1. THREE CARD MONTE: THE GLOBAL ECONOMY IN THE AGE OF UNCERTAINTY Michael A. Sadler, Ph.D. University of Texas at Austin San Antonio May 20, 2016

2. Three-Card Monte 2

3. Three Card Monte and Policy  Over the past few months, as the Federal Reserve has attempted to “normalize” monetary policy and interest rates, they have faced continued uncertainty regarding the economic environment that we face.  Sources of uncertainty  Domestic asset prices  Europe  Emerging Markets, particularly China  Every time signs point to stronger recovery, something gets in the way  Creates a very difficult environment for policy- makers  “Follow the Queen!”  But … things may be starting to change... 3

4. Secular Stagnation -- Redux  Two years ago, we discussed a new paradigm in macroeconomics, secular stagnation  The sources of growth for the U.S. economy have mostly been exploited  We can’t expect to grow at the rates we once did, or that other countries are capable of  Periods of higher growth rates in the past decades have all been fueled by “bubbles” of one sort or another  This obviously can’t continue indefinitely, so we can’t expect to see economic progress in line with historical experience – STAGNATION will be the norm! 4

5. 5 Secular Stagnation -- Redux

6. Three Industrial Revolutions  Robert J. Gordon (Northwestern U.) asks “Is U.S. Economic Growth Over?  Three Industrial Revolutions 1. Steam engines, railroad, cotton spinning, etc. 2. Electricity, internal combustion engine, indoor plumbing, etc. 3. Computer and internet revolution  The impact on productivity from the first two was truly revolutionary and quantifiable.  The productivity gains from the third revolution have petered out quickly. 6

7. Gordon’s Six Headwinds 1. Reversal of the “Demographic Dividend”  1963 – 1990: Increased female labor market participation  Now, baby boomers are retiring and reversing this effect 2. Stagnation in Educational Attainment  U.S. is losing ground to other countries 3. Increasing Inequality  Majority of income gains accrue to top 1% 4. Globalization  Effect on wages and opportunities for workers in globalized industries 5. Energy and the Environment  Remedies to climate change are costly 6. Household and Government Debt  Both are higher than historical levels 7

8. Secular Stagnation -- Redux  To Gordon and others of his ilk, the current economic malaise is a structural issue, and the only remedies are structural remedies that confront the Six Headwinds.  To others, the current malaise has its roots in the same factors that caused the Global Financial Crisis and the Great Recession  Bernanke’s “Global Savings Glut” 8

9. The Global Savings Glut  For decades, economic trends have resulted in a concentration of wealth  Increasing inequality Wealthy households have lower propensity to spend  Cash hoarding by companies Apple, Google, Microsoft Health Care and Pharma  “Surplus” Countries (most important) Oil exporters Mercantilist countries China, Germany, etc.  But the times, they may be a-changin’! 9

10. The Global Savings Glut  Investment in fixed capital provides an important source of global economic growth  Because global demand has been low, returns on such investment have not been viewed as advantageous  Exception was certain emerging markets, but that has changed over the past 2 – 3 years  Savings was “too high” relative to desired investment in surplus countries, so funds have sought out higher returns in other countries  Results in excessive risk taking leading to financial crisis  Excess capacity in countries that receive investment funds 10

11. U.S. Capacity Utilization

12. 12 U.S. Potential and Actual GDP

13. The Eurodollar Reversal  Currencies deposited in banks outside the country of issue are referred to as eurocurrencies.  By far, the most important type is the eurodollar – dollars deposited in banks outside of the U.S.  This market has existed for decades, but grew to maturity during the 1970s and 1980s, as the oil- exporting countries generated massive trade surpluses and needed to “park” these funds These funds are frequently referred to as petrodollars Petrodollars ARE eurodollars 13

14. The Eurodollar Reversal  Surplus countries invested surplus in two ways 1. “Parked” deposits leading to growth of shadow banking sector With yields so low, eurodollars were invested in MBS, CDOs, CLOs, etc. Offered higher yields than traditional fixed income securities, but without substantial increased risk. This “search for yield” contributed to global financial crisis.  Subsequent to the crisis, these funds have sought safe havens, such as the U.S., Japan, Germany Funds have flown to sovereign bonds of haven countries Increased demand for Treasuries, for example, has resulted in record-low interest rates for Treasuries  Low interest rates are not merely a reflection of monetary policy Monetary policy may must be ratifying market sentiment Some economists perceive this as an indication that there is a shortage of safe assets in the global economy 14

15. The Eurodollar Reversal  Surplus countries invested surplus in two ways 2. Invest in countries that use funds on “growth projects” Financed development in emerging markets, where return to investment was high Tended to emphasize projects that led to high demand for commodities. Supported growth in Emerging Markets.  Loss of these investment funds has contributed to the downturn in Emerging Markets 15

16. The Eurodollar Reversal  What changed? Why the Reversal?  Oil exporters have been hammered the past two years. It is likely that oil prices will remain low for years to come.  China and other emerging markets have stagnated  Is this the end of the Global Savings Glut?  What will this mean for the global economic environment?  We could be at an important historical inflexion point 16

17. A Defining Moment? 17

18. The Eurodollar Reversal Is the Eurodollar Reversal just a Historical Blip? Or a Trend?  Lower Surpluses Generated by Oil Producers  We will likely see less volatility and lower peak prices in crude oil markets.  Why?  Change in global swing producer Swing producer used to be OPEC, and specifically, Saudi Arabia. Production decisions based on OPEC goals, not necessarily on market signals Now, U.S. unconventional (shale and tight oil) producers will provide swing supply Much more flexibility in production. Supply more responsive to price changes As prices rise, higher-cost U.S. producers enter market, increasing supply and mitigating price increase. 18

19. The Eurodollar Reversal Is the Eurodollar Reversal just a Historical Blip? Or a Trend?  China  Chinese economy unlikely to grow at rates seen in previous decades  Why? Diminishing returns. Same forces that affect all countries as their economies mature. Headwinds: many of the same growth-limiting phenomena emphasized by Gordon for the U.S. economy are also affecting China 19

20. Implications for U.S. Economy  The Federal Reserve has a stated policy goal of achieving a 2.0% inflation target  Announced in January 2012  Actual inflation rate has been below target every quarter since Q2 2012  Inflationary expectations have been dangerously low  Fears of deflation emerged  Are we out of the woods yet?  There has been some improvement in inflationary expectations, but can’t really say yet whether this will be an increasing trend  Good reason to expect it to continue

21. U.S. Expected Inflation

23. Conclusions  The Federal Reserve has a stated policy goal of achieving a 2.0% inflation target  Announced in January 2012  Actual inflation rate has been below target every quarter since Q2 2012  Inflationary expectations have been dangerously low  Demand has not kept up with capacity  Fears of deflation emerged last year and earlier this year  Are we out of the woods yet?  There has been some improvement in inflationary expectations, but can’t really say yet whether this will be an increasing trend  Good reason to expect it to continue

24. Conclusions  The Fed is currently signaling an increase in their target interest rate at their June meeting.  Why increase now when inflationary expectations remain so low?  Do they know something that we don’t?  Many signs of recovery, but we could see a return of high uncertainty to to same factors or even new issues that we have not seen before.  Time will tell, but there is reason for optimism, as signs are pointing toward a changing global economic environment.

25. Finally … ¡Muchas Gracias!