September 14, 2016; Carmen Reinhart: Financial Repression Requires a Captive Audience

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Sometimes, if you find a more opaque way of picking somebody’s pocket, you may get away with it for a while. I’ve had a very tough time with a lot of people convincing them that negative real rates are a tax, which to me seems something pretty straightforward. But because it is opaque, because it is not affected through the usual channels in which you’re taxed, there is quite a bit of scope for pick-pocketing.”

– Carmen Reinhart

Kevin: Our guest today, Carmen Reinhart. David, I have to cheat a little bit and let you know that I did listen to your interview ahead of time. There is just so much that we can tap into. Carmen is a regular attendee of the very elite Jackson Hole conference that occurs in August, which just occurred a couple of weeks ago. She is also the co-author with Ken Rogoff of a book that is a favorite of yours and mine, This Time It’s Different.

David: Published back in 2009. That’s right. I’ve benefitted from a number of the papers that she has written through the years, along with the books that she has published. One of the things that I like about Carmen is that she is at the intersection of politics and economics. She is at the Kennedy school there at Harvard, but has an emphasis on economics. Again, what I like about that is that it is a blending of topics of interest, of concerns, of public policy outcomes and it means that her perspective is not purely economics, is not purely Poly-Sci, if you will, but a healthy blending of the two, which I think is always a good idea.

Kevin: You know, Dave, a lot of times we’ll get calls or letters from listeners who listen to a guest of ours and they’ll say, “These guys are in the central banking camp,” or “they’re on this side or that.” What I’ve found is, Barry Eichengreen, John Taylor, Otmar Issing, Carmen Reinhart in this case, a lot of times, since these people are the policy-makers, these are the people influencing exactly what is happening, whether you agree or not with the big picture, you’d better listen to what they have to say.

David: It’s very important to understand the context that we’re in as investors, as individuals, and by the way, each of these people are individuals, too, making personal choices in the context that they may even be setting, but they have to make their own choices in terms of how to invest, how to save for the future.

Kevin: They share the same concerns with their own portfolios.

David: Even if they may be part and parcel to creating a context where those concerns get played out.

Kevin: Right. Listening to the interview, one of the most fascinating areas was to see the picture that she painted on how financial repression is carried out.

David: That’s right. Actually, toward the end of the conversation she is talking about creating captive audiences and how incentives are used, not her language, mine here, but the equivalent of carrots and sticks to drive what is now called macro prudential policies, driving audiences in one direction or the other, using interest rates, using incentives, changing the structure and allowing people to choose, but limiting what makes sense in light of the variables put in play.

Kevin: Just to bring perspective to this, Carmen Reinhart was the co-author of This Time It’s Different with Ken Rogoff back in 2009. Ken Rogoff has later gone on to write a book, just recently, it came out a couple of weeks ago, called The Curse of Cash. So this issue about financial repression or captive audiences is on the table right now. There are those who would say that we need to remove the cash option. Again, whether a person agrees with that or not, they’d better listen to the Commentary.

David: It was very fascinating, she was talking about the opaque ways in which you have to create a guise under which you can operate in the process of picking someone’s pocket so that they don’t know that their pockets are being picked (laughs), so whether that is capital controls, closing the exits, Ken’s version of limitations being put on currency or what have you, these are realities that are, more and more, the milieu in which we exist. How do we respond as individuals, as investors? If you don’t understand the context, all I can say is that you’re likely to be one of those unfortunate animals that is simply herded.

Kevin: I’ll just mention this as a longer commentary than what we normally produce. It is normally 35-40 minutes that we ask the listener to abide by, but in this case, every minute of this interview is worth listening to at least once, maybe twice.

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David: If the next few years are written up in hindsight as a major episode of defaults, what will the journalists and the financial market historians say about the derivatives market and the double-exposure, if you will, not only debts, but also the long shadow that the derivatives market casts into the financial space?

Carmen: The derivatives markets comes under what are often referred to as hidden debt. These are things that really encompass a lot of commitments that are off balance sheet, but that in the moment of crisis end up being transferred to the balance sheet. And so, the debts are hidden before the crisis but become manifest during and after the crisis. And I think that in the emerging world, it’s less of an issue, speaking in generalities.

In the advanced economies, we, indeed, already got a very good flavor of, in 2008-2009, how unaware we were of how large some of the balance sheets had become. So in that regard, derivatives played the same role as other types of hidden debt had played in the past, and other types of hidden debts are contingent liabilities of any sort. Often corporate debts or private debts end up being resolved by the public sector.

David: As you say, these are hidden debts. They are off balance sheet until the moment of crisis when they can be transferred on balance sheet. It brings up this critical issue of how you define a default. When you’re looking at massive amounts of debt, considering the possibility of restructuring that debt, the implications of that, and of course, derivatives have been used as a way of off-loading some slice of risk from one party to another, and yet it all hinges on, “Are we in a default?” If we’re not in a default, these nuances of default, restructuring, renegotiation – some of the language allows for a latitude that, quite frankly, I’m not sure we know, today, who holds what risk. Could you help us with that?

Carmen: Well, I wish I could do a better job, the issue being, if we knew what these debts were and who held them, they wouldn’t be hidden. An example, where a lot of these hidden debts, derivatives, in this case, banks were the main agents, goes back to, among the more recent crises, the 1994 Mexican crisis. If you look at 1994 Mexico, it did not look like there was that much public debt. It did not look even like there was a substantive amount of bank debt, except for the derivatives, and that brings me into the issue of how do you define a default?

So, true to form, when the peso was devalued, it became apparent that the banks had these derivatives contracts that they could not meet. So, in that particular case, and I’m using it as an illustration of how this works more generally, the derivatives were off balance sheet, the bank balance sheet turned out to be a lot more exposed to currency risk than anyone knew beforehand. And at the time of the crisis, those contracts looked like the banks were not in a position to honor them, which would mean some large-scale defaults on the part of banks.

