Haldane, Fast and Slow

Andrew Haldane, chief economist of the Bank of England and, apparently, one of TIME magazine’s 100 most influential people in the world, gave a provoking presentation on the past and future of economic growth at the University of East Anglia a week ago, entitled ‘Growing, Fast and Slow’.

In it, - as the title suggests - he mobilized Kahneman’s framework of ‘Thinking, Fast and Slow’  to help approach the topical, or perhaps just millenarian, question of whether the world is about to lapse back into a pre-growth stupor out of which it struggled about 300 years ago.  Since I am interested in economic growth, and  have also found Kahneman's work interesting, I want to make some observations on it.

(And before I start, let me acknowledge that those of us who have not yet been named one of TIME’s 100 most influential people . . . . we do feel the lash of disappointment keenly. )

I do not think it simply professional resentment which drives my conclusion that Haldane’s delivers an  intellectual sugar-rush of covering a lot a ground quickly, which quickly dissipates when you start to digest his his thesis. Haldane fast is fun, Haldane slow is not so  good.

The Argument

Haldane wants to take on ‘one of the key issues of our time’, namely, whether the post-crisis slower rates of growth are a temporary or a longer-lasting valley in our economic fortunes. The way he wants to do this is by looking at long histories, since ‘some growth epochs have seen secular stagnation, others secular innovation.’  If we can understand the sociological and technical determinants of those growth phases, we’ll have a better idea of what’s going on today.

So he contrasts the period of secular innovation and growth  since 1750 with the three millennia prior to the Industrial Revolution, during which, apparently, global per capita GDP averaged only 0.01% a year. The conclusion is important: current growth levels are exceptional, and secular stagnation is far more common than secular innovation.  Having made this distinction, he sharpens it: ‘The short history (the Golden era) and the long history (the Malthusian era) of growth could not be more different.’

He then asks the question: ‘what caused this shift in growth?’  He characterises two possible explanations, claiming they are supported by the common theme of patience. In what he characterises as the the neo-classical explanation, patience supports saving, which in turn finances investment, and today’s investment is tomorrow’s growth.  The model is exogenous, supported by a) the patience of individuals, and b) technological progress, the ‘manna from heaven, a surprise gift which keeps on giving’.

Haldane admits this theory ‘does a decent job of explaining the phase shift in growth after the Industrial Revolution’, but identifies two problems. First, he mistrusts the exogenous role of technology, fretting there may be nothing we can do to encourage the next big wave of technological advance. Second, he is keen to develop an ‘endogenous’ growth theory in which in the key factors are as much sociological as technological - skills and education, culture and cooperation, institutions and infrastructure all work together building in a cumulative evolution fashion, rather than spontaneously combusting.

A fair portion of the paper assembles evidence supporting this second approach. For his argument, this evidence really matters because it supports what is actually his central thesis, that ‘the technological seeds of the Industrial Revolution were sown well before Hargreaves Arkwright and Watt arrived on the scene.’  And this proves that ‘innovation is more earthly endeavour than heavenly intervention’.

Still, even if you accept all this, the question still remains, why did societies suddenly being accumulating capital at particular points in history?  This is where he makes an interesting jump, arguing that ‘those technological and sociological trends may, in turn, have caused a re-wiring of our brains’.

His answer is to propose a mash-up between Kahneman and the history of interest rates. He suggests that the fall in interest rates (and return on capital) prior Industrial Revolution reflected society’s ‘evolving time preferences’ (ie, patience). Partly this reflected the possibility that income and wealth had growth enough to indulge the luxury of for more patient thinking. But also the post-Gutenberg proliferation of books may have ‘re-wired our brains’ in such a way to stimulate the slow-thinking, reflective, patient part of the brain (ie, Kahneman’s Type II thinking).  And in turn that would have supported the accmulation of intellectual capital, and consequently technology. So slow thought will have made for fast growth.

The Implications

Having constructed this framework, he then deploys it to draw implications for our own time. First, he wonders about the fall in real interest rates over the past 30 years, suggesting that perhaps this does mean our patience - capacity for Type II thought, technical innovation and growth - has grown. Perhaps, after all, technology will go on being the gift that keeps giving.

But his heart doesn’t seem in it: the last and most minatory part of the paper gloomily logs evidence that the key inputs to the endogenous growth theory are in decline: specifically, he worries that the rise in inequality (as measured by the Gini coefficient) will slow growth. Rising inequality, he fears, is leading to a deterioration in human capital. ‘Inequality may retard growth because it damps investment in education’.

