government bonds left more than $5trn of them yielding less than 0 per cent by late 2015; in effect, investors were paying governments for the privilege of lending to them. Even in the most liquid global asset class of all, the 24/7 market for foreign exchange, erratic behaviour has been on the rise. The Swiss franc, the world’s fifth most traded currency, jumped by nearly 30 per cent on one morning just over a year ago.

The potential of these dislocations to derail the UK’s economic recovery has not been lost on our policymakers. The Bank of England’s Monetary Policy Committee has comprehensively surrendered the idea of finally raising interest rates: its one member who had been voting in favour joined the more pessimistic majority earlier this month. The Chancellor, meanwhile, has been at pains in recent speeches to warn of the “cocktail of risks” facing the British economy. There seems little doubt, in other words, that the sudden acceleration of uncertainty on global financial markets is serious. But why is it happening – and what does it mean?

If the crisis of 2008 taught us anything, it is that, after three and a half decades of financial globalisation, we live in an uncannily interconnected world. A slide in the price of new-build homes in the suburbs of Las Vegas can lead to a death spiral in the shares of a German provincial bank. A squeeze in the market for an esoteric derivative product understood by only the two or three investment-bank rocket scientists in New York who designed it can force a collapse in a currency used by more than a billion people halfway round the world. The price of every financial asset is connected in some way to every other – and like the apocryphal butterfly flapping its wings and causing a hurricane a thousand miles away, a tiny bit of indigestion in the most innocuous of markets can precipitate violent convulsions elsewhere.

It is easy to assume that this complex web of interdependency makes the markets impossible to read – and in general, one should indeed be wary of plausible-sounding ­tipsters pointing to this or that particular share price as a sure sign that Armageddon or Nirvana is round the corner.

Yet although all financial prices are in this important sense equal, some are most definitely more equal than others. These days, there are three prices, above all the many thousands of others, which govern the global economy.

The first – probably the most fundamental of all, though by no means the most familiar – is the yield on the benchmark US treasury bond, the interest rate that the American government has to pay to borrow from savers for a term of ten years. This is the purest expression of the price of money: it captures the cost of acquiring purchasing power that you don’t already have in the world’s largest and wealthiest economy. It is also the best gauge of markets’ deepest fears – for when recession looms, investors want only the safest financial claims; and when disaster threatens, only claims on the US government will do. The whole world bids for US treasury bonds, making their prices fly and their yields plummet.

The second core price is better known. It is the level of the S&P 500 Index, the American equivalent of the FTSE 100: the price that summarises the value of the US stock market. The value of equity shares rises and falls with the waxing and waning of economic growth and corporate profitability – so this price measures the market’s appetite for risk, by taking the temperature of its enthusiasm for the largest, most productive and most inventive companies in the world.

The final member of this global financial triumvirate is the trade-weighted exchange rate of the US dollar, or its average exchange rate against the other major currencies of the world. The dollar is the world’s reserve currency – the one money that everyone, everywhere, is happy to use. It is the default denomination of every international debt contract; outstanding dollar loans to Chinese companies alone add up to nearly $1trn. When the dollar strengthens on the foreign exchanges, servicing dollar debt becomes more expensive. So this price calibrates the global cost of doing business.

These three prices exercise powerful gravitational pulls on every aspect of the world economy, like three moons inexorably drawing the global financial tides this way and that. As with real celestial bodies, when they are in alignment, the sea is smooth and investors enjoy plain sailing; but when their orbits diverge, we are in for equinoctial gales and rough crossings.

We need look no further than the current financial disruption for a case in point.

 

2. The markets’ trilemma

All three prices today stand close to historic extremes. At 1.75 per cent, the yield on the US treasury note is within touching distance of its all-time low in the modern era – 1.38 per cent, notched up in July 2012 at the height of the worldwide gloom over the euro crisis (see chart on page 27). The level of the US stock market, by contrast, is high; equity prices are “rich” after seven years of relentless rallies, even after the wobble of the past two months.

The dollar, meanwhile, is positively rampant. It has strengthened by 24 per cent against the US’s main trading partners in the past 18 months alone, and is more expensive than it was at the peak of the dotcom bubble in the late Nineties, when all everyone wanted was to own a bit of cor­porate America.