Default is really defined as any credit event in which the original contract is not honored, or cannot be honored. That means, if you miss the payment, that gets classified as a default. If it comes to saying, well, I can make payment if we go, instead, from three months maturity we make it six years, or ten years, lengthening of maturity. That is a recontracting. That is also considered a default. If the interest rate on the debt is trimmed. In other words, anything that changes the original contract to terms that are less favorable to the creditor is a credit event. Of course, there are haircuts. So they borrow one dollar, but will only repay 80 cents, of course, that’s a partial default.

But there are defaults, and there are defaults, meaning, in terms of orders of magnitude. I’m taking this time to clarify the concept of default because very often it is thought of as just a general suspension of payments, very dramatic, á la Argentina in 2001, for example. But the concept of default is much more general than that. I want to circle back at some point to who holds derivatives, where might the next shoe drop, or where the surprise is.

But before that I want to clarify that very often what the rating agencies are only preoccupied with are defaults on private creditors, not official creditors. So, last summer Greek defaulted on the IMF, albeit, it was a brief one. And then, there was more bailout money and they repaid the IMF. But typically, defaults on official institutions do not carry the same weight, or sometimes are not even recorded by the rating agency. That’s by way of clarification of what is considered a default and on whom is the debtor defaulting, whether it is the private sector or the official sector.

Now, who holds derivatives and a lot of hidden debt? The concern has been, and the Bank of International Settlements has written a lot on this, that we do have another layer of the shadow banks, the shadow banking sector, that we potentially have a lot of risk, both in the forms of maturity mismatches and currency mismatches. And of course, this is a huge blanket statement and varies enormously across countries, but a lot of the risks with hidden debt are very much associated with shadow banking, which is far less regulated, if it’s regulated at all, in so many countries.

David: The paper that you wrote June of 2015, “Sovereign Debt Relief and Its Aftermath,” highlights the instances of default and debt relief in the 1930s, and then fast forwards to a more current period, the 1978 to 2010 period. And interestingly a lot of those defaults related to what we might consider emerging markets and developing markets. Similar issues, in terms of maturity or currency mismatches or an exaggeration of pressure for those countries once there was the external debts harder to pay because of depreciation in the currency.

And then, just by way of comparison, your April 2012 paper for the National Bureau of Economic Research, “Debt Overhangs Past and Present,” I think it’s interesting to look and say: Today, most of your debt overhangs, most of your vulnerability, if you will, if we define debt overhang as a vulnerability, is actually in the developed world economies, not in the emerging markets.

So, to borrow from your 2009 work, It’s Different This Time, is this one of the defining factors for what we have on the horizon? The pressures ahead in the financial system may not be Mexico, Asia, if we go back to the bond defaults that we saw in Russia in the 1990s, but instead, we’re talking about the equivalent of the G7. The largest economies in the world, that’s where the pressure is.

Carmen: Let me point out, though, that it is different from the debt crisis of the 1980s and 1990s in that the debt crisis of the 1980s and 1990s was almost exclusively confined to emerging markets and developing countries, but it is not unlike the debt crises of the interwar period between World War I and World War II. Between World War I and World War II, the advanced economies were center stage of the debt overhang. If you look at that period you had in the so-called Roaring ’20s, a lot of private sector debt accumulation in the U.S. and in other countries, but the U.S. in particular because the U.S. was the leader of the Roaring ’20s.

Then you also had, in Europe, a very different phenomenon. While in the 1920s the U.S. was accumulating private debt, in Europe, it was mired with the residual public debt that had been built up during World War I. You may ask, why am I bringing this up? I’m bringing this up because it was, as it is today, a synchronous advanced economy debt overhang. You could not single out that it was just the U.K., or that it was just France or Italy. In varying degrees, the wartime experience had left these countries highly indebted, and to jump ahead to how were those debts dealt with, it was ultimate default. And it goes back to some of the earlier remarks that I had made that the memory of defaults is not even, meaning when Germany, in 1932, defaulted on its private creditors and its official creditors, everybody remember that. But importantly, it is remembered most because it defaulted also on the private sector.

But in June of 1934 the U.K. defaulted, France defaulted, Italy defaulted, Belgium defaulted. There were something like 15 countries that defaulted on their obligations to the U.S. government. In other words, the World War I debts, and they’re called World War I debts as sort of a misnomer, really, because a lot of the borrowing was done after the war to rebuild. In June of 1934 – I have a wonderful series of New York Times articles describing the collective default on those debts. I think that episode, which really was not an emerging market wave of defaults, but an advanced economy wave of defaults, is largely forgotten, and I think it has a lot of resonance for today.

What do I mean? Am I saying that the advanced economies are going to go that route on a grand scale? I don’t think it will be a repeat example, but I think there will be a lot of elements that will be similar. Let’s start with the most extreme case, Greece. The Greek debt crisis gets going in 2010 and the initial defaults, the initial credit event, involved private creditors, but the debt then shifted, and Greek debt is now largely in official hands – the EU government, the EU, European Central Bank, the ECB, and the IMF. So Greece is highly indebted, but it’s highly indebted right now to official creditors, not unlike the 1920s. Ireland and Portugal, a lot of their debts are held also by official creditors. That is not true of Italy or Spain or other of the crises countries where the lion’s share of their debt is still in private hands.

Am I suggesting that we’re going to have this across-the-board replay of what happened in the summer of 1934? No, I don’t think that. I think it will be a lot more nuanced, but I do think that we will see a lot of restructuring beginning with debt that is in official hands. And let’s face it, the amount of debt in official hands is increasing as we speak because the part of the policy response of the ECB has been to buy more aggressively, both public and private debt, so the amount of debt in official hands, including the ECB, is rising as we speak. And let me just add to that remark that I talk to a lot of people who are not aware that, actually, both Portugal and Ireland had a restructuring of its official debt in 2013, where maturities were lengthened and interest rates were trimmed, because official credit events are a lot quieter than when they involve the private sector.

