The central bankers’ rodeo

This is an audio transcript of the Unhedged podcast episode: ‘The central bankers’ rodeo’

Ethan Wu
Imagine if central bankers designed a music festival, except instead of music, [MUSIC PLAYING] you had economics professors lecturing you on their papers for an hour. That would be Jackson Hole, the annual monetary policy conference that takes place at a beautiful resort in Wyoming. Jackson Hole has just wrapped up. And today on the show, we’re talking about two headlining economics papers that we hear were total face melters. This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio, joined today by FT Alphaville editor Robin Wigglesworth, who has an entirely healthy, if above average, interest in the things that take place in Jackson Hole.

Robin Wigglesworth
Look, I’m just gonna come clean and just admit that Jackson Hole is my kind of jam. This is, you know, the Grand Teton mountains, economics papers, central bankers, a bit of booze, log cabins. I mean, what’s not to love, really?

Ethan Wu
Yeah. Your face was the one that was melted.

Robin Wigglesworth
Oh, yeah. From jealousy, from not being there.

Ethan Wu
(Laughter) Well, Robin, let me ask you then. What is Jackson Hole? Just for people that have not been inducted into the Central Banking Hall of Fame like you.

Robin Wigglesworth
Well, so, I mean, most people know Davos, right? Davos is this massive carnival. It’s thousands of people from finance, business, celebrities and so on. Jackson Hole is kind of the cool thinking person’s Davos . . . 

Ethan Wu
Hmm.

Robin Wigglesworth
. . . But just for central bankers and economists. So it’s smaller, it’s more select, but maybe even more elite. And I’d argue far more important because people who actually matter get together there. So these are the heads of — or the deputies, in some cases — of all the world’s biggest central bankers. They fly in once a year to do a bit of fly fishing, do a bit of drinking and listen to economic papers get presented and discuss all the challenges the world faces. Because it’s kind of intimate, stuff actually does get done there. Like, what people say there, the papers that presented there kind of tend to set the tone for the economic debate for the year to come. And that’s why people like me are always very envious of everybody who gets to go.

Ethan Wu
Yeah. So Robin, we’re talking today about two papers that certainly will set the tone for the economic debate in the next year and maybe many more years to come. One from a UC Berkeley professor, Barry Eichengreen, and one from Stanford professor Darrell Duffie. So to start with this paper from Eichengreen, this is primarily about US public debt, though I’d say maybe not entirely. It’s called “Living with high public debt”. And, you know, this is an old debate, Robin, that we’ve been having in the US for a long time.

Robin Wigglesworth
Oh, forever, right? I mean, what’s new about this paper? I feel this has been kind of the theme of every economics conference for the past, what, 20, 30 years now?

Ethan Wu
Yeah. I mean, certainly after the rise of the Tea Party, it was unavoidable in the US to talk about how much debt the government has. And every billboard in DC has a debt clock and all this stuff. But I think there are possibly three things that are different now. One is we massively increased spending during Covid, which is somewhat normal in a crisis time. But this was pretty extreme in terms of how much we spent during Covid using borrowing. That’s one thing.

The second thing is that we never really cut spending after the crisis passed. In some ways, we actually increased spending. You know, Joe Biden has embarked on this round of industrial policy subsidies. There were some tax increases but not fully offsetting the spending impact of Biden’s packages.

And then the last and possibly most important thing is that interest rates have gone up. We’ve gone from a world where it’s basically free for the government to borrow to one where it costs them 4 to 5 per cent. And that’s a fundamentally different world from the perspective of government finances. If it costs money to borrow money, then you have to worry about how much of the government budget is going to service interest payments as opposed to being spent on, you know, social security or Medicare or the military or whatever your priority is.

Robin Wigglesworth
So what does he reveal? Does he have a sort of secret sauce that he can give to the US to reduce its debts?

