Joachim Fels

One small footnote to the Brexit controversy: It has invigorated my interest in Lord Mervyn King’s concept of radical uncertainty.

As the former governor of the Bank of England laid out so eloquently at PIMCO’s investment forum in May and in his recent book The End of Alchemy, “radical uncertainty” refers to uncertainty so profound that it is impossible to describe the future in terms of a knowable and exhaustive range of outcomes to which we can attach probabilities. I find this concept particularly useful to describe the challenges we all face in a world of rising polarization, populism and politicization.

The King is dead, long live the King!

Lord King argues that radical uncertainty is pervasive and that the inability to conceive of what the future may hold means that the probabilistic models that economists, central banks and investors use for forecasting are doomed to fail. To quote from King’s book (p. 304):

“In a world of radical uncertainty there is no way of identifying the probabilities of future events and no set of equations that describes people’s attempt to cope with, rather than optimize against, that uncertainty. … In the latter world, the economic relationships between money, income, saving and interest rates are unpredictable, although they are the outcome of attempts by rational people to cope with an uncertain world.”

This is truly remarkable stuff from an ex-central banker who pioneered and perfected inflation targeting with its heavy reliance on economic models and forecasts, and who, in a former life, was (to quote from Paul Krugman’s recent review of King’s book) “a card-carrying mainstream economist.” Obviously, the 2008 financial crisis and the unusual New Normal macro environment ever since have made King reconsider and eventually break with the conventional approach and come up with a new one – a rare and laudable occurrence among economists and central bankers!

Re-enter the Knight

Of course, as King notes himself, the concept of radical uncertainty isn’t really new. Economists have usually referred to it as “Knightian uncertainty” ever since University of Chicago professor Frank H. Knight in his 1921 book Risk, Uncertainty and Profit distinguished between “risk,” which can be quantified by attaching probabilities based on experience and/or statistical analysis, and “uncertainty,” which is essentially unmeasurable and represents the unknowable unknowns.

However, even though the concept of Knightian uncertainty has been around in economic thinking and John Maynard Keynes also discussed it (without giving credit to Knight as far as I can tell) in Chapter 12 of his 1936 The General Theory of Employment, Interest and Money, it was largely forgotten or ignored by the following generations of economists, who became more interested in formalizing their discipline and building seemingly precise models of the economy based on the idea that we can attach probabilities to future events and outcomes based on observations from the past. And sadly, it took the global financial crisis of 2008 to lead Lord Mervyn King and others to rediscover the idea that many future events are simply impossible to conceive of today and to capture in economic models.

Stuff happens, and more often than you think

Of course, it is debatable whether one should go as far as King and declare radical uncertainty as so pervasive that all forecasting is futile. My hunch is that more often than not, and particularly over shorter time horizons, we can assume that we are in a period of overall stability, where insights into the way past events unfolded can assist in forecasting the future. However, we always have to be aware that the real world is far from stable or stationary and that, to quote King once more, “stuff happens” – think Lehman, Greece, Brexit and Trump, which can or will lead to regime shifts that render the old empirical relationships obsolete.
So what does the presence of radical uncertainty imply for analysts, central bankers and investors? Let me offer three thoughts:

Think the unthinkable, or at least try to

First, economic and market forecasts based on statistical/econometric models still make sense, but keep in mind that they always rest on the often-forgotten assumption of structural stability. Regime shifts and structural breaks (“stuff happens”) are more frequent than most people tend to believe. I’ve been doing applied economics for more than 30 years now and there have been more “structural breaks” than I have fingers on my two hands (yes, I’m a two-handed economist!). That’s why, in addition to working with models, it is important to think in terms of scenarios, engage in “what if” analysis and, importantly, force yourself to “think the unthinkable” – the trends or shocks that statistical analysis would tell you are highly unlikely because there is no precedent.

Forget forward guidance

Second, if the future is radically uncertain, then the modern central bank practice of giving markets forward guidance may be, well, misguided. Yes, central bankers always emphasize that guiding doesn’t mean promising and that, e.g., the Federal Reserve’s dot plot of an appropriate policy rate path is no more than a conditional forecast. Yet, if these forecasts turn out to be wrong most of the time because “stuff happens,” what is the value of making them in the first place?