David: So in this chapter of sovereign defaults, let’s say the United States, much of our debt is privately held. It’s domestic in nature and not external debt, suggesting that the approach to default is a little bit different. With external debt you see those classic haircuts, restructurings, extension of maturities, reduction of interest rates, etc. But with domestic debt you have inflation, which has been a classic measure of dealing with domestic debt.

In today’s creative monetary policy environment, we have, I don’t know if they are new forms of repression, but this may get to the point which you were talking about earlier, a more nuanced approach to default. It’s just a question in a default of who is the winner, who is the loser, and through repression, through zero or negative interest rates, you are choosing winners and losers as you reduce the burden of the debt in the system. So how do we look at our current pressures and translate financial repression as a part of the “solution” to domestic debt overhang?

Carmen: That’s a great question, and what you say is very complementary to the discussion that we had earlier. Earlier I had focused on explicit, or de jure, default, which really is anything that touches a contract, whether it is held by a government, or whether it is held by the private sector. But there are quieter forms of debt reduction, more opaque, that take place not by changing those contracts, explicitly, but by changing the de facto rates of return on debt.

Let me define financial repression up front so that we can talk more about that. Financial repression, first of all, is not a term that I coined. This is a term that has been around for decades, going back to the work of Ron McKinnon, who passed away some years ago. Financial repression often has two pillars. One is consistent, or sustained, negative real returns on savings. Of course, that includes negative returns on holding government debt.

And the other component of financial repression is much more heavy-handed financial regulation, to get institutions and individuals to hold more debt. The first element, which is sustained negative returns, is basically a tax. It’s a tax on the bond-holder. If you exposed that you have a negative 2% or 3% return on a bond, you’re paying to hold that bond. You’re being taxed. So financial pressure is nothing other than an opaque tax. I say opaque because it’s not legislated. Most taxes that we pay in the U.S. and elsewhere go through a legislative process. This is a tax that is largely the outcome of having yearly monetary policy being responsible for delivering negative returns as opposed to real returns.

And the other part is the regulatory part. So you get institutions to hold more government debt. That has happened not just in the U.S., but it has been fairly widespread across the advanced economy since the financial crisis. And often the umbrella is what we now call macro-prudential regulation in which it is felt that institutions should hold more liquid assets. You have liquidity ratios that require banks to hold liquids assets and the most liquid assets are government paper. And it also now extends to the latest round of regulation that comes into effect in October to mutual funds, in which the change in regulation has also already [unclear] them to hold more government debt.

Financial repression is not new. At the end of World War II this time, we have now moved from the explicit defaults of the aftermath of World War I to the more subtle forms of debt reduction, the financial repressions act at the end of World War II. When I say at the end of World War II, I really mean decades after World War II also, we, meaning the United States and most of the advanced economies, had highly regulated financial markets and interest rates were low. They were not consistently negative in the way that we are seeing in Japan and in Europe, but they were consistently low, close to zero the way we have seen here in the U.S.

But inflation, which was not the 1970s galloping inflation, but nonetheless, there was a steady dose of inflation, averaging around 4% or so. But that combination of very low nominal interest rates and a steady dose of positive inflation meant that real returns were negative about half of the time. And that helped reduce, or liquidate, government debt. That was a factor. And I think that factor is not hypothetical. This is what we’ve been living through a good part of the last eight years, that there has been debt reduction that is lower than it otherwise would have been because real interest rates in the U.S. and elsewhere have been negative much of that time.

Now, with regard to the U.S., in terms of domestic versus foreign, as you correctly noted, all U.S. debt is issued under domestic law, all of U.S. debt is issued in dollars, but the new feature, the different feature for the U.S. is that a rising share of U.S. government debt is held abroad by non-residents. And there, the haircut, if you will, is also effected if they have negative returns. It’s not done de jure through the explicit debt restructuring process, it’s done via negative rates of return.

David: So that de facto change is the way that we skirt the issue of defining a default and triggering something potentially catastrophic in the derivatives market where counter-party exposures all of a sudden are laid bare, and it seems that’s the way forward in terms of monetary policy, keeping rates at a low level. Quite frankly, it doesn’t seem altogether reasonable to raise rates. We’re talking about debt sustainability, in essence. Interest rate normalization can’t occur in this environment, given the interest and principle burden, but we’ve removed that burden through zero or negative rates.

So when you hear the discussion at Jackson Hole, or listen to some of the various regional Fed presidents talking about now it’s time to start raising rates, is it realistic to do so? We have such a massive amount of debt that still needs to be addressed. The de facto approach, running a low negative rate environment, it seems like that is a course that we have to be on for maybe five years, ten years, or longer, in order to reduce the pressure of debt. And raising rates does nothing but exaggerate the pressure of debt and actually fight what may be necessary for economic recovery. What are your thoughts?

Carmen: Well, the Fed, in their stated policy objectives, of course, don’t explicitly have a policy objective that involves debt reduction. That is something out of their mandate. However, financial stability is certainly not out of their mandate. This is very much, I think, at the forefront of policy makers’ concerns, that perhaps during the 1990s and the 2000s before the global financial crisis, central banks had shifted to just the narrower goals of price stability and full employment, and kind of forgot that we could not take for granted financial stability. I think central banks are much more cognizant about the financial stability mandate.

To deal with what you’re asking, I would say that one has to remember that the Fed does not have a mandate to help reduce public or private debt for that matter, but in effect, financial stability leans in that direction. So that is, I think, an important reason why I am inclined to believe that the tapering exercise is going to be gentle compared to any past normalization that the Fed undertook in, how shall I say, more normal times. I do think that it’s going to be a much more gradualist approach.

