In the event of another recession, who is going to re-liquify the world when the central banks need bailing out, asks economist James Rickards.
Rickards a best-selling author, economist and investment advisor told Kathryn Ryan, the US Federal reserve is running out of bullets.
Rickards latest book Aftermath, completes a quartet of titles - which included Currency Wars, The Death of Money and The Road to Ruin.
The Federal Reserve is doing the opposite of what it would like to be doing, he says. They would like to raise interest rates and improve their balance sheet so they are ready for the next recession.
“History and economic analysis show that when the US economy goes into recession, you have to cut rates by about 4 percent to get it out of the recession.
"So how do you cut rates 4 percent when you're only at two and a quarter? The answer is you can't, you can cut to zero, but then you're out of bullets so to speak.”
The problem in America is the Federal Reserve never “normalised” after the GFC in 2008, he says.
“So this is an epic failure by the Fed, the seeds of it were sown in 2009, after the immediate aftermath of the crisis, under Ben Bernanke the Fed could have raised rates a little bit, not a lot, just a little, just when the economy was in the early stages of its recovery, just to get back to normal, but they never did.
"There were six years - 2008 to 2014 – when zero rates never normalised, and now they're not ready for the next recession.”
The world is currently in disinflation he says, and on the precipice of deflation, which he says is the central banker’s “worst nightmare,” because so many economies re-loaded up with debt post-GFC.
“If you cross that boundary and go into deflation, the real value of debt goes up … if we have deflation, the value of hundred dollars goes up. You know, it's the opposite of inflation. With inflation your money's worth less, with deflation your money is worth more.”
He is also unconvinced cutting interest rates to below zero will achieve anything.
“The academic theory is if rates are negative, I'm actually taking money out of your account, you put $100,000 in your account and come back a year later, and there's only $99,000 because there's a negative 1 percent interest rate.
“So the theory is well if I'm taking money out of your account, that's going to be an inducement to go spend and borrow and invest because you'd rather do anything other than watch your money disappear. “
In real life we don’t behave as academic theory would like to believe, he says.
“People have what they call lifetime goals. You're saving for your retirement, your healthcare, your parents' healthcare, your children's education, whatever it may be.
“If banks are taking money out of your account, far from spending more, you're actually going to save more, you have to save more to make up for the negative rates, because you still have your lifetime goals.”
Therefore rather than being stimulatory, the opposite is true, he says.
“People save more and spend less, what does that do to the economy? It slows the economy and more causes more deflation. So negative rates have the opposite effect of what economists and central bankers believe.”
The other re-inflationary weapon, borrowing to spend and stimulate the economy is effective, but recent research shows certain conditions are necessary for it to work, he says.
“The conditions would be you're either in a recession, or just coming out of a recession, you don't have too much debt to begin with and you have excess capacity in the form of labour.
“If all those things are true, you can get some stimulus effect by borrowing, spending money and running a government deficit.”
This is classic Keynesian economics, he says, where a multiplier effect means a dollar spent in the economy generates more than a dollar of growth.
“Today none of those conditions are true. We're not in a recession, we're in the 11th year of an expansion. We don't have excess capacity in labour, we have the lowest unemployment in 50 years, we don't have a moderate debt to GDP ratio, we're at the highest debt to GDP ratio – 106 percent actually - since World War II,” Rickards says.
Research by Carmen Reinhart and Kenneth Rogoff indicates beyond 90 percent debt to GDP, borrowing to stimulate ceases to work, he says.
“Reinhart and Rogoff say 90 percent is the level at which your debt actually becomes a headwind to grow. If you borrow $1 and spend $1 not only do you not get a $1 of GDP, you only get 90 cents or 85 cents.
"In other words, you get less than a dollar’s worth of growth for the debt, the debt grows faster than the economy.”
A cluster of countries around the world have way higher debt to GDP than 90 percent, he says.
“Where's the United States? 106 percent. Where's Japan? 240 percent. Where's Italy? About 125 percent. Greece is 155 percent.
“So, a lot of countries, but most importantly, the United States because of its size, are way into that danger zone.”
If borrowing to spend and grow out of a recession isn’t an option, what’s then left?
Rickards says there are only two options: default on the debt, which he says currency issuing countries never have to do as they can print the money they owe, or let inflation reduce the value of the debt held.
“That's the American way, that's how we get out of it, we pay you back, but it's not worth very much. And so my expectations are we're going to have very high inflation, that will solve the debt problem, at least from the debtors' perspective, not such a good deal for the creditor.
“But here's the problem in 10 years, the Federal Reserve has been trying to get inflation and can't do it. So I like to say it's a sad day when the central bank wants inflation and can't get it - but that's exactly where we are.”
And there’s a reason for this, he says.
“They don't understand what causes inflation, it’s not money supply, it's psychology and right now people have a deflationary psychology.
“So it's going to take some doing to get that inflation, but that is the only solution.”
So if national central banks can’t re-liquify their economies in the event of a recession because they’ve run out of options, who can? The International Monetary Fund, says Rickards.
“There’s only one clean balance sheet left in the world, which is the International Monetary Fund. And they can print money; it's called the special drawing rights, a geeky name, but that's what they call it because they don't want anyone to understand what it is - I call it world money.
“They're not that leveraged so they could print 1 trillion or 2 trillion SDRs [Special Drawing Rights], that would be the equivalent of about $US3 trillion and just hand out to the members, the 188-member countries, and then they can trade it among themselves and swap or $4 or Euros or New Zealand dollars or whatever else they might need.”
That would involve a major transformation of the International Monetary System and would need an overarching convening power, he says.
“Why not have a convening power, get a group together, reform the International Monetary System before there's a panic. I don't think that's going to happen, I think that's what should happen."
It is better to do this before an international liquidity crisis hit, he says, but he is not optimistic.
“You could do it in calm times and reform the system going forward. But I don't expect that to happen, I expect it to happen in a panic.”
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