LOSING CONTROL (11 page)

This wasn’t quite a Ponzi scheme (although Ponzi schemes, most obviously Bernard L.
Madoff Investment Securities LLC, nevertheless developed), but it had much the same effect.
The combination of rapidly growing emerging economies, 1990s Asian failures and a hunt for yield left investors with the belief that capital gains had to be plucked from the tree without any real regard for risk.
Even sensible investors were forced to take part.
I recall talking to one particularly cautious bond investor in 2007 who was lamenting his company’s determination to deliver to its investors a particularly high rate of return.
The investor found himself having to buy Ukrainian government debt at a yield of 6.5 per cent which, at the time, was considerably more attractive than the paltry 4.5 per cent available on US Treasuries.
It was the only way he could ensure that his portfolio would keep up with the competition and that he, in turn, would keep his job.
Two years later, the value of his investment had collapsed: the yield on Ukrainian debt rose from a trough of 5.8 per cent to a peak of 40.4 per cent, implying a huge loss.
This was a catastrophe for the investor, his company and the company’s clients.
⁷

The pot of gold mentality did not, therefore, have a distorting effect on capital markets in the developed world alone.
It also led to
excessive flows of savings into emerging investments where returns for investors were, frankly, suspect.
Rent-seeking behaviour is not confined to greedy Western capitalists.
It is found all over the emerging world where the distinction between private companies and government control is, at best, tenuous.
Pretending that corporate governance will somehow be good enough to protect the interest of developed-world investors is, in some cases, laughable.

In
The Writing on the Wall
, Will Hutton criticizes China’s Communist Party for failing to disentangle itself from corporate China, arguing that China is suffering as a result from endemic corruption or, in Ricardo’s terminology, abusive rent-seeking behaviour.
Whether or not the corruption is endemic, the key point is, surely, that investors in the developed world have no guarantee that they’ll receive the returns they expect from investing in Chinese capital markets.
China was hardly treated well by the imperial powers in the nineteenth century.
It isn’t likely to be well disposed to investors who have every intention of extracting short-run gains at the possible expense of China’s long-term development.
Indeed, although China’s economy has performed powerfully since the 1980s, the returns to investors have been mixed.
Those who hunted for yield didn’t ask enough of the right questions.
They were too greedy.

Ultimately, we have lived through decades of false hopes.
The savings industry has failed to deliver the returns investors expected, partly because of the distortions arising from excessive government lending and borrowing.
For those of us who have worked in financial markets, this is a deeply depressing conclusion.
We have, it seems, been living through a modern-day version of the Californian gold rush in the mid-nineteenth century.

The gold rush was, arguably, the ultimate triumph of hope over what would eventually prove to be bitter experience.
Sam Brannan, one of the gold-rush pioneers, made a killing in the mid-nineteenth century not because he discovered very much gold but, instead, because he bought up every pick and shovel in the area; he then sold the tools to dreamy prospectors, making a mint in the process.
The prospectors literally believed in a pot (or nugget) of gold, and were happy to hand over their savings to Brannan who, presumably, was happier still.
Levi Strauss, a Bavarian who arrived in the US just before the gold rush, founded his eponymous company in 1853, making a fortune from the sale of heavy-duty clothing for those who would end up doing the hard yet unrewarding work of gold prospecting.
In 1873, he made his clothing even stronger with the use of copper rivets, and so jeans were born.

The gold rush, then, marked a huge redistribution of wealth from those who invested everything in their dreams to those who furnished the pursuit of those dreams.
The modern-day equivalents are surely the investment banks, the pension funds, the insurance companies, the providers of screen services and so on, who, like those who went before them, have benefited from others’ dreams.
In the nineteenth century, people believed gold would make them wealthy.
In the late twentieth century, people believed their pension contributions would make them secure in their retirement.
Anything supporting this idea was seized upon, including the pioneering investor spirit unleashed by the arrival of the emerging economies.
Yet, as with the gold rush, the real winners may not have been those who dreamt.

While emerging economies have had an important influence on developments in world capital markets since the 1980s, their impact has been poorly understood.
The most glaring error has been the belief that capital-market prices have been free of distortion.
This required the heroic assumption that the rise of the emerging economies would be entirely consistent with free-market behaviour.
As we shall see in Chapter 7, this is simply not true.
More import-antly, policymakers in the developed world have been far too happy to go along with the ‘pot of gold’ mentality.
Far better, it seems, to have pretended our savings were safe than to have faced up to the reality of poor returns, excessive risk, false promise and, through much higher cross-border capital flows, a loss of control.

Why were policymakers happy to go along with the pretence?
In part, they had become victims of their own propaganda.
With the defeat of inflation, they believed they had discovered the secrets of economic management.
In fact, their focus on inflation led them away from some of the really big threats facing Western economies.
Even worse, in a world where prices of goods, services, labour and assets were increasingly being distorted by the gravitational pull of the emerging nations, the single-minded pursuit of price stability only increased the risks of economic instability.
The next chapter explains why.

