Carmen Reinhart spoke yesterday at Harvard (where she teaches) and one of my contacts summarized her comments:
· The debt overhang in Europe will act as a constraint on ECB policy and she expects no action by the ECB this year (although they will need to announce something about the current Asset Purchase Program which is set only through December).
· Target 2 (T2) balances, which represent claims on the financial systems within the EZ (banks in Greece lost deposits to banks in Germany, so the Central Banks must square up these flows) are an representation of FX rates within the EUR. In other words, if there were floating exchange rates within the EUR the large capital outflow from Greece, Spain and Italy, among others, would have forced devaluations of their currencies and the capital flight into Germany a revaluation of its (non-existent) currency. The large magnitude of these T2 balances represents the imbalances built up within the EZ, with no FX outlet.
· Given the lack of flexibility within the EZ, she expects there eventually will be more restructuring of debt, with Greece (shorter term) and Italy (longer term) the ones to watch.
· Regulatory policy implementation after the financial crisis was (partly) designed to encourage broader holding of government debt, a policy that helped finance the huge surge in fiscal deficits.
· Japan still is a very difficult fiscal situation as the (aging) voters will not vote to cut entitlements or raise taxes to fund them. As a result, she expects low/negative yields will persist for a long time as a way to “tax” savers through negative yields to help fund the debt and effectively reduce the debt burden, a theme that is key to her views across the developed world rate markets for many years to come.
· Growth is a very good way to deal with excessive debt, and she does expect some reduction of regulatory burdens as a way to increase potential/trend growth rates which are too low to finance debt loads. But that improvement, while welcome, is unlikely to be sufficient over the long term.
· At Jackson Hole last year BOJ Gov. Kuroda opined on why the world continues to gravitate to the JPY and JGBs in times of global stress given Japan’s massive debt burden and lack of inflation and nominal growth. To be sure, Kuroda was “talking his book” as he would prefer a weaker JPY, but there is a logic to Japan being one of the worst fundamentals situations in the G7.
· On the US, she fears the combination of stimulative FP and tighter MP would drive the USD higher…and the Trump Administration would be extremely displeased. Given that she views there is little appetite for a Plaza Accord type arrangement on FX rates, she expects the Fed to tread carefully in hiking rates – 3 hikes this year, at most, in her view.
· When asked about her views on next Fed Chair, she noted the lack of respect for academics in the current Administration (still no Chair of the Council of Economic Advisors). As a result, she expects a “business type” as next Fed Chair. Her original strong expectation was Kevin Warsh, but she worries he might be viewed as too academic, although he is not. Other names now include, in her view, Gary Cohn, Bill Dudley (known quantity and, after all, he WAS a GS guy) or Jamie Dimon. Economics PhDs need not apply, apparently.
· Finally, she does NOT believe the impact of the financial crisis is behind us (and the world). Smart regulatory reform and tax policy adjustments could increase potential/actual growth, but the debt overhang in the developed world will be an issue for years to come. There are ways to deal with debt overhangs, which include strong growth (unlikely, esp in EZ and Japan), spending cutbacks, esp on entitlements (good luck), higher inflation (trying, but no progress…so far) and continued financial repression (negative real interest rates), with the latter likely to be a persistent development, particularly in the EZ and Japan.