Separately, these prices may all make sense. When we try to fit all three together, however, the tensions underlying the current market turbulence become clear. Each of the three most likely short-term scenarios for the global economy is consistent with two of them. None is compatible with them all.

The first scenario to consider is the one the world’s policymakers are currently betting on: that the economic recovery in the United States, though a bit limp, remains on track. There may be icy winds blowing from China and the other emerging markets, and a lack of momentum in Europe and Japan. Yet fundamentally the US economy remains in good health, and the collapse since mid-2014 in commodity prices – from oil to copper and iron ore – is, on balance, a net positive for American growth.

The second scenario is the one that is all over the press: the US, and perhaps the whole world economy, is already in recession. China piled up a mountain of debt seeking to offset the negative effects of the last crisis, but that borrowing financed the construction of ghost cities and commodity speculation. Now the reckoning has arrived, the Chinese boom has gone into reverse, and the resulting fall in commodity prices is wreaking economic and political havoc from Riyadh to Rio de Janeiro – and even in the US itself.

The third scenario is superficially the least dramatic, and hence figures least in the news. It is that things have got neither suddenly better, nor suddenly worse. Fundamentally, the US and the world remain stuck in the same, mildly disappointing rut they have been in since 2009. Call it the “new normal”, call it “secular stagnation”, it is neither a proper recovery nor a new global recession: it is simply the familiar pattern of low growth, low inflation and low interest rates that we have been living with for the past seven years.

Which of these scenarios is the one we actually face? For the purpose of understanding the current market meltdown, it doesn’t really matter. The reason for investors’ manifest uncertainty is that none of these three scenarios is consistent with all three of the governing prices in the global system.

If the US recovery is intact, then a strong dollar and a fully valued stock market look reasonable – but US treasury yields should be significantly higher, reflecting the higher inflation and more hawkish monetary policy that robust growth inevitably implies.

If, on the other hand, the US is close to or in recession, then both low treasury yields and dollar strength could be justified as the product of a flight to the safest asset in the global system and its main reserve currency – but the stock market is hopelessly overpriced because profits are doomed to dry up.

If both these dynamic views turn out to be red herrings, and the US is to be stuck in the recent grind of low growth and low inflation for the foreseeable future, then it is easy to envision treasury yields staying low and equity markets staying high under the continuing influence of ultra-loose monetary policy. Yet by the same token, it is difficult to see why the dollar should keep up its stunning run: it has been the stark divergence in monetary policy – hawkish in the US, dovish everywhere else – that has propelled its dizzying ascent.

The problem is that one of these three scenarios (or something broadly similar) will eventually come to pass. When it does, at least one of the three master prices that govern the global economy will have to adjust, and probably rapidly. The markets are in the grip of a trilemma that will almost certainly prove highly disruptive – and investors are cottoning on.

 

3. Monetary policy rules, but for how much longer?

So much for the current market action and its proximate cause. What about the longer term?

The first and second scenarios – recovery and recession – at least have the virtue of being familiar. A global recovery would certainly be preferable to a global recession. But either scenario would at least restore confidence that the type of business cycle we have known for the past sixty years still exists. That would be important because it would mean that the conventional models of the economy remain valid, and policies derived from them the best bet there is.

The third scenario – a return to the lacklustre but at least relatively stable path of the past seven years – would be more worrying, for many investors. The reason is simple. It would reinforce the sense that neither investors nor policymakers really understand what is going on.

The key feature of the relative economic calm that the world experienced from 2009 to mid-2014 was the unprecedentedly loose monetary policy implemented by the world’s major central banks. Central bank interest rates in the US, the eurozone, Japan and the UK have been pinned close to zero. Policymakers have made delicately turned verbal commitments to keep rates low for a very long time – the policy experiment called “forward guidance”. Trillions of dollars, euros and yen, and hundreds of billions of pounds, have been freshly printed under the rubric of “quantitative easing” (QE) in order to make money still more freely available when the conven­tional strategy of cutting interest rates has been exhausted.