For many years, policymakers have pursued low and stable inflation with virtuous zeal.
Understandably, they have no desire to return to the dark days of the 1970s and early 1980s, a time when inflation in all its many forms was rampant and economic performance in the Western world was, at best, disappointing.
Low and stable inflation is now typically seen as a necessary condition for economic stability.

Yet, with the rise of the emerging nations, it is no longer so clear that the single-minded pursuit of price stability is delivering the goods.
If anything, in a world where price disturbances in the West are increasingly the result of economic developments in the emerging world, the pursuit of price stability has contributed to mounting economic instability.
Policymakers – governments, central bankers – like to take credit for the achievement of low inflation.
Their institutions are specifically designed to prioritize price stability above all else, often based on the premise that price stability can easily be encapsulated in a single inflation target.
This premise is wrong.
Policymakers have chosen to ignore the ways in which
emerging nations bend, twist and warp prices.
The blinkered pursuit of low inflation in the West has been a mistake, leading to asset-price bubbles, economic booms and busts and excessive accumulation of debt.
It is time for a rethink.
That rethink must involve a better understanding of the role of emerging nations in determining inflation, both in the emerging world and in the West.
¹

For those brought up in the 1970s, the achievement of price stability became the big macroeconomic prize.
During that decade, one economic disaster followed another, largely because there was no monetary discipline and, hence, no anchor for inflationary expectations.
The commodity price surge at the beginning of the 1970s came about partly because the US over-stimulated demand in a bid to fund the Vietnam War.
The collapse of the Bretton Woods exchange-rate system, and the volatility that followed, reflected the willingness to tolerate inflation as the ‘acceptable’ cost of delivering a low rate of unemployment.
The quadrupling of oil prices at the end of 1973, as a consequence of the Arab oil embargo (itself a reaction to the Yom Kippur War), was only possible because the inflation genie was already out of the bottle.
As inflation – and expectations of inflation – picked up, so industrial relations deteriorated, creating a legacy of strikes, huge wage and price increases and the beginnings of so-called ‘stagflation’, whereby inflation went up but economic growth and employment came down.
Meanwhile, those on fixed monetary incomes – most obviously, pensioners – were often robbed of their savings through ever-bigger price increases.

While the desire to control inflation is now a central tenet of monetary policy, the shift during the 1970s towards a focus on inflation rather than unemployment as the main macroeconomic policy objective represented a remarkable change of view compared with
the 1960s, when most policymakers believed in the pursuit of full employment and didn’t worry too much about inflation.
The best economic ideas tend, eventually, to go out of fashion, upstaged by unexpected or irregular economic developments.

The shift in stance is summed up nicely in two well-known quotes.
The first, ‘we are all Keynesians now’, is commonly attributed to US President Richard Nixon in 1971, although the original source was a tongue-in-cheek Milton Friedman in a 1965 edition of
Time
magazine, lamenting the dominance at the time of the intellectual ideas stemming from John Maynard Keynes’s
General Theory of Employment, Interest and Money
.
²
The conventional wisdom held that Keynesian demand-management policies – changes in tax and public-spending levels to foster a desired level of economic activity – would bring about full employment.
These policies were to be actively used at all times to avoid a repeat of the economic calamities of the 1930s Depression.

A handful of years later, with the onset of the excessive inflation of the 1970s, this view of the world was gradually rejected.
Jim Callaghan, the UK prime minister at the time, administered the
coup de grâce
for Keynesian demand-management policies, at least from a British point of view, at the Labour Party conference in 1976:

Put another way, if everyone knew a government was prepared to guarantee full employment through demand-management policies,
it no longer mattered how far individual prices and wages rose.
With everyone thinking along similar lines, inflation was bound to take off.
Meanwhile, if some prices and wages rose faster than others, there would be an arbitrary and unfair redistribution of income and wealth.
Those on fixed incomes – savers, pensioners – would lose out.
Others – debtors, unionized workers able to demand annual wage increases – would gain.
Meanwhile, increasingly volatile movements in prices and wages would make life impossible for businesses.
They would not easily be able to single out profitable investment opportunities, leaving capital spending unnecessarily depressed, as proved to be the case in many countries during the 1970s.
Socially, economically and politically, excessive inflation was a corrosive disaster.

Callaghan’s comments marked the beginnings of an experiment with monetarism, the belief that controlling the money supply would be the best way of stabilizing inflation and, hence, restoring economic stability.
This approach was wholeheartedly embraced by Paul Volcker’s new-look US Federal Reserve and Margaret Thatcher’s new-look British Conservative government at the end of the 1970s via the use of monetary targets.
The overriding ambition at the macroeconomic level became the control of inflation, a controversial idea at the time but one that is now entirely mainstream.
Liberated markets, with reduced union power and only modest government intervention, would in turn sort out problems of unemployment.