Ethan Wu
(Laughter) You know, in some ways, the paper is very pessimistic, right? It looks at how countries have actually cut their debt before and those conditions don’t look like they’re in place in the US. So Eichengreen has a lot of categorisations, but maybe I’d boil it down to just two. One is that countries cut debt because they have a political consensus. So he talks about, like, Victorian-era Britain had a consensus on sound money. You know, sternly regulated public finances were the right and proper way to run a country’s fisc. And that clearly is really not the case in the US, right? We don’t have a political consensus. Democrats have a lot of spending priorities; Republicans like cutting taxes and actually like spending, too. (Laughter) So there’s not really that political consensus in the US.

And then the sort of second main way that countries reduce debt is by having favourable interest rate and growth dynamics, right? You have what really matters at the end of the day is your debt relative to your GDP. And so if growth accelerates faster than your debt payments grow, then you can kind of grow out of the problem. And this has happened in many points in history.

But Eichengreen makes the point, well, like, look at the numbers, right? Our interest payments are growing 4, 5, 6 per cent and growth’s 2-3 per cent. And there’s a strong case that those dynamics are going to stay roughly in place for five, 10 years, who knows how long. And if they do, there’s really not a convincing way that the US would be able to grow out of its current debt burden. So the political route is closed and the growth route is closed. And so he makes the point if both of those are closed, literally, how do we get out of the situation?

Robin Wigglesworth
Yeah, I haven’t actually had the chance to read Barry’s paper yet, and he’s the man. He’s been writing about this for ages. But I was also surprised at how big that paper became, because what he’s describing is frankly not new. Was his theme basically kind of the subtitle of Dr Strangelove, like How I Learned to Stop Worrying and Love Public Debt As It Were? (Ethan laughs) That we just need to live with this thing?

Ethan Wu
I think he’s saying we need to learn how to live with it, but not in kind of a reassured, like, oh, it’ll be fine kind of way. This is a, you know, it’s a relatively alarmed paper. What if we just don’t reduce it? And the problem there for policymakers is in the next crisis, in the next shock, you may not have the fiscal capacity to be able to borrow as much as we did during the pandemic. If there’s a similar level shock, if there’s a war, can we do that level of borrowing again without something breaking? And you sort of gestured at this, Robin. One of the tricky things about this discussion is that it’s been around for so long, and I think a reason it’s been around for so long is that there’s not a threshold at which you say the debt level has reached X per cent and now the US economy has broken. It’s not like that, right?

Robin Wigglesworth
Yeah. I mean, that actually has implications for the paper I did read from Darrel Duffie from Stanford.

Ethan Wu
Yeah.

Robin Wigglesworth
His argument that basically the size of the US Treasury market, the US government bond market has become so big compared to the size of the bank trading desks that basically make sure that they match in buy or in sell of Treasuries that most of the time it functions well. But at times of acute stress when everybody wants to sell Treasuries because they need to raise cash, as they did in March 2020, it just kind of overwhelms the capacity of banks to intermediate trading and that can cause problems.

Ethan Wu
Yeah. Let’s draw the connection between these two just so we can sort of close the loop here. Eichengreen is talking about the level of public debt level of borrowing. Darrell Duffie at Stanford is talking about the Treasury market, and that’s where the borrowing happens. Just mechanically speaking, you know, the US government needs to raise some debt, so they go to investors and they sell a Treasury bond. That’s the literal mechanics of how it works. And so it makes it a really important question of fiscal and public policy. How does this Treasury market work and does it work? And in the past couple of years, we’ve had a few episodes where it’s gotten a little scary in the Treasury market, where the way the market is structured has not been able to support the huge levels of borrowing that the US is doing right now. So I think, Robin, to make Duffie’s point, it’s really worth backing up to the way the Treasury market is built, the way it’s structured, because it’s not quite the same as other markets people might be aware of. And the structure of the Treasury market is really quite essential to this point.

Robin Wigglesworth
Yeah. I mean, structure begets substance in many respects in markets . . . 

Ethan Wu
Yes.