Now, before I elaborate on that further, let me also say that if you look at other Fed roles, the case for raising rate can hardly be made on the fact that we’ve conquered public and private debt overhang entirely, or even partially. The greatest case for Fed tightening usually cites the fact that, look, the labor market has come a long way already in the eight years since the financial crisis, employment looks like we’re at, or very close to, full employment. If you also look at the estimates that the Fed, the IMF, and other substantive official institutions have put out, the estimate is that potential output in the U.S. has been drifting lower. So that, in effect, it’s not like we have a big output gap to justify continued easing.

So the argument for allowing rates to rise, generally, and from the view that the economy in its new incarnation, which is with a lower level of potential output growth, is pretty close to full capacity. And there are some signs out there that inflation and wages are drifting slightly higher, closer to the 2% range. Depending on what price index you’re looking at, we’re either slightly below, at, or slightly above, but drifting in the direction of the stated inflation objectives. So, on the basis of inflation and output gaps and employment, there isn’t a lot to go on to say that rates needs to stay really low indefinitely. And hence the discussion of policy driving rates higher resurfaces in that context.

I would say that there are two things that I would like to highlight, why I think the increase in interest rates is likely to be of a more gradualist nature. One is what you’ve already mentioned which is, certainly, there is a lot of fragility associated with balance sheets, and some of it we may not even be fully aware of. The second reason is that, even if the Fed does behave by allowing rates to drift higher at a very modest pace relative to what other major central banks are doing, that’s tightening, because it’s one thing to raise rates gradually as the rest of the advanced economies stay put or raise rates themselves, it’s another thing to raise rates, even gradually, while other advanced economies are aggressively lowering rates.

In the recent Project Syndicate, the piece I wrote just before going to Jackson Hole, I did make that point, that we have had a string of moves by major central banks in other advanced economies lowering rates further or doing more QE or a combination of the two things – Japan, the U.K., Australia, New Zealand, of course the ECB has had a negative rate policy for some time – so even modest increases in U.S. rates, if others are lowering their rates or stepping up QE, or a combination of these, really puts pressure on the dollar to strengthen.

And a very strong dollar has adverse impacts on U.S. manufacturing and U.S. competitiveness. A strong dollar has been a drag on growth in the recent period, and I think when you have an economy that is not growing particularly rapidly, as the U.S. is, with fairly modest growth, and you shave three quarters of 1% because of a strong dollar, then you’re really running close to the ground. So I think the fact that other advanced economy central banks are in a very open-ended easing mode, many of them, will also be a factor that will weigh in on the speed and magnitude at which the Fed moves this interest rate.

David: In that article you talk about devaluation and that, in a world where we have entirely fiat currencies, where the value of one floats against the value of the other, there is no plumb line like we might have had under the goal standard, that it may not be appropriate to talk about devaluation, yet it is the desire of the central banks to maintain a low level. So how should we understand what in a prior period we might have called a competitive currency devaluation, where everyone is wanting a slight trade advantage by having a lower-valued currency so that they can promote economic activity domestically?

Carmen: In the old days when you had pegged exchange rates, whether it was pegged to gold, or pegged to the dollar, the notorious, or nefarious, periods of competitive devaluations was if your domestic economy is depressed you would devalue your currency in order to export more and import less. Obviously, if everybody is doing the same thing it becomes self-defeating, and this is what, in 1944, Ragnar Nurkse and a League of Nations study – this is a much-cited, classic work – that highlighted, to make a long story short, that during the height of the depression, competitive devaluations made things worse, on the whole. And you are absolutely right to point out that we don’t live in that world. Exchange rates are floating.

But the concept that you want a cheaper currency and more competitive currency so that you can export more and import less, is alive and well. I alluded to the numerous easings that we saw earlier this year, and you can certainly talk about the Bank of Japan’s historic quantitative easing and asset purchases and negative rates and all of that in the context of a very domestically depressed economy and deflationary concerns. And to varying degrees, you can make some of those arguments for Europe, as well. It’s hard to make those arguments for either Australia or New Zealand. Australia and New Zealand are both countries that did not have a financial crisis in 2008-2009. Australia and New Zealand at present have had to deal with concerns about a real estate market that’s really hot and booming, especially New Zealand. You cannot really say that group performance is nothing other than satisfactory.

So why ease? Why lower rates? Well, the motivation for lowering interest rates was because they were concerned about a sustained appreciation of their currency. And in the end, whether we see a devaluation in the old-fashioned sense that you have a pegged exchange rate and you devaluate, you make it cheaper in one shot, or whether you try to get a more depreciated currency in a floating rate environment by lowering interest rates, it’s more about how it’s done than what is done. So we are definitely in a situation in which central banks are very concerned about having an overly strong currency.

I mentioned Australia and New Zealand, but those are not the only examples. You can look also at Sweden, for example. Sweden is also in the spot in which it has followed the interest rate policies of the ECB, not so much because Sweden has particular concerns about debt overhang, or their exceptionally depressed economy, Sweden also does have a booming real estate market. It has followed the rate policies of the ECB because if not, you would have a substantive and sustained appreciation of the currency versus the euro, which is not seen as desirable.

David: Let’s stay on that theme of how versus what, because it seems like we could be in an environment that sees, for instance, the Fed begin to raise rates, and yet, on the other hand, use their balance sheet aggressively to manage prices and rates in the open market by asset purchase programs. They currently have a balance sheet north of 4-4.5 trillion. It has been suggested that they could even double that under appropriate circumstances, but could you see a world in which, again, it’s the “how you get it done.” On the one hand you’re raising rates 25 basis points at a time consistent with your mandates of price stability and full employment, and you already have the moves in the labor markets. I’d say they’re probably a little bit blinded by Phillips curve analysis on that, but that’s just a personal opinion.

On the other hand, you have this opportunity to expand the balance sheet considerably (laughs). What are the limits of central bank balance sheet leverage, and is that where we see the next move in terms of rate repression, à la the Swedes? Even your colleague, Ken Rogoff, has suggested, “No, this is something we need to get used to. Negative rates for a long period of time, this needs to be in our stable.” How you get there may not be the official policy rate. It may, in fact, be central bank balance sheet. What are your thoughts?

