Mounting Tensions Between Central Banks and Politicians 

 

 

8/1/2013 

Neil Dwane, CIO Equity Europe, says game theory can explain how central banks and policy makers are facing off. The object of the game? Forcing the other party to make the difficult decisions. Find out the implications for investors in "safe" assets.

Summary

There is clear evidence today that central bankers globally have bought time for politicians to appreciate and comprehend the challenges facing their economies and yet politicians have done nothing of note, thereby forcing more and more interventions using monetary policy.
Game theory shows that the risks of assets thought to be safe are rising rapidly and that, if the 'taper' threat does not change the policy preferences of politicians, central bankers will have to prolong monetary policy risking high or hyper-inflation or raise interest rates and force a shock.
It is essential that investors understand the forces now driving the risk attached to different asset classes and control it accordingly; by doing so, investors should view the risk of their investments not primarily as a chance of loss but equally, as an opportunity to gain.

Whilst on holiday in Crete recently, noticing people engrossed in books like Dan Brown's Inferno, I caught up on some much needed and relaxing reading. In particular I'd recommend:

Red Capitalism1, as a refresher on how important and central to Chinese economic policy the big banks are and why, therefore, the recent interventions into the shadow banking activities are, indeed, part of a plan from Beijing to rein in and refocus these activities usefully back into the Chinese economy.
I also enjoyed Against the Gods2 (recommended by my colleague Jim Dilworth) which tells the story of risk through time, explaining improvements in mathematics and game theory, that "to earn a return you need to take risk" and also importantly that you can look at the risk of your investments not as a chance of loss but as an opportunity to gain.

Mounting tensions between central bankers and politicians

Blinder's payoff matrix
'Against the Gods' contains a matrix by Alan Blinder, a former US Federal Reserve Vice-Chairman, reproduced below, which outlines the economic policy tensions between central bankers and politicians from a 1982 perspective.

The matrix shows the policy preferences, from 1 (the favourite choice) through to 9 (the least-favoured choice) for central bankers and politicians respectively. The preferences of the central bankers are above the diagonal in each payoff matrix square; those of the politicians are below the diagonal in each square. The matrix illustrates that monetary policy is normally expected to be tight when fiscal policy is loose and vice versa.


(Adapted from Alan S. Blinder, 1982, "Issues in the Coordination of Monetary and Fiscal Policies," in Monetary Policy Issues in the 1980s, Kansas City, Missouri: Federal Reserve Bank of Kansas City, pp. 3-34.)

The object of the game: forcing the other side to take the difficult decisions
The central bank preferences in the early 1980s are in the top left corner, where they leave the prospects of the real economy to politicians and try to steer a steady course. The politicians' preferences are in the bottom right corner, where monetary policy promotes and stimulates growth and thereby popularity; these, of course, are the least favoured choices for the central bankers.

Were one to assume that central bankers were independent, then rationally one would be positioned in the bottom left corner, where politicians favour fiscal policies in order to drive their own popularity, as they have for the last 30 years, and central banks rein in any inflationary excesses thereby caused.

These preferences have become more complex since the early 1980s because the politicians at the time, Reagan et al, unleashed the banking industry with deregulation and mega-consolidation, culminating in the end of the Glass-Steagall policy in the late 1990s. This resulted in an explosion of debt and leverage in most developed economies. Consequently, central bankers have then been forced to include banks and their behaviour into central bank monetary policy decisions, as we saw in the Savings and Loans crisis of the early 1990s and QE1, used to save the banking industry in 2008/2009, as well as economic events like the Year 2000 threat.

The Nash equilibrium
The challenge of the top right payoff in the matrix above are central to the Nash equilibrium which won the scholar, John Nash, a Nobel Prize in 1994, where these outcomes are stable but sub-optimal and yet can only be improved upon if the politicians and central bankers work together and realign or readjust their positions. Today, we see clear evidence globally that the central bankers have bought time for the politicians to appreciate and comprehend the challenge facing their economies (and controlling their oversized banking industries) and yet the politicians have done nothing of note, thereby forcing more and more, though maybe more reluctant, interventions using monetary policy.

Game theory in the current environment
Thus central bankers know that they are contributing to, or entirely financing, an economic expansion whilst the politicians are running fiscal deficits, i.e. overspending their incomes which, over time, history has shown to be highly inflationary.

Japan, now using Abenomics, is both deliberately trying to create inflation, absent for nearly 20 years, whilst buying all the bonds issued by the government to finance its overspending.
In Europe, the European Central Bank (ECB) with its Emergency Liquidity Assistance (ELA) and Long-term Refinancing Operations (LTRO) is buying the banking system time for the politicians in Brussels and the European Union (EU) nations to create credible new economic policies and reforms to correct the mistakes of the past 15 years of convergence.
Recent rumours of Larry Summers replacing Ben Bernanke as Chairman of the US Federal Reserve could add to fears that the US would adopt a more friendly government financing policy provided it was targeted with fiscal policy rather than QE to the banks—either way it's still spending newly printed money.

Risk and game theory both foretell that at some point in the future either this mono-solution does not work or the central bankers conclude that their policies have created inflation, which needs to be tamed with higher interest rates. Where is this inflation? It’s certainly not in the indices created by governments to pay pensions and other cost of living benefits. However, a brief look at the changing costs of real-world items like fuel, health insurance, education fees and other staples like food and utilities shows that prices are rising by two or three times the official inflation rate, with no pay rises in sight as unemployment remains stubbornly high.

Yet, in the last two months, we have seen the first central bankers openly discussing the wish "to taper" monetary policy (not even threatening an interest rate rise) and we have then experienced huge ructions in bond and credit markets, producing sizeable investor losses.

Conclusion
Game theory shows that the risks of assets thought to be safe are rising rapidly and that, if the "taper" threat does not change the policy preferences of politicians, then central bankers will have a binary choice to prolong monetary policy past the point of both desirability and usefulness towards high or hyper-inflation or to raise interest rates and force an unpleasant but necessary shock to political policy and society in general.

At Allianz Global Investors we believe that it is therefore essential that investors understand the forces now driving the risk attached to different asset classes and control it accordingly; by doing so, investors should view the risk of their investments not primarily as a chance of loss but equally, as an opportunity to gain from the game theory moves which may lie ahead of us.



Source of all data (unless otherwise stated): Allianz Global Investors, as at July 2013.
1 Carl E. Walter and Fraser J. T. Howie, Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise.
2 Peter L. Bernstein, Against the Gods - the remarkable story of risk.
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

 

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585, us.allianzgi.com, 1-800-926-4456.

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