Robin Wigglesworth
. . . And it’s underplayed. But the equity market, look, it’s a kind of a massive sandbox where everybody’s playing together. So you have high-frequency traders, you have individual investors through their brokerage accounts, you have big hedge funds, you have asset managers, mutual funds, sovereign wealth funds, pension plans. They’re all trading with each other all the time throughout the day. The bond market is very different. So broadly speaking, especially in the Treasury market, banks sit at the centre, especially kind of a club of banks called primary dealers. And that’s kind of a fancy word for banks that allow to sell US government debt at auction. So the US government auctions out debt. The primary dealers buy it and they distribute it to all their clients, and those are asset managers, mutual funds, brokerage accounts and so on. But the primary dealers sit at the centre and they are kind of the fulcrum on which the entire edifice rests.

Ethan Wu
Yeah.

Robin Wigglesworth
And Duffie’s worry is that fulcrum that supports this massive and growing Treasury market is just not strong enough anymore, is not big enough, because we wanted to make banks safer after the financial crisis, and that’s been a great thing. But the way we made them safer was to make sure they didn’t do as much trading. So one hand you have a massive market that needs more trading, more intermediation and a smaller group of banks that kind of had their wings clipped at the same time.

Ethan Wu
And just to name names, the primary dealers are banks people have heard of, right?

Robin Wigglesworth
Yeah.

Ethan Wu
It’s JPMorgan, it’s Morgan Stanley, it’s Citi, banks like that. And I think you put your finger on exactly the right tension, Robin, which is that after 2008, regulators tried to fix one problem, which is that the banking system did not work and melted down. And in some ways they created a new problem by putting constraints on the ability of these big banks, these primary dealers, to be able to make this entire Treasury market work. And so now we have, and you’ve written a lot about how central the bond market is to financial stability today, how risk has migrated from the banking system to the bond market. And in some ways, this is what we’re talking about. Is Treasury market structure fit for purpose with this banking-centric system, given how crucial the bond market is to finance today?

Robin Wigglesworth
No. And this is where . . . 

Ethan Wu
Yeah, that’s the answer, right? (Laughter)

Robin Wigglesworth
And that’s why I kind of agree with Duffie. I think it’s not just the banks. It’s not just that’s an issue. But I do think, like his main idea for a solution is to move basically kind of almost like to the stock market model. In financial jargon, it’s called all-to-all trading. Everybody trades with everybody. And there are certain things you have to do around that that’s, like, kind of jargony, like central clearing and trade transparency. But broadly speaking, kind of lessening the grip of these banks. And don’t forget, they want that grip. This is quite prestigious work. It’s kind of essential to what they do. And I think, like, they’re not being disingenuous when they say we shouldn’t rip up the model, kill it . . . 

Ethan Wu
Yeah.

Robin Wigglesworth
. . . In a cavalier fashion. But I think that is the direction of travel and that is actually healthy, that, you know, unfortunately, maybe we’ll end up having, like, flash crashes and more, even more flash crashes in Treasuries as well as we move to like a stock market model. But I think overall, for the resilience of the system, the more desperate actors, the rise — it’s like in any ecosystem, right — the more different types of animals are in that ecosystem, the healthier it is. And I think that’s kind of what we want for the US treasury market, which, look, this is not just sort of stuff that Treasury secretaries tell to themselves when they go to bed. It genuinely is the most important market on the entire planet.

Ethan Wu
Yeah. The funny thing about all-to-all trading as a jargon term is that that’s what most people would call trading.

Robin Wigglesworth
Yeah. (Laughter)

Ethan Wu
You know what I mean? (Laughter)

Robin Wigglesworth
Yeah. And I think, look, banks will always dominate the bond market for a host of technical, legal and practical reasons. But it would be healthier if we opened up that market a little bit more. I mean, the asset managers trade there, big hedge funds trade there, but it’s in kind of balkanised format. We all put them in the same sandbox and let them have fun, essentially. I think probably some people are gonna have some sand kicked in their eyes, but on the whole it’ll be a healthier ecosystem for it.

