‘US is close to a Keynesian liquidity trap’

(This interview, with CLSA head of economic research Eric Fishwick, was published in DNA edition dated October 18, 2010.)

The outlook on the global economy has been clouded over by the stirrings of a currency war, with the rhetoric escalating in shrillness with each passing day. And although the US has momentarily held back from naming China a currency manipulator, CLSA’s head of economic research Eric Fishwick says there’s a real risk that things could develop in an “untidy fashion”. In an interview to DNA Money’s Venky Vembu, Fishwick also flags the risk that the inevitable second round of Quantitative Easing in the US may not generate a positive outcome – in much the same way that the first round didn’t work. Excerpts:

Is there a real risk of a global currency war, or is this just political grandstanding?

There’s a real risk that we see things develop in an untidy fashion. The tidiest solution would be a currency realignment under the auspices of the IMF under which both the US and European currencies are depreciated versus emerging market currencies in general, and emerging Asian currencies in particular. But there’s virtually no chance of that happening under any situation. When (US Treasury Secretary) Tim Geithner argues that countries that keep their currencies undervalued are destabilising, he is correct. However, when (Chinese Premier) Wen Jiabao retorts that the renminbi can’t be appreciated too rapidly because of thin-margin exporters, that statement also is correct. The Chinese economy has grown within the framework of cheap capital and a cheap currency. And therein lies the problem: that the economic structure that we have at the moment is backward-looking. China has recognised that it needs to move away from being export-dependent. The favoured solution – rather illogically, in opinion – has been to try and raise domestic price and wage levels, rather than the currency. That gives them more control over the allocation of resources.

Before the global financial crisis, China recognised it needed to move away from exports, but the crisis has certainly focussed attention. From their perspective, they are doing something already, and yet they are still being criticised and pressured to rapidly adjust their currency. 

On the American side, we’ve had policy from Day One that’s been designed to minimise the adjustment process that the US has to go through.

Do you mean the first round of Quantitative Easing (QE)?

QE 1 was a policy that was designed, in my opinion, to inflate asset prices sufficiently that the non-bank private sector didn’t really need to de-gear. So, in both fiscal and monetary policy, we’ve had an explicit attempt to enable the US economy to stay as much as possible how it was before the collapse of Lehman Brothers. The pre-2007 situation was unsustainable: there was excess consumption in the West, and excess production in the East. But in the US, government and policymakers have been desperate to slow that rate of adjustment. That gives them very little moral high ground to pressure emerging markets to accelerate the adjustment on their own side.

For what it’s worth, there’s also a balance of power issue here. The US, by virtue of its aggressive policy, abrogated leadership in this role. But there’s also the fact that with the US, broadly speaking, on one side, and emerging markets – and in particular China – on the other side, neither side is overwhelmingly dominant. Given that, I think there’s very little chance of an administered solution.

In the absence of an administered solution, we’re all playing Prisoner’s Dilemma. No single country wants to do it unilaterally because everyone else won’t. That generates a natural equilibrium around the current rate, and my personal feeling is that we’ll not see any emerging market allow their currency to appreciate sufficiently – or sufficiently rapidly – to make much difference. I’m sure they’ll all go up, because I’d also expect the US Fed to continue to try and prevent the private sector from having to deleverage by adopting a second round of QE. So although emerging market currencies will get stronger, they’ll only get stronger versus the dollar. I wouldn’t really see any significant emerging market currency appreciation against the euro, which is the easiest benchmark to distinguish between emerging market currency strength and dollar weakness.

In my opinion, if the European Union were to start aggressively pressuring China or emerging Asia in general, that would change the situation markedly. Firstly, it would change the balance of power. We might then get to a situation where we can have one side having a significantly greater claim on global GDP than the other. It would also go a long way to undermining the easy pushback that emerging markets have at the moment – that the problem is not with their currency policy, but with US monetary policy. The ECB hasn’t really adopted QE except on a minute scale.  And the European Union has a much greater claim to the moral high ground. But as of today, there’s no consensus within Europe behind criticising emerging economies’ mercantilist policies.

What would be the consequences of a disorderly unwinding of the currency mechanism on emerging Asia?


My belief as to the geopolitical situation means we’ll see very little currency appreciation. Which means practically two things will happen when the US Fed starts QE 2. The first is that within Asia, the most pressing risk is of restrictions in capital inflows. We’ve already begun to see that outside of India. India stands alone here, and their last policy shift was in fact designed to encourage capital inflows. The increase in FII limits in India clearly revealed that the concern is still about insufficient capital, rather than too much.

India is a current account deficit country, and any deficit country needs foreign capital inflows. Incidentally, if you were to allow the Indian rupee to float upwards, the balance of payments would balance. In a freely floating exchange rate, the current account deficit (in this case) and capital account surplus must sum to zero. The active intervention allows the overall balance of payments to remain in surplus. So you’re monetising a balance of payments surplus, and that’s ultimately perpetuating the money inflows to compensate for a financial system that is short balance-sheet, short deposits. I wouldn’t say that India’s ‘intervention’ is necessary evidence that it is resistant to capital flows. I think that the intervention process is the mechanism through which capital inflows are turned into domestic liquidity.