Carmen: I started talking about a long era of negative real interest rates back in late 2010, early 2011. My first paper on financial repression was in early 2011, in which I said, given the debt overhang that is a collective problem in the advanced economies I think negative real rates are going to be with us for a while, because every time that we have seen high levels of debt, especially when it’s a collective problem across countries, not just an individual problem for one country, I think that negative real rates are going to be with us for a while. I don’t have any basis to change that view at this stage. In terms of balance sheets and how it’s done, I think there are a lot of other ways that central banks are not just hypothetical, this is real-time experience that are doing that the Fed is not engaged in. For example, the latest BOJ announcement, part of that package involved doubling the size of its equity purchase from three to six, roughly a doubling of their equity purchases.

Now, I’m not going to derail this conversation, but I want to get in one historic example that I think is relevant to how much we’ve changed thinking about central bank policy post-crisis. In 1998, Joseph Yam, then the head of the Hong Kong Monetary Authority, during the Asian crisis Hong Kong was getting hit on both sides by speculative attacks on the currency in which they had to raise rates and investors were engaged in a double play in which they would short the equity market, because the high rates would hurt the equity market. And what was considered terribly, terribly controversial, the Hong Kong Monetary Authority bought into the equity market to provide support to the equity market in Hong Kong in 1998. They were viewed as pariahs at the time by the central bank community. This was peanuts relative to what we are seeing done today. But this gets to your issue of, where are the central bank balance sheets going, both in terms of size and composition? Well, we’ve come, as I said, an enormous way, in terms of adapting to what looks like a much bigger central bank balance sheet indefinitely, and one that is involved in not just buying the classic government securities, but buying a lot of other assets.

At the current moment, I don’t see a compelling reason, or I don’t discern Chairman Yellen and other members of the Fed inclined to go the route of further balance sheet expansion. I don’t see that at the current conjuncture. I think a lot of the debate in Jackson Hole was really about: Is part of normalization shrinking the balance sheet or not? My own sense is that those balance sheets are not going to shrink any time in the foreseeable future. I think that, for a variety of reasons, the Fed will keep a very large balance sheet. However, that is a different statement than saying, despite what may be a 25 basis point increase in rates, they are going to be doing other things to expand the balance sheet at this stage. At this stage.

I don’t rule out that if for any reason, this is not my baseline, and if for any reason the U.S. would look really shaky in terms of showing signs of weakness, and having negative surprises on consumer spending or investment, or whatever the trigger factor may be, that negative surprises on that score, that then the process of quantitative easing could be restarted, but at this stage, that’s not my baseline.

My baseline is the Fed will keep a large balance sheet and will allow rates to rise, but again, to reiterate, my expectation has been that they will go gradual. I think there is a lot of “innovative” policy tools that are being discussed. I’m not just talking about negative rates, but I’m talking about branching out into purchases of equity and branching out into other asset types. But all those possibilities are, I would say, to echo Chairman Yellen’s words, things that I think the Fed will be studying, but I don’t think they will necessarily be embracing it if the economy remains pretty much on track.

David: It’s very interesting, looking back to 1998, Joseph Yam and the Hong Kong Monetary Authority, because that was an exception to the rule. Looking across the pond to Europe, it’s becoming more the rule. And, of course, if you go to Japan, as you mentioned, the idea of buying corporate equities, corporate bonds, not just sovereign paper, is becoming again an accepted policy.

Coming back to one of my earlier questions dealing with the nuance of language and how we define things, we understand one of the Fed’s mandates to be price stability. How have we lost track of price stability in terms of goods and services, and those prices as it reflects inflation, deflation, and finding the perfect market balance there, and instead, a focus to price stability in terms of asset prices, where just as Joseph Yam stepped in to create calm in the marketplace, that activity of creating price stability can very easily slip into price controls? And that seems to be what we have in the interest rate structure in Europe where essentially you have the central banks involved in a price control mechanism. That leads me to the question (laughs). I’ll speed up here. What do we have in terms of a historical precedent for the success of price controls?

Carmen: Let me say that, again, there are price controls, and price controls. In the old days, really, price controls were just that – ceilings. It’s much more nuanced. It sort of parallels, to some degree, the discussion we had about devaluation versus depreciation. Look, I’m not convinced that stability of goods and prices has been forgotten in all of it. I’m not. If you look, the deflationary forces in Europe and Japan have been enormous. Enormous. In goods and prices. And that, of course, is something that central banks really, really have to fight, especially in a highly leveraged world. If you go back to the writings of Irving Fisher, writing in the 1920s and 1930s, the debt deflation problem is a very serious one for financial stability.

If you have a consumer price index falling, you have deflation, then the real burden of debt is rising, for both public and private sectors, and I think battling deflation is still very much a goal. It’s been a goal in the U.S., but we haven’t had the deflationary forces to the same degree that Japan and Europe have been experiencing, and are still battling. So, I’m not as convinced as many are that these policies of quantitative easing and all these exceptional policies have been terribly successful. I’m not convinced of that because if you look at the last historic episode where advanced economies faced a deep financial crisis, synchronously, as they did in 2008-2009, that was the 1930s, and in the 1930s deflation of 6%, 8%, even 10% in some years, was the outcome.

So I think the objective of avoiding those extreme deflation episodes has been very much part and parcel of the headwinds that central banks have been fighting. I think what we forget is that counterfactual to what we’ve observed, what we observe is largely seen as disappointing, right? Japan, even after doing all kinds of, for lack of a better term, exotic policies, certainly by pre-crisis standards, still has trouble maintaining a consistent positive inflation rate and driving inflationary expectations higher. Some of those same challenges also are particularly present in Europe.

But I think one has to remember that if one looks at an era in which central banks were faced with very acute financial crises, as they have been in 2008-2009, and did not react as aggressively as they have now, the outcome was very, very deep deflations. Deflation of 1% is very different from a deflation of 10%, especially in terms of what it can mean for bankruptcies. Again, deflation really can increase debt burdens very dramatically.