Perhaps, it would be better to acknowledge the existence of radical uncertainty and stop making policy forecasts that will inevitably be proved wrong most of the time. So far, the Fed has only made a small step in this direction by calling itself “data dependent.” Yet, by publishing forecasts for economic variables and its own interest rate path, it still creates the illusion that the future is highly predictable. As I see it, true data and regime dependence is not compatible with explicit forward guidance. And, as an aside, doing away with the dot plot and the guessing about how it will evolve and who is who in the dot plot would free up many analysts’ time to think more about the unthinkable.

Populism promotes even more radical uncertainty

Third, radical uncertainty may be even more acute today than it has been over the past several decades because we seem to be entering an era where politics again dominates economics in shaping market outcomes. “Political economy” variables usually don’t enter economic forecasting models. Yet, as King rightly points out, it has often been big surprises on the political front that drive major developments in the world economy. They represent “not the random shocks of the forecasters’ models but the realization of radical uncertainty,” as King phrases it. Brexit, Trump and the rise of populism – what are the consequences, and what is next? We can all make educated guesses (see for example my take on how Brexit could lead to a stagflationary outcome). But only time will tell.

Insecure stability

Not so incidentally (as King spoke at our Secular Forum in which we looked out three to five years), the concept of radical uncertainty also played into our forum conclusions, where we characterized the longer-term global outlook as “Stable But Not Secure.” Yes, the global economy and financial markets appear relatively stable, and that stability may well last a while longer, perhaps even beyond our cyclical (six to 12 month) horizon. However, a deceptive, treacherous stability it is, as risks are lurking and building in the background – ever more elevated asset prices relative to historical norms, mounting private and public debt, diminishing returns to monetary policy and the rise of populism. And these are just those risks we are able to identify. All of this, and the uncomfortable but uncanny presence of radical uncertainty, leads to a very simple conclusion for investors: Let capital preservation be thy King!

By Joachim Fels

The post King, Keynes and Knight: Insights into an uncertain economy appeared first on AdviserVoice.

Joachim Fels

• The global savings glut is likely to grow in the coming years because of negative “time preference” in the advanced economies and macro adjustment in the emerging economies.
• In more affluent societies where life expectancy keeps rising, many people choose to be “patient,” saving money for retirement and the high costs of medical and other care.
• Slower growth (China) or even recessions (Russia, Brazil) in emerging economies and depreciating currencies contribute to larger current account surpluses.

Mr. Market, that manic depressive partner of all investors, yielded to despair last month – so much for a quiet August! Since my colleagues and I regularly provide topical, high-frequency commentary on market, economic and policy events on the PIMCO Blog, I’ll refrain from piling on in this monthly missive and, instead, continue to focus on the framework and the big picture. In fact, your reactions to last month’s Macro Perspectives, which described my “Three Gluts” framework, suggest that the thesis (first formulated by Ben Bernanke a decade ago) that a secular global savings glut is largely responsible for low long-term interest rates remains controversial and may require further elaboration.

To recap, the term “savings glut” is short code for a situation in which the world’s desired saving exceeds desired investment. This depresses the natural real rate of interest, which is the mechanism that brings savers’ and investors’ diverging desires into equilibrium. While there is a host of potential reasons for the ex-ante excess supply of saving over investment, here is my top-five list again:

1. History (the long shadow of the financial crisis)
2. Demography (we live longer but don’t necessarily work longer)
3. Inequality (the rich save more than the poor)
4. Technology (capital becomes cheaper and less of it is needed)
5. Necessity (emerging market (EM) economies have to tighten the belt as capital pours back into developed markets)

Quantifying the impact of the global savings glut

Several of you have asked whether it is possible to quantify the impact of these and other potential factors. The unfortunate truth is that it is virtually impossible to quantify the drivers of the global real long-term equilibrium interest rate or even come up with approximate estimates. An important reason is that the equilibrium, or natural, real interest rate cannot be observed directly. The same holds for desired, ex-ante saving and investment, which, according to our thesis, show an excess of saving over investment (S>I). All we can observe in the data are actual, ex-post saving and investment, which, according to simple accounting principles, must be equal (S=I), unless we discover that capital flows to and from Mars.