In Pacific Rim Asia, although we’ve started to see the first glimmer of capital controls, so far it’s been relatively benign: there have been restrictions on inflows into fixed-income markets, which are very shallow here and so easy to destabilise or there are restrictions on inflows into banking systems. That suggests that the resistance is not to money inflows per se, but to them becoming destabilising.

Asia in general is prone to property bubbles, because for cultural reasons it is historically seen as the preferred way of saving. And no one wants to have a property bubble so soon after the Americans have had theirs. A property bubble in Asia would be much less destabilising because there is much less domestic leverage. But if money inflows drove property prices for any length of time, you could see increased amounts of leverage.

I’d hope that the capital controls in Asia remain confined to areas that are seen as destabilising. So far we’ve not seen, either in Asia or Brazil, measures to limit flows into equity markets.

That’s the Asian side. On the US side, my feeling is that trade tensions will get worse, that’s really a combination of the East being perceived as not doing the right thing – and US domestic politics. At the moment, there is a mid term election effect. That will pass, but the economy is weak. Democratically elected politicians in weak economies often look for very short-term solutions, and blame someone else.

The most recent data shows China’s foreign exchange reserves are at $2.6 trillion. Are Chinese policymakers being tone-deaf to the political rhetoric in the US?

In a sense, they’ve responded: the rate of appreciation of the yuan has ticked up, but this has been during a weak dollar period. If we look at yuan-euro, it’s a very unimpressive chart. My personal feeling is that we’re being naïve. These are national policymakers that have to set policy according to their own countries’ requirements first.

But when your actions in the short term compound the pushback you get in the longer term, are you serving your country’s requirements in the best way?

I think China has hit the point where its ability to exist as a manufacturing exporter is going to be limited by international political situations. If it were a small country, no one would be paying it any attention because China’s development model is entirely usual for an emerging market.  The difference is that China is an economy of such monumental scale that we’re starting to hit the limits of the rest of the world’s desire to absorb the surplus production that is implied by that growth model. We’ve seen it before – in Japan and earlier in the US.

What we’re seeing in Sino-US trade tensions is an extreme version of something that’s been rumbling away for some time. China has been rubbing against the maximum size that its manufacturing can grow without annoying developed markets.

If China were to continue its manufacturing-centric, export-centric growth model, it has to find new markets rapidly. It’s trying to grow its domestic market through its own peculiar policy of an administered appreciation rather than through currency movement. But it’s also going to start targeting emerging markets as customers for its products. India is clearly the gorilla in the corner because of its scale, but we’re starting to see this in China’s trade relations with Africa.

How badly will China be affected in the short term in the event of a disorderly unwinding of the currency arrangements?

In terms of measured export numbers, it’s hard to find many tariff wars that have a measurable impact. If you’re forecasting China, you should have materially slower export growth in your numbers. I personally have a forecast of 8% export growth next year, compared with 30% growth this year. Most of that is a negative global forecast. So it’s adding to problems that the state of the world economy imply anyway. But in practical terms, the aggregate macroeconomic impact of the sort of the trade tensions I’d expect on export numbers is likely to be relatively small.

What it does though is to raise sovereign risk because the future is uncertain. Individual stocks or products it can be potentially extremely destabilising. Certainly if we’re looking at a global environment where the US is weak next year and Europe is also weak, adding to that increasing trade friction are very clearly growth negative. And that’s not only for the producers since you’re effectively imposing a terms-of-trade loss on your domestic consumers.

But if the currency realignment actually happens, the negative growth impact of this in the US will become more apparent, because that would start to shift the total import price of the US quite rapidly. At the moment, China is still a source of dis-inflation for the US. That might be upsetting (Federal Reserve chairman) Ben Bernanke who wants to get inflation expectations up, but from the perspective of weak wage-growth consumers, the supply of low-cost products is necessary.

Will QE 2 work? And what are the risks of the Fed favouring some kind of price level targeting, in the hope of driving inflation expectations higher?

You have to assume, first, that QE 2 will be large-scale. Ultimately the great danger is it succeeds in generating price inflation, and that proves very difficult to control: that’s the long-term economic cost. Inflation targeting for a central bank is anathema. Even in Japan, they’ve been quite careful about that.

The current state of the US economy is deflationary: households are de-gearing, wage growth is minimal, and there’s a likelihood that jobs will on balance be being lost in the private sector rather than just the government sector. None of that would suggest that there’s a short-term inflation expectation in the US. So what do you do? You generate a long-term inflation expectation that’s sufficiently big that over the lifetime of the loan, prices are expected to rise a significant amount, and bingo, you’ve got yourself your negative real interest rate that supposedly restarts spending. If you can’t change the near-term future, you’ve got to change the distant future. So inflation targeting would really have teeth if the Fed were to come out and say, ‘we will keep monetary policy easy until inflation is, say, 1% for a protracted period of time’.