David: On the one hand, it increases the debt burden in an acute fashion in a short period of time, and you’re right to say the counterfactual may have been far worse, it seems, perhaps, we’ve just exchanged the acute pain of one or two years, or however many, of deflation and deleveraging, with debt overhang and a reduction in economic growth for a long period of time. Your paper on debt overhang suggests that when you get to a certain critical threshold you may, essentially, be bearing that burden of debt and it may cost you economic growth for up to 23 years. That’s reminiscent of what we see in Japan, but it’s almost as if we need to get used to that concept moving forward for the developed world, subpar growth for a long period of time.

Carmen: That’s right. But the point to be made in that regard, it is less about central bank policy and more about the refusal to restructure debt, because debt restructuring, per se, is out of the jurisdiction of a central bank, and we, collectively, whether it is Japan, Europe, the U.S., the U.S. being the more laissez faire in that regard, and I’m talking about whether it is public debt or private debt. In the U.S. we go back to the crisis years, and we had the foreclosure waves which were ugly, were messy, were certainly painful, but they were swift, meaning that households did significantly reduce their debt overhang and many of the financial institutions also. And what are foreclosures? They are defaults. Europe and Japan, as painful and disruptive as such things are, over the very near term never had the same market, if you will, approach. So as a consequence, there is a lot of evergreening of debt. And evergreening of debt is an extended pretend strategy.

David: That’s right. And it seems to me that the acute deleveraging deflation which might take you to those negative 1%, negative 10%, in terms of deflation, we saw a version of that in a small space within the real estate market in the United States. It was swift, and it was done. Is there some argument that, perhaps, what we’re doing here in central bank monetary policy is, we’re so afraid of the unknown that we just can’t go there, and are willing to take on one to two decades of subpar growth, rather than see a brief, short, painful liquidation and restart. Because to me, it suggests that if we can’t accept the swift restructuring, it’s either because we’re afraid of the boogeyman, and it may be more than a boogeyman, it may be an actual monster. It’s either that, or we’re protecting vested interests within the financial system.

Carmen: I do think there is this great fear. I’m not saying it’s a combination of both. I think where I depart from what you’re saying is that it’s all in the central banks. This is not just the central banks, this is very much a fiscal policy issue, and also, it comes down to actual law on dealing with Chapter 11 and the like, which very much disfavor and penalize default and restructuring in Japan and in Europe. So what I’m saying is, and this is often voiced, I think, in some of the frustrations you hear also Draghi voice, central banks have been buying time for other solutions to materialize. It’s just that those other solutions have not materialized, and the process gets drawn out, year in, year out.

One of the things that in my work with Christoph Trebesch we highlight on debt restructuring, is that two of the global episodes we look at, one in the emerging markets in the 1980s and 1990s, and the other one in the advanced economies in the 1920s and 1930s, to get to the point we’re saying, “Okay, we’ve tried all these other things and they haven’t worked, we have to bite the bullet and do write-offs,” that it’s taken a very long time to get to that stage. Let me put that more concretely. Not that many years ago, at the end of World War II, countries like the U.K., France, Belgium, Italy, all knew they had a serious debt overhang, and proposals for restructuring in terms of extend and pretend, lowering interest rates, extending maturity, those proposals started in 1922.

And it’s interesting, I actually have some of the proposals they made, and some of the debts that they were extending would have matured in the early 1980s. And that was 1922, and the final resolution came 12 years later. In the emerging market case, the debt crisis of the 1980s, the Brady plan, which followed the Baker plan, which was not sufficient to end the debt overhang and to cope with the debt overhang, the Brady plan was completed in the early 1990s and as late as 1994 for a number of countries, and the debt crisis had gotten underway. Really, by 1981 they were in trouble and by mid 1982 Mexico was in default.

So again, it seems that policy makers just hope that something miraculous will happen and they get bailed out, and they don’t really have to bite the bullet, but the tendency to delay is not entirely new. Although I think, in terms of dealing with private debt, at least, it’s gotten worse. If you look at the resolution of the banking crisis in Scandinavia, the banking crisis in Norway in 1987 and in Finland and Sweden in 1991, those resolutions were a lot swifter – the write-offs, the cleanup of the balance sheets. They were painful crises, they were systemic crises, but still, the resolutions were much faster than what we’ve seen in Japan, and in Europe, and to some degree also in the U.S.

David: I agree with you, there is a fiscal policy element, there is a Wall Street lobby element. There are a number of things that are extending this beyond an ideal timeframe. It seems like the use of special purpose vehicles where lots of debt, whether it is private or public sector, if it came under pressure, you just sweep this all into a special purpose vehicle, not unlike what we had with Maiden Lane, back in the context of the crisis, and then you can either write it down once you have your arms around it, and it’s not held by bond funds and hedge funds and you’re not negotiating with private parties, it is a single institution (laughs) that gets to say – 20%.

It seems like that is the next major step, which takes me back to that idea of maybe we’re not quite done with the expansion of central bank balance sheets. We don’t have the events that are going to promote that, or give license for it, but if we have market-driven events that open it up, that’s the easiest solution if you want to deal with, ultimately, relieving the pressure of debt, not just through repression, but through an actual haircut of sorts.

Carmen: Right. And the distinction I was making is that I completely share your view that balance sheet expansion is definitely far from over in Japan and Europe. At this stage, again, barring negative surprises on the U.S. front, I think the U.S. is not quite in that same boat. But certainly, balance sheet expansion is alive and well and continuing in both Europe and Japan because this is part of what I was alluding to earlier, that debts are being shifted, to some degree, from private hands to official.