And from there it is but a short step to worrying about short-termism, and proposing that the ability of the internet to cause a neurological re-wiring like that he proposed for the impact of Gutenberg.  ‘But this time technology’s impact may be less benign.’  He speculates that this time ‘an information-rich society may be attention-poor’. ‘It may cause fast-thinking, reflexive, impatient part of the brain to expand its influence. If so, that would tend to raise societal levels of impatience and slow the accumulation of all types of capital.  Fast thought could make for slow growth.’

Hence, it is not unreasonable to worry about a relapse back into pre-Industrial Revolution economic stupor.

Criticisms

There are many things unsatisfactory about this paper. I won’t even begin to list the number of questions I have about the historical data he relies upon. Similarly, there are a number of points at which he reaches for conclusions which, upon reflection, seem unnecessary and even arbitrary. But there are three areas which are central to his thesis, and which seem to me to be extremely contentious - eventually to the point of culpability.  In ascending orders difficulty, with the least-difficult first, they are:

The Role of Interest Rates. First, it is quite remarkable that he wishes to interpret interest rates, even real interest rates, solely and merely as an indicator of ‘patience’. It is remarkable, for example, that he does not acknowledge the role of inflation expectations, and their rate of formation, in the decline of bond yields over the past 30 years. It is remarkable, too, that he has nothing to say on the impact (or otherwise) of monetary policy and monetary institutions throughout the ages.  How is this possible? Surely he does not envisage monetary institutions and policies as merely far derivatives of underlying changes in neurological structures affecting our degree of patience?

Technological Teleology. Second, underlying his entire paper is a search for a technological teleology. Offering a theory of that teleology derived from an underlying stipulation of, or assumption of, increasingly broad and unquantifiable categories of ‘capital’  lies at the heart of the ‘endogenous’ growth theories he proposes. These attempts to categorise and quantify these purported types of capital are, I think, inherently implausible. (Two reasons: i) they can’t be counted and ii) even if they could, they’d suffer the same catastrophic problems with ‘real prices’ as all other capital stock estimates do.)  But much more dramatically, they dismiss the quite plausible possibility that technology has its own teleological aims and trajectories.  Haldane writes: ‘innovation was an earthly creation, not manna from heaven’, but that hardly exhausts the list of possibilities of what’s going on with technology. It seems quite likely that technological innovation implies and develops its own trajectory, and that that internal logic has a more powerful causative impact on the development and distribution of various types of capital, than vice versa.

The book I’d recommend for this is Kevin Kelly’s ‘What Technology Wants’. One of the ironies of Haldane’s presentation is that at some stages, he comes awfully close to acknowledging the possibility that technology in fact has its own teleology independent of human intention. He admits, for example, that ‘empirical evidence suggests a high degree of history-dependence, or hysterisis, in technological transfer’.  But not, apparently, in technological development itself, only its transfer. Really?

The Rise of China and Asia. But the worst fault, the most glaring absence, is the way Haldane has wiped the rise of China and Asia over the last 30 years from his assessment of the world’s current situation. This surfaces at every argument he advances for the worries about the state of the conditions allowing for ‘endogenous’ growth. For example, he worries about the decline of social capital, specifically that the rise in inequality (as measured by the Gini coefficient in the US) will slow growth.  He also worries that this will get worse as middle-class jobs continue to be ‘hollowed out’ by technology.

But you cannot exclude China from any argument about inequality and growth.  All analysis agrees that China’s historically-unprecedented growth has been accompanied by a large rise in inequality (so maybe a rising Gini coefficient doesn't automatically result in a lower growth rate, as claimed elsewhere?). Conversely, the rise of China’s working masses has also led to an unprecedented reduction in global poverty. It seems very likely that, when measured in global rather than national terms, the last 30 years has seen a narrowing of inequality rather than its accentuation.

Simply  noting the that the Gini coefficient in the US has risen at the same time as its growth rate has slowed hardly even classifies as argument, let alone as demonstration.

Similarly, Haldane worries about a possible decline in human capital. Why? The evidence he offers is that ‘the US is slipping down the international league tables of education attainment’ and ‘the UK could be following suit’. So what? Tell it to the Chinese!  On a global scale, you cannot conclude that human capital is eroding simply by noting that US and UK students no longer always rule the roost.