But what you’re basically saying is that you will not adjust to inflation as and when it occurs. It’s anathema to how a central bank is run. If it’s successful, ultimately it’s a very dangerous policy because it is destroying accumulated wealth from anyone that is invested in fixed instruments.

But practically speaking, if you’re in too much debt, there aren’t that many things you can do with it. You can repay it – which is growth negative; or you can transfer it by hook or by crook by various subterfuge means on to some other sector. In this case you’d be transferring it – via inflation and via ultra low interest rates – to savers that have large weights of fixed income in their portfolios. That would effectively be an inter-generational transfer, from near-retirees to younger households that have large amounts of property debt. Whether or not that’s justified is a moot point, but that’s basically what you’re doing.

You have one other option: you allow the loans to become delinquent, which means the cost, rather than being socialised and transferred to a large group, is transferred to a small group: in this case, banks’ equity holders.

I said ‘by subterfuge’, because in the US, there’s a cunning plan in practice, which is that we have a hidden resource transfer. You have banks having delinquencies rise so you have a specific transfer to the capital bases of the banking system, but their overall profitability has been extraordinarily inflated by the ultra low interest rate environment, so you have a sneaky cross-subsidy to borrowers from fixed-income savers. But ultimately, whichever way you do it, someone has to pay: the debt cannot vanish into thin air. And if it does, an asset has simultaneously vanished. So, it’s a zero sum game.

What are the odds that things could go horribly wrong?

It depends on what you mean by ‘go wrong’. The obvious pressing point is that QE 1 didn’t work – in the sense that it didn’t generate an absolute positive result; it might well have stopped something worse from happening. The Japanese experience of QE or zero interest rate policy didn’t seem to work either.

The real problem that we have is that we’re fighting extremely inelastic real economies. The elasticity of real economic activity to changes in asset prices is extremely low. We are close to a Keynesian liquidity trap. And that means you have to do more and more extreme things: the adjustment in asset prices has to become more and more extreme in order to have a small economic result. My growth forecast for the US next year is just below 1.5 per cent; that marks me out as a bear, but we’ve started to see some quite chunky downgrades to people’s expectations of US GDP growth. I’ve got QE assumed in my forecast, and I’d bet money that they too have QE assumed in theirs. So, we’re all assuming that the short-run impact of this in generating a positive outcome is actually pretty minimal.

Is QE 2 therefore a case of throwing good money after bad?


Ultimately, history will look unkindly on policies that try and prevent economies from adjusting. It smears out the ultimate adjustment process, and probably involves a greater amount of pain. It’s just that the ‘time-density’ of that pain is reduced. Markets should be allowed to clear. In a real-world environment, that is a completely amoral stance to take. We’d always have to cushion downside, but there’s a point at which you have to allow markets to clear.

I think that Europe has the right balance here. It’s recognised that it has to reduce its government liabilities. Its lack of discipline ahead of time was shameful, but at least there’s recognition now that the balance sheet imbalances have to correct. The US has gone a little bit extra to try to prevent the balance sheet adjustment from happening at all. And ultimately, even if it succeeds, even if inflate asset prices to the point at which the US private sector stops deleveraging, how will you allow asset prices to adjust back down to normal? How do you exit from that strategy? That’s the real difficulty at the moment.

At the start of this year, we were thinking about exit strategies, but now no one is thinking about them anymore.

Sounds like a maze you get trapped in..

It’s an addiction to low cost of capital. It’s a very dangerous situation: so much of the global economy is in danger of getting hooked on cheap credit; it’s no less hooked than it was before, and probably more hooked. There are relatively few central banks or policymakers that I’d say are acting prudently in the current situation.

Name three.


The only one that I can think of that actually scores on both fiscal and monetary is Australia. The eurozone and the ECB are pretty close to getting ticks on both fiscal and monetary policies. Britain gets one tick in the fiscal policy box, but the Bank of England has already been given the green light by the new Chancellor to restart QE.

You sound sanguine about the eurozone sorting out its problems, whereas in fact it’s only been postponed…

On a 10-year view, yes; but on a one-year view, it means the growth outlook is atrocious. You’re seeing economic events unfold of comparable magnitude to what happened from 1929 to 1939. That was a decade during which you saw periods of rapid growth. But the end solution to that economic imbalance was ultimately a political event. This time around, I don’t think the adjustment scale is any smaller. I don’t know what the end-point is, but current policies, which are basically pushing it forward into the future, are not the solution. You have to recognise that economies have to structurally change. Practically speaking, it goes back to your very first question: emerging markets should appreciate their currencies. But the exchange for that is that developed markets should force their economies to de-gear. You can’t have one without the other.


About Venky

Journalist, blogger, amused observer of worldly goings-on... More about me here.
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One Response to ‘US is close to a Keynesian liquidity trap’

  1. Pingback: Think Asia is out of the woods? Think again | It's only words…

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