The striking thing about these policies is that they are only tangentially supported by the theoretical frameworks that these central banks use to understand the economy. As Ben Bernanke, the then chairman of the US Federal Reserve, put it in his final public appearance in office in 2014, “[T]he problem with QE is it works in practice but it doesn’t work in theory.”

People who don’t spend their time staring at Bloomberg screens might be forgiven for asking why this matters. If, as Bernanke says, QE works, then who cares whether we know why it does or not?

The reason is that all policy – and monetary policy more than any other kind – depends critically on people’s expectations of what its outcome will be and their confidence that the policymakers understand the mechanism. In the field of public policy, the risks of unintended consequences are always large. They are multiplied many times over if the people in charge cannot explain why their actions are producing a particular result.

The looming risk is that monetary policy – the one tool that governments have been willing to use aggressively over the past seven years – starts to lose its grip. If its potency depends on investors believing that central banks know what they are doing, but those central banks lose their credibility, monetary policy may cease to work.

The point is far from academic. At the end of January, the Bank of Japan surprised the world by announcing that its monetary easing had not, as many had assumed, reached its limits. Concerned that the turmoil on the markets would spark a strengthening of the yen, it took its policy interest rate into negative territory for the first time ever in order to discourage safe-haven flows to its currency.

Until now, the near-automatic effect of such a loosening has indeed been to drive investors into riskier yen-denominated ­assets and out of the yen altogether, leading to its sharp depreciation against other major currencies over the past three and a half  years.

Now, it seems, the magic is wearing off. Bond yields dropped as expected, all right; but the yen did not comply. It has strengthened more than 4 per cent against the US dollar since the new loosening policy was introduced. The credibility of the Bank of Japan is fading. The market does not believe it can do what it wants to do – or even, perhaps, that it knows how its experimental interventions really work.

Investors’ bigger fear is that such doubts infect the Federal Reserve. The consequences
of such a crisis of confidence in the powers of the most central of central banks would be of an order of magnitude far more serious.

Ever since the collapse of the Bretton Woods system of pegged exchange rates in 1971, the sole guarantee that currencies will maintain their purchasing power, both domestically and abroad, has been confidence in central banks’ discretionary policies. A loss of faith in the consensus model of monetary policy would pitch us into the anchorless world that the architects of the Bretton Woods system always feared.

The past few weeks have been nerve-shredding for those who work on the financial markets. They should prepare for more of the same – and those who have nothing to do with the trading of stocks, bonds and currencies should ready themselves, too.

If it is belief in the power of loose monetary policy that has kept bond yields low and equity prices high, we should prepare for spikes in interest rates and stock-market crashes – with painful ramifications for companies and households that need to finance their activity. If it is confidence in the power of central banks to manipulate the value of their currencies that has bolstered the dollar and depressed the euro and the yen, then we should expect dramatic re-evaluations of these exchange rates, with inevitably disruptive consequences for global trade.

Over the longer term, the most consequential result of all will probably be an urgent search for a new framework for monetary policy, and above all for a new anchor. History – and, in the US, actively discussed political proposals – would suggest that the abandonment of discretionary policymaking in favour of formulaic rules, or even a return to a gold standard, are the candidates most likely to be chosen at short notice.

The sad fact is that these measures would represent last resorts from failure. Flexibility in monetary policy, credibly deployed, is probably the single most effective tool of government ever invented. It would be a confused and benighted age that chose to abandon it in favour of more primitive techniques of control.

Felix Martin is a macroeconomist, bond trader and the author of Money: the Unauthorised Biography

This article first appeared in the 18 February 2016 issue of the New Statesman, A storm is coming

Photo: ANDREW TESTA/THE NEW YORK TIMES/ EYEVINE
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Interview: Nicola Sturgeon's Scottish referendum dilemma

In a candid interview, the First Minister discusses Theresa May’s coldness, Brexit and tax rises – and why she doesn't know when a second referendum will be held. 