David: Let me end with a political hot potato, because we’ve already said that fiscal policy needs to play a role, moving forward. Do you see any difference, one way or the other, between a Republican outcome in the election, a Democratic outcome in the election? It seems like that has to be done, it doesn’t matter who is elected. There might be a differentiation between what kinds of projects get funded or what kinds of tax strategies are employed, who pays what to whom, but isn’t it inevitable, at this point, that either a Republican or a Democrat taking the White House in the next four years, fiscal policy has to be front and center?

Carmen: Yet I doubt it will be, to tell you the truth. I think the next move on fiscal policy – it depends on what kind of fiscal policy you’re talking about. Momentum is building to increase public infrastructure investment. I think that is the next wave, if you will. But some of the issues that we’ve been talking about also, that ultimately reach out to dealing with the sustainability of pensions and the like, I’m not sure that will be at the forefront of the agenda. And I think momentum is building in Europe, an effort to stimulate growth via increased public infrastructure projects. It just feels like that is the next wave. Whether we have anything larger than that, I just don’t see it on the horizon.

David: Carmen, you’ve got this great historical context going back well into the 1800s, 19^th century, and it puts a lot of the current policy choices in a really healthy perspective. As maybe we see the introduction of new policies, what are the implications, what does this imply?

Carmen: I think right now there really is just a wave, a view that we really need to be much more aggressive. Private investment is not anywhere we would like it to be, let’s do public investment. But beyond that, I don’t really get a sense of strategy. Do you?

David: No, I don’t. I don’t see it. You have Richard Koo’s arguments that, really, businesses and consumers have what they need and are not real interested in a massive increase in leverage to their balance sheets. Corporations have, to some degree, done that, but capital spending is still weak. They have, unfortunately, used a lot of their borrowings for share buy-backs and things like that, and really not buying new stuff and driving economic growth. So yes, government has to step in. Yes, to prop up aggregate demand it’s to be necessary to spend. The question is, I think the only strategy difference is whether or not it is going to be deficit spending, or we see the open door for an increase in taxation to make sure we don’t slip further into debt.

Carmen: That’s absolutely right, but you look at what either Clinton or Trump are saying, and that’s just the next wave. I just came back from Brussels, the Bruegel annual meetings. You know, big forum. Did a presentation on doing debt. And my sense is that Europeans have begun to talk more, or acknowledge the possibility of restructurings are not limited to Greece, but not much more than that, and the one idea that seems to have made headway there is very much like what we’re hearing here, that it’s time to try stimulus via public investment. I’m skeptical. I’m really skeptical, to tell you the truth.

David: Let’s say they do come out with, here in the United States, a couple of trillion dollars’ worth of spending initiatives, infrastructure rebuild, and what not. Are we in a position, having defended against deflation for so long, to actually have the needle go the other direction and go from low RPMs on the inflation scale to high RPMs on the inflation scale, because our bias has been so, fight deflation, fight deflation, fight deflation. No you take a trillion, two trillion, in fiscal spending, public investment.

Carmen: I think part of the mentality that we’re seeing transition in central banking, the enamorment with 2% inflation, just sort of grew somewhere organically. But I think what we’re seeing is the beginnings of broader acceptance that maybe higher is better.

David: Is that because they would like to keep the same policies in place longer? Why move off of that 2% target?

Carmen: John Williams is one of them. But why 4% rather than 2%, say? Let me give you different views out there, then I’ll circle back to some of the things that we’ve talked about, that I’ve written about. Let’s say that real rates, some idealistic studies say, are at 1%. If real rates are 1% and inflation is 4%, interest rates at 5%, rather than if inflation is 2% you have interest rates at 3%, not 5%. And 5% gives you more room to maneuver up and down if there are shocks to the economy. A slightly higher inflation rate, somewhat higher inflation rate, allows central banks, keeps them further away from the zero bound and gives them more room to react to [unclear] shocks.

David: Do foreign creditors not protest on that? If you said, “Now we’re running a 4% rate of inflation,” with more and more of our debt being held by individuals overseas, I know that it doesn’t matter how you pick my pocket, I’m never going to be happy with it.

Carmen: Oh, but look! That’s the marvel of a lot of these things in which sometimes if you find a more opaque way of picking somebody’s pocket, you may get away with it for a while. I’ve had a very tough time with a lot of people convincing them that negative real rates are a tax, which to me seems something pretty straightforward, but because it is opaque, because it is not effected through the usual channels in which you’re taxed, there is quite a bit of scope for pick-pocketing. In the 1970s there was all this literature and money illusion that wage gains that in effect would be eroded by inflation were initially seen as real wage gains.

The point I’m making is that I think the central bank community, at this stage, is getting ready for a revisit of the 2%, and would be quite happy, if not outright ecstatic, especially in the case of Japan, with something higher. And one rationale, which is the one that I described, is, well look at the central banks, you’re further from the zero bound, and you have more room to maneuver. From the work that I’ve done, I’ve been saying over the last six to seven years, the effective in terms of debt reduction period of financial repression involved a combination of keeping the nominal rate close to zero, never really negative, but close to zero. But a steady dose of inflation. Inflation, you know, some years was 3%, some years was 5%. But it was definitely, on the whole, somewhat higher than what we’ve had since the crisis.

Now, the real trick is, of course, how successful are central banks in making sure that it doesn’t go from 4% to 6% or higher? But I think that is my sense where things are moving because a 4% inflation does erode debt twice as fast as 2%. In addition, as I said, I do think that it can be useful in providing a bigger scope for countercyclical policy for the central banks.

David: Do you remember the Summers-Barsky thesis? Larry Summers? This goes back to the 1980s, and he did a study and basically looked at negative real rates of return being an environment where investors tend to opt for assets like gold. And it’s basically just opting out. If a market return is not positive and yet you’re still taking market risk, then you just sit out for a while. So gold tends to do well under those environments of negative real rates of return. That is, in a nutshell, the Summers-Barsky thesis.