Despite these almost insurmountable difficulties, two researchers from the Bank of England have recently made an interesting attempt to identify which secular factors have contributed how much to the approximately 450-basis-point (bp) decline in the global real long-term interest rate since the 1980s (see the two-part post by Lukasz Rachel and Thomas Smith on the Bank Underground blog). I’ll leave it to you to check out the methodology and details and will focus here on the main results: In a nutshell, the study finds that secular trends in desired saving and desired investment can account for 300 bps, or two-thirds, of the decline in real long-term interest rates over the past three decades. Another 100 bps are attributed to slower expected trend growth, and only the remaining 50 bps remain unexplained.

To add some more detail, the study suggests that of the 300-bp contribution of the global savings glut to lower real rates, a bit more than half (160 bps) is due to higher desired saving:demography accounts for 90 bps, inequality for 45 bps and EM current account surpluses for 25 bps. A little less than half (140 bps) is due to a decline in investment demand, with a lower relative price for capital goods contributing 50 bps, lower public investment contributing 20 bps, and a wider spread between the risk-free rate and the rate of return on capital contributing 70 bps. As the authors note, these estimates are highly uncertain. Yet they manage to explain the bulk of the decline in real long-term interest rates using evidence independent of the decline itself. And, taken at face value, the results support the thesis that a global savings glut has been the dominating factor behind the decline in the real equilibrium long-term interest rate.

Why the savings glut is more likely to swell than ebb

Looking ahead, my hypothesis is that the global savings glut is more likely to increase than decrease in the coming years. This is chiefly for two reasons: negative “time preference” in theadvanced economies, and macro adjustment in the emerging economies.

First, the demographics in the advanced economies are likely to remain a driver of higher desired saving for some time as people will want to build wealth to prepare for a longer prospective retirement period. We all hope and (at least on average) can expect to live longer, yet the increase in the average retirement age is not keeping pace with the rise in life expectancy. There is even the intriguing possibility that, for many people in affluent societies, the rate of time preference has become negative. In plain English, we may value future consumption during our retirement higher than today’s consumption.

To many economists, the notion of negative time preference sounds like heresy. In fact, it has been one of the subjects of a heated email debate on the causes of ultra-low interest rates that has been raging for some time between more than 100 (mostly academic) German economists, in which I have occasionally participated on my weekends. The debate was initiated by the MIT-trained German economist Carl Christian von Weizsäcker, who proposed the idea of a negative equilibrium rate of interest long before Larry Summers popularized it with his “secular stagnation” thesis. Most economists resist the notion of negative time preference because, ever since 19th century Austrian economists (like Eugen Böhm von Bawerk and Carl Menger) and early 20th century American economists (like Irving Fisher) thought and wrote about the subject, the standard assumption has been that people are impatient and thus prefer today’s consumption over tomorrow’s consumption. In other words, they display positive time preference. In the neoclassical Austrian capital theory, this is one of the justifications for why interest rates must be positive – people demand compensation (interest) for deferring part of their current consumption into the future through saving.

It is easy to see why time preference should be positive in relatively poor societies where many people don’t earn much more than their subsistence level and where life expectancy is relatively low – pretty much the 19th century world of the Austrian economists who came up with this notion. In that world, people can in fact be expected to be “impatient” and to value today much more than tomorrow. However, in our affluent societies where life expectancy keeps rising, many people seem to be very “patient” and prefer to save for all the nice things they plan to do once retired (think long cruises) – and also for the potentially very high costs of medical and other care in the last years of their lives. One intriguing consequence of negative time preference is that it provides a theoretical explanation for negative interest rates. If time preference was the only factor influencing interest rates (which of course it is not), negative interest rates would, in fact, be natural!

The second reason the global savings glut is more likely to swell than ebb lies in emerging markets. Recall that when Ben Bernanke first presented his savings glut thesis 10 years ago, he put major emphasis on the impact of high and rising current account surpluses of emerging economies like China and the related capital exports from these economies. More recently, he put more emphasis on the high euro-area current account surplus, particularly in Germany (see his April 1 blog post). Also, the former Fed chair concluded that with China transitioning to domestic-demand-led growth and the euro area recovering from its slump – with domestic demand and, thus, import growth picking up – the global savings glut may ebb over time.