Monetary targets didn’t quite go according to plan.
Money supply was difficult to control and its relationship with the economy as a whole was nothing like as steady or predictable as monetarists had claimed.
Nevertheless, policymakers were keen to stick to simple macroeconomic rules in the pursuit of underlying economic stability.
Monetary targets were replaced by other targets, the most enduring of which have proved to be inflation targets (in the
developed world) and exchange-rate targets (in the emerging world).
Meanwhile, to rid policymakers of undue political influence, many central banks were granted independence, to a greater or lesser degree, from their ultimate political masters.

Central bankers have become the high priests of price stability and pursue their beliefs with a theocratic orthodoxy.
They believe not only that price stability is good but that its achievement is the single best ‘top-down’ way of delivering overall economic well-being.
They also believe they have the tools to keep inflation under control at all times.
Most obviously, they control short-term interest rates in the hope of meeting their broader economic aims.

Changes in short-term interest rates feed through to the economy and to inflation through a series of different channels.
They work on people’s expectations.
Rate increases, for example, are commonly regarded as a sign of more austere times ahead and can, therefore, act to constrain wage demands.
Interest rates can affect asset prices.
Other things equal, lower interest rates make other assets easier and more attractive to purchase.
Lower mortgage rates, for example, tend to increase demand for housing, thereby pushing up house prices.
More generally, lower interest rates reduce the returns on bank deposits in relation to other, more risky, investments such as equities and commercial property, thereby stimulating asset-price increases.
Changes in interest rates will directly impact on the willingness of companies to borrow for investment projects.

In an international context, higher interest rates will make a given currency more attractive to foreign investors, thereby driving the currency’s value up on the foreign exchanges.
Imports end up cheaper while exporters are forced to control their costs with more rigour.
All in all, changes in interest rates alter demand and cost pressures within an economy, have an impact on people’s expectations about the future path of the economy and, if credible, influence inflation and inflationary expectations.

Yet if the channels between changes in policy rates and their ultimate effect on inflation are distorted, closed off, diverted or overwhelmed by events taking place elsewhere in the world, it’s not at all obvious that the revolutionary claims of political leaders at the end of the 1970s or the beginning of the 1980s – namely that the control of inflation brings with it lasting economic stability – can still be met.
Either inflation itself cannot be controlled or, more likely, its control leads to unexpected problems elsewhere in an economy.

Indeed, the relentless pursuit of near-term price stability is increasingly likely to be a source of economic and financial
instability
.
Linked with the growing size and influence of the emerging world, the battle against inflation is changing.
Unfortunately, central banks are still pursuing the tactics of yesterday’s war.
For them, price stability is a necessary condition of overall economic stability.
This may still be true at the global level but, at the national or regional level, I am not convinced this claim still holds.

Typically, inflation is defined either as a sustained rise in the general price level or a sustained decline in the value of money.
Deflation, conversely, is a sustained fall in the general price level or sustained rise in the value of money.
The general price level, in turn, refers to prices of everything – goods, services, labour and capital.
A central bank that safeguards the value of money is, therefore, delivering price stability.

Which prices should be included?
The consumer price indices which normally are the focus of an inflation-targeting regime are based on a ‘typical person’s’ basket of goods and services.
This immediately raises some awkward issues.
The spending pattern of the wealthy Upper East Side resident will not match that of someone who hails from the mean streets of Detroit.
What, then, does inflation refer to?
⁴

Even if all US citizens were the same, what should be in the basket?
Are volatile components, such as food and energy, to be included even when they might give misleading indications of inflation ‘in the long run’?
How should changes in the quality of goods be accounted for?
Should only goods and services be included or should the prices of assets also be included?

Conventional measures of inflation – and conventional inflation targets – focus on consumer prices.
The pursuit of price stability, however, ultimately has to take into account not just prices but also costs.
A world in which both prices and wages are rising – the inflation of the 1970s – is a very different world from one in which prices are rising but wages are not.
Both worlds see a pick-up in measured inflation in the short term, but while the first leaves spending power unchanged, the second makes workers poorer.
The second example can be better described, therefore, as a redistribution of income away from workers.
Many of the uncertainties over inflation we see today are routinely of this second variety.
Commodity prices go up and, in the developed world, the price level rises in relation to wages.
Manufactured goods prices – laptops, iPods, flat-screen TVs – come down and the price level falls in relation to wages.

The problems of defining inflation don’t end there.
What about the relative price of goods and services in one country against another?
If both countries have the identical domestic inflation rate, it’s still possible that the relative price of goods and services in one country will rise or fall against another country as a result of movements in the exchange rate.
Moreover, sudden changes in demand in one country can easily have spill-over effects in other countries.
Because many of these spill-over effects may surprise both in timing and magnitude, there’s a good chance that policymakers will make mistakes.

A good example comes from the 1970s, when Germany and Switzerland burnished their anti-inflation credentials.
Most countries benefited from relatively low inflation in the 1950s and early
1960s.
By the late 1960s, however, many policymakers were beginning to lose the price-stability plot.
Fearing a major rise in unemployment – and, in the US, spending vast amounts of money on the Vietnam War – they left monetary conditions too loose, and it wasn’t long before inflation globally started to accelerate.