And finally, he frets about infrastructural capital where, it is said, ‘investment trends are not encouraging’. Really? First, he equates infrastuctural capital with the size of public sector investment to GDP - can he really believe this to be a useful proxy? Second, of course, once  again, the only relevant data is taken to be from the West. It’s not as if there’s been any significant infrastructural investment in Asia over the last 30 years, is it?

To be frank, this sort of cherry-picking of the data, this consistent willingness to edit from the picture that part of the global economy which is not based in the US or Western Europe, ruins the latter part of his paper. Maybe 20 or 30 years ago, the omission of more than half of humanity from the story might have been overlooked, or at least excused as an inevitable result of a lack of data. But not now - extrapolating global growth trajectories from the narrow and difficult recent experience of the Western middle classes is simply dumb.

My Conclusions

Having made these criticisms, I feel duty bound to offer my own conclusions on the future of economic growth. I have three.  First, any competent interpreter of Solow growth models will recognize that the underlying assumption is that there is no reason why with sufficient capital back-up an Asian (say) cannot be as productive as (say) a European or American.  So if capital flows are truly global, the ineluctable tendency will be for the world to become less unequal, and, specifically, that the unusually privileged position enjoyed by Europeans and Americans will be constantly under threat. Second, that in these circumstances, the immediate response will be for those privileged to seek to entrench their privileges by securing monopolistic or oligopolistic market positions in any way they can. In this scenario,  widening national inequality measures in the West will almost certainly reflect rising  economic rents, and usually market failure. Third, technology has its own teleology; it is infinitely more likely to surprise and amaze us than to sputter out because of our own ‘lack of social capital’. 

How the Oil Price Shock Is Hitting US Industry

It's reasonable to attribute the recent disappointments of domestic demand (retail sales down 0.9% mom in December, down 0.8% in January) to the impact of the oil-price shock.  During the initial price shock (which does not hit before November 2014), households are surprised and so do not adjust the rest of their spending patterns, with the result that the savings ratio ticks up swiftly and inadvertently, even as overall retail sales soften.  Later, of course, households get habituated to the lower price of energy, and spend the windfall. In short, you get a J-curve impact on domestic demand, so can afford to be relatively relaxed about the initial weakness in sales.  

But such complacency may be misplaced when it comes to the industrial sector.

The headline numbers don’t look disastrous: January’s industrial output rose 0.2% mom, and capacity utilization rates were unchanged at 79.4%, and the preliminary reading of February’s Markit manufacturing PMI showed a mild acceleration to 54.3. Nevertheless, by the end of 2014 there were some imbalances opening up between manufacturing supply and demand which would normally be enough to set alarm bells ringing. I track headline industrial momentum by looking at industrial production, inventory/shipment ratios, capacity utilization and exports.

As the chart shows, this combination of measures produced the sharpest fall in momentum in December 2014 since the financial crisis.  The two most obvious sources of weakness were a 0.3% mom fall in industrial output which was 1.5SDs below trend, and a 2.3% yoy rise in exports which was 0.7SDs below trend.

But this was not really what did the damage: rather it was a rise in the manufacturers’ all-industry inventory to sales ratio to 1.34, which was the highest since August 2009, and represented a very sharp rise from a ratio which for the previous five years had average 1.29 with a standard deviation of just 0.01pt.

Which sectors were doing the damage?  Obviously, petroleum and coal inventory/sales ratios have risen sharply,  presumably generated by a fall in speculative demand as prices have fallen: the ratio rose to 0.74x in December from a low of 0.68x in September. Even so, this level of inventory mismatch is not unprecedented: we saw the ratio at this level in mid-2012, in mid-2011 and throughout 2010.  But that spike would perhaps have been unremarkable had the overall total not been boosted by a steady climb in the ratios for computers/electronics, chemicals, textiles, printing and possibly beverage and tobacco.  One way of interpreting the modest build-up in printing, textiles, beverage and possibly even computers/electronics is that these are sectors which are likely to have been hit by the unexpected shortfall of retail demand in 4Q.

If so,  then a continuing deterioration in inventory position usually results in production cut-backs in the short to medium term. The suspicion that such a disequilibrium quietly opened up during 4Q is confirmed when one looks in more detail. In particular, one can compare the momentum of manufacturing output with the momentum of sales and inventories. The red line in the chart below subtracts sales and inventories momentum from output momentum: when the line is positive, it tells us supply momentum is outpacing demand.