Nicola Sturgeon – along with her aides, who I gather weren’t given much choice – has taken up jogging in the verdant country­side that lies to the east of the Scottish Parliament. “The first time was last week,” she says, when we meet in her large, bright Holyrood office. “Loads of people were out running, which made me a bit self-conscious. But it was fine for ages because everybody’s so focused. Then, suddenly, what must have been a running group came towards me. I saw one of them look and as they ran past I turned round and all of them were looking.” She winces. “I will eventually get to the point where I can run for more than 100 yards at a time, but I’m not at the stage yet where I can go very far. So I’m thinking, God, they’re going to see me stop. I don’t know if I can do this.”

This is a very Nicola Sturgeon story – a touch of the ordinary amid the extraordinary. She may have been a frontbencher for almost two decades, a cabinet minister for half of that and the First Minister since 2014, but she retains that particularly Scottish trait of wry self-mockery. She is also exceptionally steely, evident in her willed transformation over her adult life from a shy, awkward party member to the charismatic leader sitting in front of me. Don’t be surprised if she is doing competitive ten-kilometre runs before the year is out.

I arrived at the parliament wondering what frame of mind the First Minister would be in. The past year has not been especially kind to her or the SNP. While the party is still Scotland’s most popular by a significant margin, and Sturgeon continues to be its dominant politician, the warning lights are flashing. In the 2015 general election, the SNP went from six seats out of 59 to 56, a remarkable result. However, in Theresa May’s snap election in June this year, it lost 21 of those seats (including those of Angus Robertson, the SNP leader at Westminster, and Alex Salmond), as well as half a million votes. Much of the blame has been placed on Sturgeon and her call for a second independence referendum following the vote for Brexit. For critics, it confirmed a suspicion that the SNP only cares about one thing and will manipulate any situation to that end. Her decision also seemed a little rushed and desperate, the act of a woman all too aware of the clock ticking.

But if I expect Sturgeon to be on the defensive, maybe even a little downbeat, I’m wrong. Having just come from a feisty session of First Minister’s Questions, where she had the usual barney with her Tory opposite number, Ruth Davidson, she is impressively candid. “When you come out [of FMQs], your adrenaline levels are through the roof,” she says, waggling a fist in my direction. “It’s never a good idea to come straight out and do an interview, for example.” Adrenalised or not, for the next hour, she is thoughtful, frank, funny and perhaps even a little bitchy.

Sturgeon’s office is on the fourth floor, looking out over – and down on – Holyrood Palace, the Queen’s official residence in Edinburgh. As we talk, a large artistic rendering of a saltire adorns the wall behind her. She is similarly in blue and white, and there are books about Burns on the shelves. This is an SNP first minister’s office.

She tells me that she and her husband, Peter Murrell, the party’s chief executive, took a summer break in Portugal, where his parents have a share in an apartment. “We came home and Peter went back to work and I spent a week at home, just basically doing housework…” I raise an eyebrow and an aide, sitting nearby, snorts. She catches herself. “Not really… I periodically – and by periodically I mean once a year or once every two years – decide I’m going to dust and hoover and things like that. So I did that for a morning. It’s quite therapeutic when you get into it. And then I spent a week at home, reading and chilling out.”

In a recent Guardian interview, Martin Amis had a dig at Jeremy Corbyn for having “no autodidact streak”. Amis said: “I mean, is he a reader?… It does matter if leaders have some sort of backing.” One of Sturgeon’s great strengths is that she is a committed bibliophile. She consumes books, especially novels, at a tremendous rate and raves to me about Gabriel Tallent’s astonishing debut, My Absolute Darling, as well as Bernard MacLaverty’s Midwinter Break. She has just ploughed through Paul Auster’s daunting, 880-page 4 3 2 1 (“It was OK. I don’t think it should be on the Booker shortlist.”) She also reread the works of Chimamanda Ngozi Adichie before interviewing her onstage at the Edinburgh International Book Festival in August.

The First Minister is now reading What Happened, Hillary Clinton’s book about her defeat by Donald Trump. “I’ve never been able to read any of her [previous] books because literally every word is focus-grouped to the nth degree,” Sturgeon says. “This one, there are moments of frankness and raw honesty and passages where it’s victimhood and self-pity, but that’s kind of understandable and very human. The thing that fascinates me about Hillary, apart from the politics, is just her sheer bloody resilience.  Given what she’s gone through and everything that’s been chucked at her, I genuinely don’t know how she keeps coming back.”