I’m curious, because cash is as much of an opt-out as gold would be, if you’ve ever had interaction with Ken Rogoff on this point, because his suggestion, you know he just published a new book this month, The Curse of Cash. It’s an elaborate argument for why we need less of it, and maybe from a social cultural standpoint we would all be better without it, but the real heart of the message is, we can’t effectuate a negative rate environment if people have an opt-out (laughs). And he cites his disagreement with Otmar Issing on that, where Issing says, “Look, you can’t take away coined liberty from people, nor should you,” which is what Issing thinks currency is – coined liberty. Where are we going where, whether it is running inflation at 4% or at 2%, and we’re dealing with negative real rates, or if we’re actually in a negative nominal environment, the only way of making that happen is, basically, closing the exits for everyone?

Carmen: Well, look, never underestimate the capacity of governments to do that. You mentioned sitting it out on gold. That was not a possibility until the 1970s in the United States.

David: That’s right.

Carmen: When during the Depression the abrogation of the gold clause came in with all kinds of controls and prohibitions of, and transactions on, gold. And so, closing exit doors, which is what capital controls and limitations on currency, and part of financial repression, a big part, is you create captive audiences. And part of how you create captive audiences, some it can be via “incentives,” i.e., macropru says, well, for banks, you’re better off having these higher liquidity ratios. It keeps you healthier. But some of the measures of that era involved closing other options, because if not the quest for yield, or your own preferences, in the case of cash, if you have no yield on less liquid assets, why hold them, when your option is cash? Or if you have options, or less liquid assets that bear a high return, why hold the lower return ones, if you can?

I think right now, the limitations have been also coming in simply from the availability of other alternatives, right? I think many institutions would love to hold more high-yield paper if they could. But who offers high-yield paper? The emerging market. Well, that is not that readily available. And also regulations limit how far you can take that. So you hold cash. The general point that I’m making is, one can never underestimate how restrictions on alternatives help shape those captive audiences.

David: Do you think that has an echo of Keynes, going back to destruction of the rentier class, where it’s just, “We need to get the money in the system. By any means, get the money in the system. Don’t let it sit there passively, collecting a magic 5%, or collecting anything. We need the money in the system.” Does it have a ring of that to it?

Carmen: Well, look, debt overhangs need a transfer from the creditors to the debtors. Whether they get that transfer right away, cleanly, with a capital levy, i.e., a default, a haircut, it is a capital levy. Or whether it is done more gradually through negative returns and restrictions on what kind of portfolio you can hold. But one way or another, creditors, obviously, do not want to make that transfer. So it is teeth pulling. This era that we talked about, the inter-war years, there is actually a wonderful book edited by the late Rudi Dornbusch and Mario Draghi. It’s a book on debt. And there is a very nice paper by Barry Eichengreen that reviews the discussion, the popular press and the discussion of wealth tax that was so prevalent in the inter-war years.

Let’s not forget that, one way or another, the rentiers, the British upper classes, got hit with a whole slew of new taxes at the end of World War I – inheritance taxes, property taxes, all kinds of new taxes. So it’s part and parcel of the debt overhang resolution. I think one of the things enormously slowing Europe down is that the creditors and debtors are in the same bag, and the creditors, of course, are the big foot on the EU decisions. So you seldom vote against yourself. But it’s hard to imagine that, sooner or later, these debt overhangs will not be resolved with a transfer of one form or another.

David: Carmen, when you look and say, “Okay, well, this book that I wrote – decent royalty income from that, and a post at Harvard, a decent income, and I live beneath my means, so here’s some savings,” you may not be the British aristocracy, that rentier, who is moving toward sitting in the crosshairs with new taxes and fiscal solutions, including squeezing those who have anything, or something, in order to settle accounts and create greater equality, as happened post World War I. But how does Carmen look at that? Do you say, “Well, I’m going to keep a diversified portfolio and hope for the best?” Or do you say, “Gosh, this is tricky. Maybe I do want some cash. Maybe I do want something as low profile as gold.” Or do you just say, “No, look, I don’t care. I have problems to solve, and we need to create the best possible solutions for the general public, and I’m not really worried about that. I have my daily bread and that’s enough.”

Carmen: Well, my view, first of all, is – and I’m not making light of this – the potato chip theory, which is, you go to a supermarket, and you see a bag of potato chips that is roughly the same size as what was there before, and roughly the same price as what was there before. It just happens to have much fewer potato chips inside, which is, you got a haircut. That’s how I think of pensions, first of all. So I save commensurate to thinking that pensions are at risk.

That’s why I said there are many ways of fooling people, and the strategy adopted by marketers in which the size of the bag doesn’t change that much, and the price doesn’t change that much, but when you get right down to it, the content did, you’re getting fewer goods and services in the future for your savings, fewer goods and services for your pension. And therefore, part of it is planning accordingly, being risk averse and trying to internalize that. And beyond that, I’m really looking at a lifestyle of provision of goods and services and having adequate savings to meet that, means diversify, but with the full expectation that taxes come in many ways, and some of them are quite disguised so the idea that in the future the inflation tax may rise, I think, while realistic, has not been bad for that.

I think, longer term, cycles come and go, I still think emerging markets, as a class, have promise. This is someone who has written a lot about defaults, and so on, right? And this is not just a cyclic search for yield, but you do look at a core group of countries where we have seen convergence start to happen. Advanced economies have demographics going against them, even if emerging markets remain emerging markets, and volatile and everything, I think long-term real rates of return will warrant a presence there. So these are small things that, on the diversification, just being prepared for – when I say lower transfers it’s the same thing as saying higher taxes, really.

David: Listen, thank you so much for the generosity of your time, and sharing your mind with us, not only in today’s Commentary, but in the research that you’ve been doing, and the research that you’re still doing. I thank God for academics, because you shrink the world, and copious, copious amounts of study and research, into more digestible quantities. I’m still fascinated by bibliographies and sample from them routinely, but I also recognize that there is about 100 times the work that goes into that distillation process, so I’m grateful.

Carmen: Thank you, it’s really been a pleasure to talk to you.