If this disequilibrium becomes extreme as it did in 2001 and 2008, it heralds recession.  However, quite clearly, we're not there yet, and in addition such a negative result can be sidestepped if export momentum picks up sufficiently to soak up the ‘excess’ industrial production. This is what happened in 2003-2004 and again in 2009-2010.  The bad news is that currently, the rise in the dollar coupled with the fact that the US is leading the world economic cycle means that US exports are under pressure (falling 1.1% mom sa in November, and falling 0.8% in December), so this option is not available.

Conclusion? The impact of lower energy prices is having an unexpectedly significant impact on US manufacturing in the short term. The up-sweep of the J-curve in the retail sector therefore will be met with considerable cyclical relief.

China's Continuing Credit Squeeze, Impact on Trade

China’s January monetary data has to be read with extra caution, since the available data can be read either as:
a) disclosing a significant loosening of policy, with M1 growth up 10.6% yoy (from 3.2% in Dec), and new bank lending of Rmb1,470bn, which was the highest since the credit splurge of early 2009, and up 11.4% yoy; or
b) showing not significant improvement in liquidity conditions, since M2 growth slowed to 10.8%  (from 12.2% in Dec), and new aggregate financing, (which as well as bank lending includes ‘shadow banking activities’, foreign lending, bond and equity market financing) came to a less-striking Rmb2,050bn, which was 21.2% less than in January 2014.

On balance, the dour conclusion is probably nearer the truth. The key development driving January’s seeming expansion of bank lending was PBOC’s late-December decision to broaden the definition of deposits which are counted in bank’s loan to deposit ratio, which is subject to a regulatory ceiling of 75%. Specifically, PBOC now includes in its definition of commercial banks’ deposits those savings held by banks for non-deposit-taking financial institutions – such as stockbrokers, for example. Not only are these savings now included in the deposits calculation but in addition,   for the time being banks are not compelled to hold reserve ratios against them.  This rule-change matters, since these types of savings accounted for approximately 8% of the total deposits of listed banks, and consequently, they allow and encourage a significant increase in bank lending. 

But there is a cost: if these deposits are used to fund commercial bank lending, they are not available to fund other forms of financing. Hence whilst January’s bank lending rose sharply, this was paid for by the virtual annihilation of entrusted loans and trust loans.  In December, Rmb 668bn of these were issued/created; in January that total collapsed to just Rmb86bn.  So whilst growth of bank lending accelerated to 14.3% yoy in January, with a monthly gain which was 1.5SDs above historic seasonal trends,  the stock of total aggregate financing, by my estimate at least, slowed to 13.3% yoy on a monthly movement which was 1.2SDs below historic seasonal trends. And that broader financial aggregate is the one which matters. 

The unrelieved financial stress on China’s industrial economy also shows up in January's trade data. The trade surplus hit a record US$60.1bn, but this reflected the dramatic weakness of imports (down 19.9% yoy), not any strength in exports, which fell 3.3% yoy and were 0.6SDs below historic seasonal trends. This is a record surplus born out of shocking weakness in import demand, not an export-machine grabbing market share, or even a terms of trade benefit granted by falling commodity prices. More policy stimulus is urgently needed  to bolster working capital and cashflow in China's industrial sector.

January shouldn't have been a particularly weak month for China's trade - the calendar disturbances around Chinese New Year should have flattered January's totals slightly, since Chinese New Year doesn't fall until the middle of February this year, whilst coming at the end of January last year. So, if anything, the 19.9% yoy fall in imports, generated by a 21.2% mom fall which was 1.2SDs below historic seasonal trends, was even worse than it seems.  What's more, this collapse was not simply a reflection of commodity prices falling. Indeed, in volume terms, there was surprisingly steady demand for copper, iron ore, steel products and refined oil, whilst imports of crude oil continued to climb. Of the main industrial commodities, only coal took a real battering in January. Rather, it reflected a real gap-down in inter-Asian trade, with the worst hits showing up in Hong Kong, Japan and Asean. 

The sheer scale of this fall in import demand tells us unambiguously that major parts of China's economy are still very weak. Which parts and why? The fact that the worst hits were taken by inter-Asian trade strongly suggests that China's distributors are unwilling or unable to keep supply channels stocked at the levels previously taken for granted. This was also the message hidden away in December's fall in industrial profits, when despite topline pressures, companies cut their holdings of inventories and accounts receivable more than expected. Northeast Asia's trade with China is, after all, focussed on capital goods and intermediates, so it is these which must be taking the brunt.  Overall domestic demand indicators in China are weak but not spectacularly so, but the tightening of monetary conditions imposed in 2H14 has not yet been successfully reversed. It seems that directing some financial relief on cashflow and working capital is becoming a more urgent priority.

