Nobel laureate Scholes: Global economy is in unchartered territory

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When governments intervene to try to temper the natural ups and downs of the economic cycle, the result can be a mess.

That’s the view of Nobel laureate Dr Myron Scholes, who said in an interview yesterday that calls for more intervention in the US, in the form of a third round of quantitative easing by the Federal Reserve Bank, were missing the important point.

“Every day, you read people saying the government’s got to do this, or do that, but why?” Dr Scholes told The Royal Gazette.

“The debate should be that we need volatility on the downside and the upside. If you try to smooth everything like the government’s been trying to do with stimulus every time something happens, then what happens if you’re wrong? Then everyone’s relying on you to do things, and it’s a much bigger mess.”

He added that the global economy was now in “unchartered territory”, with the combined balance sheet of the world’s eight largest central banks standing at about $16 trillion, about one third of the value of global stock markets.

Balances would have to be reduced over time, he said, but the unwinding process would have to be done very carefully and would inevitably lead to some “earthquakes” along the way.

Dr Scholes, who was awarded the Nobel Memorial Prize in Economic Sciences in 1997 for a method to determine the value of derivatives, was in Bermuda yesterday to speak at a business lunch put on by fixed-income specialist Cutwater Asset Management.

Among those attending were Premier Paula Cox, Bermuda Monetary Authority CEO Jeremy Cox and representatives of many re/insurance companies.

Cutwater has some $37 billion in assets under management and has clients on the Island. Cutwater’s CEO and chief investment officer Cliff Corso agreed with Dr Scholes and said further intervention by the Fed was unlikely to help much.

“I think that’s part of the reason we got into the mess — the great moderation of the last 30 or 40 years,” he said. “Every time there was a stumble, monetary and fiscal policy came in. It’s like too many penicillin shots.

“We’re at zero percent interest rates now. People are calling for Bernanke to come in with QE3, but we’re already at 1.5 percent [yield on a ten-year US Treasury]. How much firepower is that?”

Mr Corso said that with all the money pumped into the financial system, inflation was likely to emerge in time.

“There’s a huge amount of money supply growth, but there’s no velocity right now,” he said. “There’s been about a 350 percent growth in the money supply. How do you unwind that? The Fed is the biggest player in the bond market right now.”

The US government’s escalating debts meant that the Fed would find it difficult to raise interest rates in anticipation of inflation, as that would seriously increase the cost of servicing the public debt, Dr Scholes said.

“The Fed is supposed to be independent of government, but if they raise rates then government goes bankrupt,” he summarised bluntly.

The sovereign debt crisis in the European Union has overshadowed global markets in recent months. Fears over Spain were eased over the weekend when a $125 billion bailout for Spanish banks was agreed by EU finance ministers.

“They’re putting a firewall around Spain and the indication is that Greece is a lonely orphan out there right now,” Dr Scholes said. “Greece is going to have its election on June 17 and probably leave the euro some time this summer, while Europe puts a ring fence around Spain and maybe some of the other countries.

“What it means is that Germany is getting in deeper and deeper and Europe’s is going to be strangled for quite a while. It’s like trying to marry people together who really aren’t that marriable.”

Still of major concern is that Spanish bank customers may continue to move their deposits out of Spain. Dr Scholes said these deposits total about one trillion euros or roughly equal to Spain’s GDP. “They’ve given the banks 100 billion euros or so to help them deal with their troubles,” he said. “The question is now, will the people believe it, or will they move their money out anyway?”

Politicians in Europe had been slow to act on the crisis, Mr Corso said. But after Spain’s borrowing costs rose sharply, action was taken.

“Without market pressure, not much gets done,” Mr Corso said. “And the market’s losing patience here. We have the Greek election coming up on Sunday and it will be interesting to see how the market reacts to that.”

The euro was akin to a gold standard, Dr Scholes added, in that it limited adjustment mechanisms for individual member countries. In peripheral struggling countries, wages and real estate values needed to fall, and benefits had to be reduced commensurately in order for such countries to become more competitive — a painful process.

With the spring and summer slump in the US economy apparently happening for a third successive year, Mr Corso said he did not believe the US was in recession. The big concern for him was to do with policy and politicians.

“What we worry about most is the lack of certainty around tax policy, regulation and healthcare,” he said. “There are so many unknowns at this point.

“If I were sitting in a corporation and thinking about hiring 10,000 people, we wouldn’t know what it was going to cost us. So we’d probably decide to hire only half as many.”

So with a range of tax breaks and benefits set to expire by year end, was Mr Corso confident that members of the US Congress would be able to finally come to agreement?

“I would like to think they would,” he said. “And not to repeat the debt ceiling debacle when they took it right to the wire. The same dynamics are setting up again with the fiscal cliff we’re facing at the end of an election year. I don’t know how encouraged I am that they’re not going to take it to the wire again, because each party seems beholden to their extremes.”

Dr Scholes that the US government was still failing to deal with huge issues, while bickering over much smaller affairs.

“If you have a government that’s not going to deal with the fundamental issues, like the entitlement problem and the social security problem, and talk about small things at the margin, you increase uncertainty,” Dr Scholes said.

“Then people make shorter term investments, rather than investing for the future. Cash becomes your friend. The uncertainty being infused into the economy by the government and its policies are actually hurting growth.”

He said the main problems facing the world featured demographics, technology and scarcity, as well as the political interactions surrounding those three problems.

But perhaps the major challenge facing the global economy in the years ahead was automation, replacing workers with machines, Dr Scholes suggested.

“We’ve always had a theory that if you give a man a machine, the man is more productive,” he said. “Anyone who’s displaced from a job finds a new job. But we haven’t had a great new idea in a number of years that actually employs people.

“If you look at Wal-Mart, they employ 1.9 million people, but if you look at Google, a much more valuable company, they employ just 20,000. If we keep replacing men with machines than we get the idea that instead of being a complement to man, they are a substitute for man, then where are we going to employ the displaced people? That’s really the most important overhanging thing facing the US and probably the world right now.”

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