Ethan Wu
And I think between these two papers, between Eichengreen’s point that it looks pretty hard if you look realistically to lower the level of government debt and Duffie’s paper that the Treasury market needs these structural fixes, I think they’re kind of setting the stage for the next five or 10 years of what (laughter) everyone’s going to be talking about in central banking and economics and finance, which is this new world of arguably higher structural inflation, higher spending and markets bearing with that level of pressure. I don’t know if either of these is a prediction of an unavoidable or imminent crisis, but it’s more setting the table for the things people have to worry about for the next five years, the next 10 years. You know, we’re moving out of the era of low rates. We’re moving toward a kind of a different paradigm. And these are the worries that are gonna characterise that paradigm.

Robin Wigglesworth
Yeah, you stuck that one, Ethan. [MUSIC PLAYING] Ending on paradigm is kind of that’s a 10 out of 10. So I’m gonna just shuffle off and think about (Ethan laughs) my Long/Short recommendations.

Ethan Wu
We’ll be back in a moment with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing we love, short a thing we hate. I’m getting much better at saying that. I feel like I messed it up (Robin laughs) like multiple times when we launched the show. Today, Robin, I am long the Securities and Exchange Commission’s new rules for private funds. I’ve been critical of some of the things the SEC has been doing, but I think these make a lot of sense. Like, they want to have disclosure requirements on private capital the same way that a lot of public funds have. And I just wrote on this on the Unhedged newsletter, I think it makes sense. I think so much money has moved here, so many investors of different levels of sophistication, including individual investors who are just, you know, a little wealthier, are migrating to this market. It makes sense to have kind of standard disclosure requirements. And the SEC kind of walked back some of the less sensible regulations they’d initially proposed. I like it. I think it makes sense and I’m long what the SEC is doing on private funds.

Robin Wigglesworth
Do you think the industry agrees with you?

Ethan Wu
No. (Both laugh) However, I will know, you know, when the initial rules came out, they said these are fundamentally unworkable, we’re gonna sue you. And now they’re saying we’re gonna consider our options. So that’s at least something. We’ll see if they end up suing.

Robin Wigglesworth
Yeah, that’s a win in SEC land, I think.

Ethan Wu
For now, yeah.

Robin Wigglesworth
OK. So I’ll go short something. I will go — and riffing off the Jackson Hole theme earlier — I’ll go short R-star. R-star is basically the economist’s profession imaginary friend. It’s something they talk a lot about, but doesn’t actually exist. So it’s the idea that there is some sort of natural or neutral level of interest rates that for a perfectly strong economy with moderate inflation, doesn’t stimulate or constrict economic activity. And I just think frankly, it’s useless as a guide and they should just stop talking about it because it doesn’t really help them, us or anybody.

Ethan Wu
You know, Robin, the real issue with R-star is that we’re giving the people that say economics is astrology for nerds, we’re giving them too much ammo.

Robin Wigglesworth
Yeah. True.

Ethan Wu
All right, we’ve already have enough and we need to, like, take it away from them, not give them more.

Robin Wigglesworth
For me, the only advantage really, of R-star is it’s very pun-worthy: “R-star Wars”, “The Fault in R-stars”.

Ethan Wu
I hate the puns. I’m sick of them. They’re tired.

Robin Wigglesworth
Oh, I love ’em. I’m a middle-aged dad, you know. If you take puns away from me, I have nothing. (Ethan laughs)

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Ethan Wu
You can take my money. You can take my guns. You’ll never take my puns.

Robin Wigglesworth
Amen.

Ethan Wu
All right, Robin, thanks for being here. We’ll have you back very soon. And listeners, Unhedged is going on a little Labor Day break, so we will not see you Thursday. We’ll be back in your feed next week. Catch you then. By the way, if you like the show, we’d really appreciate it if you left us a five-star rating on Apple Podcasts, Spotify, or wherever you listen. It really does help get the word out there. And if you’re not already subscribed, I just don’t know what you’re doing. Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie and Jess Truglia. FT Premium subscribers can get the Unhedged newsletter for free. A 90-day free trial is available to everyone else. Just go to FT.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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