Petrol Prices and the J-Curve Impact on US Retail

They key shock of the week was the 0.8% mom fall in January’s total retail sales, or 0.9% if you exclude autos. How much of this was simply a reflection of lower gasoline prices, and if gasoline prices are responsible for the fall, what is the future trajectory of retail sales likely to be over the coming months? Gasoline prices and gasoline sales were the key to the whole retail slowdown in January. Sales at gasoline stations fell 9.3% mom sa, which is hardly surprising given that the average price of regular unleaded fell by 11.3% mom. Excluding gasoline sales (and autos), sales rose 0.2% on the month. On a 3ma basis, sales excluding autos are falling sharply averaging a 0.5% mom fall, but excluding gasoline, sales growth is running at 0.3%, dipping very slightly from the average run-rate of 0.4% which has been seen since 2011.

Consumption of goods accounts for 23% of US GDP, so at first sight this slowdown threatens growth. But since falling petroleum prices have been responsible for almost all of the slowdown of the last few months, the deflators will take care of that impact as far as GDP growth is concerned. The key word, however, is 'almost': beyond the simple price impact on the headline nominal numbers, the sudden fall in petroleum prices - down 25% since September - has another less obvious effect on consumer behaviour.  If the fall in gasoline prices is experienced as an unexpected windfall by the consumer, one would expect an initial phase in which the fall in prices is an unexpected windfall which initially (and inadvertently) saved,  only to be spent subsequently when the consumer adjusts to his/her new and larger budget.  In other words, one would expect a ‘J-curve’ effect.

Is this happening? The first crucial question to be addressed is: at what point would one expect the fall in gasoline prices to  take consumers by surprise?.  If the answer to this is: ‘when it falls significantly below the range recently experienced, then this is not difficult to spot. The chart below shows a fairly clear range sustained between January 2011 and October 2014, in which the price of regular conventional gasoline averaged $3.48 a gallon, with a standard deviation of 20 cents. In this chart the dotted lines show the two standard deviation level, which at the lower boundary comes out at $3.07 a barrel. One might speculate that above this level, the consumer would be unlikely to react to price fluctuations, but when it dived sharply below that, it represents a clear break from recent experience. According to Energy Information Administration that happened only in the last week of October. So it is only in November, and more obviously in December that one would expect any J-curve effect to be developing.

How big an impact? In the year to September, spending on petroleum accounted for 13% of retail sales (ex autos): a 25% fall in prices since then therefore amounts to a windfall gain equivalent to 3.3% of the retail budget.  This windfall looks to have been unexpected and to have been saved in December at least, when, reversing a decline in the trend visible since the middle of the year, the savings rate jumped 0.6pps to 4.9% in December (vs 4.1% in Dec 2013).  We should expect to see a similar or even higher rate in January.

But later, that savings rate is likely to retreat again as households adjust their spending to their newly-expanded budget. When petroleum prices stabilize, so will that portion of retail sales. Meanwhile, as consumers adjust their spending to reflect the new lower petroleum prices the personal savings rate falls and ex-petroleum sales accelerate beyond the current 0.3% mom run-rate, and probably, for a while, beyond the longer-term 0.4% rate. Looking back, we will see the J-curve effect at work.

ECB's QE: More Magic Than Mechanics

So, will it work? 

It would be easier to answer that question if we could form a clear idea of what Mr Draghi thinks this quantitative easing will achieve and how it will achieve it. That is not easy.

It seems to me that throughout this financial crisis there have been four models about what QE might achieve:

• The first is relatively straightforward: quantitative easing has been (in the US and UK particularly) a way of publicly guaranteeing the solvency of potentially distressed financial systems. 
• In the second model the central bank hopes to master the longer-end of the bond market, driving investors are driven into riskier instruments, and thus driving down risk premia. In terms of the economy, by depressing bond yields below 'fair value' rates, central banks and economists entertain the hope that savings rates would be cut, and investment spending encouraged. In both the US and UK this has happened very slowly, very late in a business cycle, and to the extent that it has happened at all there is no certainty (and limited probability) that QE played a key role in changing savings/investment choices. 
• The third model involves using QE to announce a public 'regime change' of monetary policy which, by itself, manages to raise inflationary expectations. 
• The fourth model is quite different and the polite financial community pretends it hasn't noticed it: in Japan, QE is being used as a way in which the central bank can achieve hegemony over/functionally replace a banking system which seemingly cannot be revived from its decades-long coma. 