However, given the ever-more-apparent plight of many large emerging economies over the past several months, EM countries are more likely to become larger contributors to the global savings glut in the foreseeable future. One reason is that slower growth (China) or even recessions (Russia, Brazil) depress import growth and thus contribute to larger current account surpluses. Another is that capital flight from many of these countries, including China, is on the rise. While it is true that official reserve acquisition by China has gone negative recently as the yuan is no longer undervalued, this official contribution to the savings glut is likely to be replaced by private capital outflows from China. An important factor behind these capital outflows is likely to be the deteriorating demographics due to China’s past one-child policy, which is likely to lead to a structurally high savings rate. With domestic investment in China bound to decelerate over time, China will continue to be a large net exporter of capital. Moreover, virtually the entire emerging market complex has seen significant currency depreciation this year, and China has recently embarked on this route, too. This will improve EM cost competitiveness against the advanced economies and should lead to larger current account surpluses or smaller current account deficits in EM over time.

All this means the global savings glut is here to stay and, if anything, is likely to increase further in the foreseeable future. While cyclical forces – propelled by the other two global gluts, the oil glut and the money glut – may well push interest rates higher from their currently depressed levels, the savings glut is likely to limit the extent to which rates can rise. But this is unlikely to come as a surprise to you – after all, PIMCO has long condensed this view into the New Neutral concept. And regarding near-term forces, as usual, we will discuss and update our views at our Cyclical Forum this month. Stay tuned!

By Joachim Fels, PIMCO

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Joachim Fels

In last week’s “Macro Matters,” I argued that China’s currency regime change is bad news for the global economy and risk assets unless it will be accompanied by further domestic monetary easing and reforms in China and unless central banks elsewhere smell the coffee and ease policy further or postpone tightening.

My point was that in the absence of such actions, which could result in a win-win for the global economy and risk assets, China’s currency move would likely be seen as beggar-thy-neighbor policy and thus azero-sum game for the global economy.

Alas, with China’s central bank (the PBOC) refraining from easing policy last week, and with other major central bankers on vacation, investors decided to endorse an even more negative interpretation: not win-win, nor even zero-sum, but rather negative-sum as both Chinese and global risk assets sold off in tandem.
In times of volatility, I am reminded of how famous investor Benjamin Graham described “Mr. Market” as a manic depressive who fluctuates between euphoria and despair. As I see it, there are five reasons why Mr. Market should remain calm.

1. Everyone and their dog has known for some time that most emerging market (EM) economies are in the midst of a very bumpy, long transition to new growth models. The mood on EM among investors has been bearish for a long time, and rightly so. How much worse can it really get after last week?

2. As regards negative spillovers from emerging to developed economies, yes, they exist, but initial economic and financial conditions in the latter are the strongest they’ve been in many years. Domestic demand in the U.S. and U.K. looks solid, and even the euro area is enjoying a slow but broad-based economic recovery.

3. True, plummeting commodity prices put commodity-producing economies and sectors under pressure and increase vulnerabilities and default risks. However, the world as a whole, and consumers and businesses that use rather than produce commodities in particular, are still better off as we have to pay less for the useful things we drill and dig out of the ground and employ as an important production factor.

4. Given Mr. Market’s precarious condition, central banks stand by to offer some medication. China already eased banks’ reserve requirements and cut interest rates today. Mario Draghi may use the 3 September press conference to emphasize that the European Central Bank stands ready to do more if needed. And in Japan, the chances of an extension and/or top-up of the current monetary easing program as early as October have increased with the contraction of GDP in Q2 and inflation hovering way below target.

5. Finally, as regards the Federal Reserve, FOMC participants may be asking themselves whether they can remain “reasonably confident” that inflation will return to the 2% objective over time given the drop in market-based inflation expectations, the strength of the U.S. dollar and the chaos in risk assets. Prudent timing of the first rate hike will be crucial to calm markets.

In short, provided central banks act appropriately, Mr. Market may well recover soon.

By Joachim Fels, PIMCO

The post Macro Matters: Five reasons the market oversold appeared first on AdviserVoice.