***

Speaking of resilience, does she have any fellow feeling for Theresa May, humiliated by the electorate and, for now, kept in No 10 like a racoon in a trap by colleagues who are both power-hungry and biding their time? “At a human level, of course,” she says. “When you’ve got an insight into how rough and tough and, at times, downright unpleasant the trade of politics can be, it’s hard not to feel some personal sympathy. Her position must be pretty intolerable. It’s tempered, though, by the fact that nobody made her call an election and she did it for purely party-political interest.”

How does she get on with May – who is formal and restrained, even off-camera – in their semi-regular meetings? Sturgeon starts laughing. “The Theresa May that the country ended up seeing in the election was the one I’ve been dealing with for however long she’s been Prime Minister. This is a woman who sits in meetings where it’s just the two of you and reads from a script. I found it very frustrating because David Cameron, whose politics and mine are very far apart, always managed to have a personal rapport. You could sit with David and have a fairly frank discussion, agree the things you could agree on and accept you disagree on everything else, and have a bit of banter as well.

“I remember just after May came back from America [in January], when she’d held Trump’s hand [Sturgeon starts laughing again], she’d also been to Turkey and somewhere else. This was the Monday morning. We sit down, it’s literally just the two of us, and I say, ‘You must be knackered.’ She said, ‘No! I’m fine!’ And it was as if I’d insulted her. It was just impossible to get any human connection.”

Given this, and the weaknesses exposed during the election, Sturgeon is scathing about how the Conservatives fought the campaign, putting May’s character and competence front and centre. “The people around her must have known that vulnerability,” she says. “God, we all make mistakes and we all miscalculate things, so this is not me sitting on high, passing judgement on others, but don’t build a campaign entirely around your own personality when you know your personality’s not capable of carrying a campaign… Even if you can’t see that yourself, somebody somewhere around you should have.”

Sturgeon might not be in May’s beleaguered position but she has problems. Her demand in March, at a press conference at Bute House, Edinburgh, for a second independence referendum by spring 2019 was a serious mistake and it has left a dent in what had seemed her impermeable personal popularity. Polls show support for the SNP and independence now share a similar downward trajectory. Over the next three years, the First Minister must persuade a sceptical electorate that her party deserves a fourth consecutive term in government.

Does she regret demanding another vote on separation?

Here she gets as close as she will go to a mea culpa. “Obviously I’m thinking pretty deeply about it. I think Brexit is a complete and utter car crash – an unfolding disaster. I haven’t changed my views on that, and I think it’s deeply wrong for [Scotland] to be taken down that path without the ability to decide whether that’s right or not.

“I recognise, as well – and it’s obviously something I have reflected on – that understandably people feel very uncertain about everything just now, partly because the past few years have been one big decision after another. That’s why I said before recess that I will not consider any further the question of a second referendum at this stage. I’m saying, OK, people are not ready to decide we will do that, so we have to come back when things are clearer and decide whether we want to do it and in what timescale.”

Will she attempt to hold a second referendum? Could it be off?

“The honest answer to that is: I don’t know,” she says. Her expression of doubt is revealing.

Would she, however, support a second EU referendum, perhaps on the final separation package? “I think it probably gets more and more difficult to resist it,” she tells me. “I know people try to draw lots of analogies [between the EU and independence referendums], and there are some, but whatever you thought of the [Scottish] white paper, it was there and it was a fairly detailed proposition.

“One of the beautiful things about the independence referendum was the extent to which ordinary folk became experts on really technical, big, macro­economic positions. Standing on a street corner on a Friday morning, an ordinary working-class elderly gentleman was talking to me in great detail about lender of last resort and how that would work. You can say the white paper was crap, or whatever, but it was there, people were informed and they knew what they were voting for.

“That was not the case in the EU referendum. People did not know what they were voting for. There was no proposition put forward by anyone that could then be tested and that they could be held to account on. The very fact we have no idea what the final outcome might look like suggests there is a case for a second referendum that I think there wasn’t in 2014. It may become very hard to resist.”