Which of these engines does the ECB think it has set in motion?

The first move is to listen to what Mr Draghi had to say. The key passage, it seems to me was this: “while the monetary policy measures adopted between June and September last year resulted in a material improvement in terms of financial market prices, this was not the case for the quantitative results.” What does he mean by quantitative results? He could mean either there was insufficient positive results in terms of credit (and he's right, bank lending to the private sector fell 1.4%, or by Eu151 bn over the 12m to Nov), or alternatively, the 'quantitative result' he may be referring to could be economic output and economic growth.

Nor did Mr Draghi get significantly more coherent as he outlined what he thought might be achieved: QE would

1. decisively underpin inflationary expectations 
2. ease financing conditions for firms and households 
3. 'reinforce the fact that there are significant and increasing differences in the monetary policy cycle between major advanced economies.' 

That last is simply obscure: the obvious explanation is that he is simply talking down the Euro – is this really what he intended?

If from all this you can construct a clear set of aims, and a picture of the mechanisms by which the Eu60bn per month buying of assets will achieve those aims, you are one step ahead of me. But if pushed, I would say he is relying on a 'regime change' to push up inflationary expectations, whilst hoping that ECB's bond-buying will somehow be passed on to firms and households.

There are two problems getting in the way of that second hope. The first, of course, is that the longstanding expectation that ECB would eventually be driven to something like QE has already depressed both sovereign Eurozone bond yields, and risk premia. Ten-year Eurozone sovereign bond yields are only around 50bps, with the risk premium of 10yr BBB bonds approximately 100bps, and, for troubled sovereigns such as Spain, around 140bps. The marginal impact of squeezing these premia down further can surely be only slight.

The second problem is that even as national central banks buy bonds from their own financial system, the receipts are likely to pool in the most credit-worthy systems. Within the Eurozone, that means the German banking system, where we will be able to track the process by the Bundesbank's Target 2 balance with the ECB. Outside the system, the Swiss National Bank is making a radical assumption that plenty of the ECB's QE is coming its way. For evidence, consider changes in the ECB's balance sheet:  

and the way the fluctuations of 2011 to 2014 have been mirrored in the Bundesbank's Target 2 balances with ECB: 

and the short term liabilities and foreign investments build-up in the Swiss National Bank:

Why should we expect it to be different this time?

China in 4Q: Tactical Reverse Delivers Modest Victory

China's release today of December's monthly data and 4Q GDP results contain enough information to give us answers to two distinct questions:

• To what extent have China's authorities succeeded in halting the slide of the first three quarters?
• How much progress has been made in 2014 towards steering China towards a less resource-inefficient model of growth?

The answer is that it's reasonable to believe the slowdown in China's economy was indeed brought under control and in some respects reversed. But there is a price: virtually all measurements suggest China made no progress at all in 2014 in discovering a more efficient growth-model.

December Data and 4Q Growth

There was just enough in December's industrial and domestic demand data to suggest the underlying loss of momentum continued to moderate. For the industrial sector, the 7.9% yoy rise in output was a surprise exactly big enough to offset the fall to 7.2% recorded in November.  It included a 2.6% yoy rise in electricity generation which also just about kept that indicator conforming to trend.  Similarly, the 9.5% yoy growth in US dollar exports (9.8% yoy in Rmb terms, and 9.4% in volume terms) was very modestly greater than historic seasonal trends would expect. So the industrial sector ended 2014 in much the same state as it has been since 2012 - oscillating in a narrow range around, and usually just under, trend momentum.

Domestic demand has been the greater challenge as, broadly speaking, it tracked fluctuations in monetary conditions.  And December's data was collectively strong enough to show positive momentum for the first time in a year, which pulled up the 6m trendline slightly, although it is still solidly negative. The strongest signal was from car sales, which rose 16% yoy and were 1.5SDs above trend. In addition, retail sales growth of 11.9% yoy was 0.4SDs above trend for a second successive month. But these gains were offset by still-slowing urban investment (15.7% yoy ytd), and the continuing deterioration in employment conditions as tracked by the official manufacturing PMI.

