John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognizes the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronized global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.
By Way of Background…
Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specializes in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.
I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.
We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.
When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.
John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.
The Gathering Storm
JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?
JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronized global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronized, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.
JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a non-issue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?
JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.
JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While counter-cyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?
JL: The central tenet of Keynesianism is subtler than the bastardized version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.
Financial Repression Past, Present and Future
JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidize government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?
JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.
JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?
JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarized to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfill.
Present at the Creation
JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration. Given recent developments, this seems a bold view to some. Would you care to elaborate?
JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalization: but you get the point.
JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?
JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realize that they could get rich also by selling to themselves. To this day, they have not learned that lesson.
JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalized the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?
JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. But alternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.
JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?
JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.
From Debt Crises to Currency Crises
JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?
JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a prior theorizing only to be proved wrong later, I am, I confess, rather more humble.
JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganization of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?
JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbors, airports, even certain types of housing, and sell them off later to the private sector later when confidence returned. Surely that ought to be possible.
JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.
JL: I think that leaving the euro is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.
JB: But if the UK economy needs to re-balance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?
JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.
On Financial Market Valuations and the Monetary Future
JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global re-balancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?
JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.
JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?
JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.
JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are skeptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?
JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.
JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?
JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.
If John Were in Charge
JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?
JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling [Chancellor of the Exchequer –JB] did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls [Darling’s successor –JB] understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.
JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.
JL: Thank you John.
JB: Perhaps we can do this again in a year or so to see how things are panning out?
JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.
JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.
JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.
JB: Indeed. Well Happy Holidays!
JL: To you too John.
Post-Script: From Risk to Uncertainty
My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.
This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.
This brings us, I believe, to the crux of the risks the lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.
Financial markets are notoriously bad at pricing in qualitative risks, or ‘uncertainty’ if you prefer. Anything that doesn’t fit a Gaussian (ie ‘normal’) distribution cannot be put through any conventional asset valuation model, or any robust quantitative model for that matter.
Take, for example, the low level of benchmark interest rates in developed economies. One reads frequently that this indicates that the financial markets are complacent about the risks of unusually large sovereign debt burdens and unconventional monetary policy. That is simply not true. In much the same way that a plunging share price or credit spread is both indicator and exacerbating cause of corporate distress, when it comes to the interest rate at which a heavily indebted sovereign borrower funds itself, a sharp rise does not merely indicate an increasing risk of a crisis; rather, it IS the crisis!
Financial market risk premia are never stable, in part because they cannot be calculated with certainty. They are in constant flux with each and every transaction. For financial assets, the process commonly referred to as ‘price discovery’ is really a process of ‘risk discovery’. With policymakers intervening in their debt markets to an unprecedented extent via QE and various forms of financial repression, it is a stretch to believe that observable ‘market’ interest rates tell us anything at all about the true, underlying riskiness of sovereign debts.
Far more useful is to look at risk measures that remain relatively free from government or central bank intervention. For example, take a look at corporate valuations in a historical comparison, adjusted for the low level of interest rates: Risk premia are high, not low. Take a look at dividend payout ratios: They are high, not low. Take a look at the low rate of fixed capital formation which, net of depreciation, is outright negative in many developed economies. Why are economies consuming the very capital that enables economic growth?
I will tell you why: Financial market participants are strongly negative about the true, real, after-tax future returns on capital invested because they know that expansive central planning produces poor and perhaps even disastrous economic outcomes. And as we know, actions speak louder than words.
But is this pessimism overdone? Is it now time to buy risk assets? Momentum has turned positive of late. Is this the turning point? Or merely short covering? Or year-end, low-volume noise?
To answer these questions, we need only consider again how we got into this mess in the first place: Policymaker activism. Whether it be setting interest rates too low; stimulating consumption with easy credit; discouraging savings through taxation; subsidizing risk taking in various ways, including outright bailouts of failing institutions; centrally allocating scarce resources with ‘green pork’ or other largely uneconomic policies; or whatever, the fact is that policymaker activism caused the bubbles and thus caused the busts. With policymaker activism now having escalated to unprecedented levels, I would argue that risky asset valuations should have sunk to unprecedented lows. Yet they have not.
I have written so before and I do so again here: Before we have seen the bottom in real (ie inflation-adjusted) risky asset prices we are going to see valuations in developed markets drop below those seen in the late 1970s/early 1980s, when confidence in economic policy was also weak. We have come a long way, to be sure, but we have perhaps an equally long way to go yet (even when assuming that policymakers eventually get their act together).
While well over a generation has passed since there was general stability in money and credit growth and prior to the relentless rise of the modern, debt-financed welfare state, in my experience most people, young and old alike, are quick learners when their livelihoods depend on it. People who have pushed paper around their entire working lives wondering how it possibly adds value to anything will wonder no longer when the incentives are right. They will go about the business of doing what receives acceptable compensation and stop doing that which does not. Resources, labor and capital will be reallocated, economies will deleverage and then growth will begin anew.
Once this is recognized by the financial markets—rather quickly I should think—then valuations will begin to rise again, only this time on a healthy and sustainable (if necessarily subjective) basis. When the entirely necessary if at times painful economic restructuring is mixed with all the wonderful technological advances of modern times, an era of great prosperity is highly likely to commence.
I have little idea how long it is going to take to get there or just how big the crisis will be that finally forces policymakers to step back and allow a free market in goods, services and in money itself. But I certainly believe I know what to look out for and I hope regular Amphora Report readers feel as if they do too. An opportunistic investment approach based on a qualitative, policy paradigm-shift is the way to play it, whether in 2013 or well-beyond. Patience—or ‘low time-preference’ if you prefer—is indeed a virtue, albeit one in unusually short supply amid zero interest rates and other artificial, unsustainable economic stimulus. Only an arch-Keynesian paperbug could think otherwise.
In the meantime, portfolios should be overweight ‘insurance’ and by that I don’t mean shares of insurers. I mean the ultimate forms of financial insurance, that is, unencumbered real assets (eg gold, other marketable commodities) and broad diversification across assets, jurisdictions, etc.
Along those lines, here is a final ‘picture’ of advice as I also offered in the last edition, immediately following a sharp drop in the gold price:
I wish a happy and prosperous 2013 to all readers of The Amphora Report!
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