Sturgeon hasn’t found the Brexit process “particularly easy”, especially when the government at Westminster is in the grip of what is becoming an increasingly vicious succession battle. The SNP administration has repeatedly clashed with the relevant ministers at Westminster, whom it says have given little care to Scotland’s particular needs. Sturgeon’s view of David Davis, Liam Fox and Boris Johnson is not rosy.

“Probably not a day goes by where I don’t look at them and think, ‘What the hell’s going on?’” she says. “That’s not meant as a personal comment on their abilities – although [with] some of them I would have personal question marks over their abilities. But they’re completely paralysed, and the election has left them in a position where you’ve got a Prime Minister who has no control over the direction of her government, and you have other senior ministers who are prepared to keep her there only because it’s in their short-term interests to do it. If you’re sitting on the European side of the table now, how can you have a negotiation with a government where you don’t actually know what their position is, or whether the position you’re being told across the table is one that can carry support back at home? It’s a shambles and it’s increasingly going to be the case that nothing other than Brexit gets any bandwidth at all. It’s really, really not in the interests of the country as a whole.”

***

This is an accusation that is directed at the SNP, too – that the national interest takes second place to its constitutional imperative. It is undoubtedly something that Sturgeon considered over the summer as she sought to rebalance her administration. As a result, the programme for government unveiled earlier this month was impressively long-term in places: for example, its promise to create a Scottish national investment bank, the setting of some ambitious goals on climate change and the commitment to fund research into a basic income.

Most striking, however, was Sturgeon’s decision to “open a discussion about… responsible and progressive use of our tax powers”. With the Scotland Act 2016, Westminster passed control over income tax to Holyrood, and Sturgeon intends to use this new power.

“For ten years,” she says, “we have done a pretty good job of protecting public services as best we can in a period of austerity, while keeping the taxes that we’ve been responsible for low. We’re now at a stage where austerity’s continued, we’re going to have economic consequences from Brexit, we all want good public services, we want the NHS to continue to have strong investment, we want our public-sector workers to be paid more, we want businesses to have the right infrastructure. How do we progressively and responsibly, with the interests of the economy taken strongly, fund our public services going forward? Most people would think right now that there is a case for those with the broadest shoulders paying a little bit more.”

I wonder whether the success of Jeremy Corbyn has influenced her thinking – many expect that a revival of Scottish Labour would force the SNP to veer left (it will also be interesting to see how Westminster reacts to Scotland raising the top rate of income tax). “It’s not particularly Corbyn that’s made me think that,” she insists, a little unconvincingly.

Isn’t Sturgeon concerned that making Scotland the highest-taxed part of the UK could undermine its competitiveness, its attraction as a place to live and as a destination for inward investment? “We should never be in a position where we don’t factor that kind of thing into our thinking, but you talk to businesses, and tax – yes, it’s important, but in terms of attracting investment to Scotland, the quality of your infrastructure matters. Businesses want good public services as well, so it’s the whole package that determines whether Scotland is an attractive place to live and invest in and work in,” she tells me. “It’s seeing it in the round. The competitiveness of your tax arrangements are part of what makes you attractive or not, but it’s not the only part.”

As for the immediate future, she is upbeat. She believes that Ruth Davidson, her main rival, is overrated. “I think Ruth, for all the many strengths people think she might have, often doesn’t do her homework very well,” she tells me. “From time to time, Ruth slips up on that… Quite a bit, actually. I know what I want to do over the next few years, and I’m in a very good place and feeling really up for it. After ten years in office, it’s inevitable you become a victim of your own success. What’s more remarkable is that, after ten years, the SNP still polls at least 10 and usually 10-15 points ahead of our nearest rivals.”

Author's note: Shortly after this interview went to print, the SNP got in touch to say that Nicola Sturgeon’s comment, ‘the honest answer to that is: I don’t know’, was about the timescale of the next independence referendum and not whether there would be one. The misinterpretation was mine.

Chris Deerin is the New Statesman's contributing editor (Scotland). 

This article first appeared in the 18 February 2016 issue of the New Statesman, A storm is coming