My momentum indicators suggest that the deterioration of 1H has been mildly but successfully reversed in 2H, and particularly in the last quarter. And,  perhaps surprisingly, the quarterly nominal GDP results suggest the same thing.  This is not immediately obvious: nominal GDP growth slowed to 7.8% yoy in 4Q from 8.5% yoy in 3Q.  When one strips out the impact of the trade surplus (Rmb 917.3bn in 4Q14 vs Rmb554.3bn) in 4Q13 in order to get an idea of domestic demand, nominal GDP growth actually accelerated very mildly, to 6.1% yoy in 4Q from 5.7% in 3Q14.  Going further, one can also strip out the fiscal position, to get closer to movements in private domestic demand: we have the fiscal data only for October and November, but  judging from those two months, it seems clear that, despite the public commitment to supporting economic growth, the fiscal position actually tightened slightly during the quarter. (In the 3m to Nov, revenues rose 8.4% yoy and spending rose only 1.9%, and the Rmb 350.8bn deficit compared to a deficit of Rmb 540bn in the same period 2013).  As a result, when you exclude the impact both of the net trade position and the fiscal position,  I estimate the remaining private sector domestic demand grew 8.2% yoy in 4Q, up from 5.2% in 3Q and 5.8% in 2Q. In short, the deterioration was checked in 4Q.

That conclusion is also supported by my proxy for  the private sector savings surplus, comprising the trade surplus minus the fiscal position.  As the chart shows, the huge build-up of private savings surpluses which accompanied the slowdown throughout most of 2014, stabilized during the last few months of 2014, as confidence stabilized enough to cap the rise in precautionary saving. We do not yet have current account data for 4Q, but during the 12m to September, the PSSS rose to 4.6% of GDP from 3.5% in 3Q13.  For the time being, it seems likely that the ratio did not rise more in 4Q14.

Structural Issues - The Challenge Ducked

The evidence suggests that the government's attempts to avert a spiralling slowdown met with modest success during the latter part of 2014. But there has been a price: there has been no obvious sign that China is edging towards a more resource-efficient growth model. Rather, the longer-term deterioration has continued,  with the marginal improvements since the middle of 2013 scuppered in 4Q14.

My return on capital directional indicator expresses nominal GDP as a flow of income from a nominal stock of fixed capital, and I calculate movements in that capital stock by depreciating nominal gross fixed capital formation over a 10yr period. We do not yet have the formal by-expenditure breakdown of GDP for 2014, so 2014's 7.7% yoy investment spending is modelled from the 15.7% yoy rise in urban fixed asset investment.  This may prove a conservative estimate of investment spending in the national accounts, but even so, it implies China's capital stock is growing around 13.3% yoy - far faster than the c8.2% growth in nominal GDP. As a result, there is absolutely no sign that the fall in the directional indicator is easing up.

Perhaps it might be argued that after the huge investment frenzy of the last 20 years, it is quite unreasonable to expect a rapid turnaround in this indicator. However, it is difficult to see any improvement in other indicators, such as monetary velocity (GDP/M2): although the pace of deterioration has clearly moderated, it has probably not yet improved. (Monetary velocity may be interpreted as indicating changes in marginal output/capital ratios once the effect of changes in the credit cycle are accounted for.)

More directly, one can look at the economic efficiency of finance, tracking how nominal GDP has reacted to the addition of 1 yuan of bank lending, or more broadly 1 yuan of neg aggregate financing. At the beginning of 2014 there were signs that this was finally beginning to recover from the falls of 2008-2009 and 2012. However, developments in 4Q appear to have snuffed out that recovery: in 2014 one yuan of bank lending was associated with just 0.53 yuan of GDP growth, down from 0.77 yuan in 4Q13, and dipping back to the lows of early 2013.  Calculating the similar ratio for aggregate financing, one yuan of aggregate financing was associated with marginal GDP growth of just 0.30 yuan in 2014, down from 0.40 yuan in 2013.

None of this is to write the obituary on China's efforts to re-cast its growth model. But such a traverse is tremendously difficult at the best of times, and in 2014 China's authorities evidently discovered this was not the best of times. The economic strategy no doubt remains, but 2014 was a year in which economic tactics took precedence.

If ECB Goes QE, Remember Bundesbank's T2

Even if Mario Draghi can retain unanimous monetary policy board consent to a really sizeable programme of quantitative easing, the underlying untreated fractures in the Eurozone’s financial system make it difficult to believe it could significantly deflect the Eurozone’s economy much from its current trajectory. Put baldly, the mechanism by which the central bank can hope to transmit monetary policy initiatives throughout the economy are broken. And they are most broken where they are most needed.

Regardless of the ECB’s public policy pronouncements, movements in its balance sheet reveals what policy has actually been. And that policy has been to claw back the support to the Eurozone financial system it provided during the first phases of the Eurozone crisis in 2012. Between 3Q12 and the end of 2014, the ECB’s total balance sheet contracted by just over Eu1tr.  In calendar 2014, the ECB’s balance sheet shrank by Eu251bn, a contraction equivalent to approximately 3% of Eurozone GDP.

In terms of net lending to the Eurozone’s financial institutions, the total has fallen from roughly Eu650bn in 2H2012 to around Eu480bn in 2H14.  Evidently, the desire to shrink the ECB's balance sheet was a higher priority than steering the Eurozone away from deflation, fostering growth or eroding the unemployment totals of Southern Europe.

This will at least please the Bundesbank, since the fractures in the Eurozone banking system have forced it to become a massive lender to the ECB.   The problem is that Germany’s role as the Eurozone’s principal banking system safe haven results in large chunks of Eurozone liquidity pooling into Germany's banking system, which in turn results in the Bundesbank being the chief re-cycler of those funds back to the ECB. The chief tracker of Germany’s save haven/capital recycler role within the Eurozone is the fluctuations of the Bundesbank’s Target 2 net position with the ECB.  When Euro liquidity was fleeing Southern Europe financial systems and washing up in Germany’s commercial banks, the Target 2 net position of the Bundesbank with the ECB rose to a peak of Eu751bn in August 2012.  This was an amount equivalent to just under 25% of the ECB’s total balance sheet. Subsequently, this flow modestly reversed, with the Target 2 total falling to Eu470bn by March 2014, but since ECB also shrank its total balance sheet during the same period, the Bundesbank’s net position is still equivalent to 22% of the ECB’s total assets.  

Since March, however, the position has been largely unchanged, though over the past few months it has expanded very slightly. But this stability is not a return to 'normality': between 2000 and 2007, and prior to the Eurozone debt crisis, the Bundesbank's Target 2 balance averaged under Eu10bn. 

Now consider the implications of the relationship between movements in the size of the ECB’s overall balance sheet and the Bundesbank’s Target 2 balances with the ECB: they rise together than more recently have fallen together, but whilst the ECB’s balance sheet has returned to 2010 levels, the Bundesbank’s Target 2 balances are approximately two and half times what they were in 2010.  

What this tells us is that, despite what the fall in sovereign risk premia may assert, the perceived imbalance of risk in banking systems between Germany and the rest of the Eurozone has not been eradicated.  ECB’s guarantees of liquidity have suppressed risk premia, so that at present, Spanish 10yr sovereigns carry a bare 88bp risk premium, but if that premia has been ‘artificially’ suppressed by central bank actions and/or promises of action, it merely means that investors are no longer paid enough to offset the residual financial system risk. Hence liquidity continues to flow out of the Eurozone’s riskier banking systems and back into Germany’s banking system. 

The underlying fracture in the Eurozone between Germany and the rest of the Eurozone has not mended. The analogy of the ECB using a sticking plaster to treat a fracture is compelling: the smooth surface masks terrible and possibly irreparable damage beneath the skin. 

In particular, it illustrates just how limited any ECB ‘quantitative easing’ must be in effect, even if Germany’s representatives should allowed a concerted effort in that direction. For the evidence suggests that if ECB poured liquidity en masse into the Eurozone’s banking system, the economic and financial fractures in the Eurozone would result in liquidity quickly circling back once again,  quite uselessly, into Germany’s banking system.  Whilst this might – only might – help inflate German asset prices, it can hardly be expected to do the same for, say, Spain CPI, or Italian unemployment, or ex-German Eurozone growth. The underlying divergence directly sabotages the mechanism by which any conceivable (ie, nationally non-specific) monetary policy can take effect. 

It has been claimed that central bank quantitative easing can or has achieved different things at different times, using different mechanisms. The two most common beliefs are that sufficiently aggressive central bank intervention can effect ‘regime change’ which effectively encourages nervous financial systems with depleted risk capital, to reassess likely future returns and expand balance sheets which would otherwise be frozen.   Secondly, it has been asserted that if central banks can crush the risk premium across the range of financial assets, it can drive investors back into those ‘riskier’ assets from which they had recently fled.  

Both make the assumption that although balance sheets may be compromised and risk capital in short supply, the fundamental banking mechanism through which a central bank can act remains sufficiently intact to be rescued.  But in the Eurozone’s case, the enduring size of the Bundesbank’s Target 2 balance tell us that is not the case: Europe has many distinct national banking systems  with different risk characteristics masquerading as a single system.  But it's the still-giant Bundesbank Target 2 balances which reveal the truth.