2021 - No Choice But to Expect Policy Errors

It's a hard and negative thing to say, but the most salient feature of this year is its unique ability to generate important economic and monetary policy failures. If we are lucky, these will be caught in time and we will remember 2021 as a year of dramatic policy reversals. If not, 2022 and onwards will have to be years of repair.

Why is policy failure so likely? The fundamental problem is that the pandemic's lockdowns have disrupted the most basic flows upon which economic activity usually surfs. Since normal economic history provides no precedent for these disruptions, we (economists, investors, policymakers) have no real understanding of whether, or to what extent, or over what period of time, those 'normal' flows will be resumed. We can make assumptions, but we don't really know. Worse, policymakers can make assumptions but - crucially - they are not free to believe them, or set policies which would be appropriate to those assumptions. Rather, they have no choice but to set policies appropriate to only the worst, most pessimistic scenarios.

The massive disruption of normal private sector flows is the key unignorable observation which surfaces in the calculation of Kalecki profits. The disruptions are similar across the globe: household dissavings have plummeted, net investment has fallen, and these have been offset by massive public sector deficits. Strangely, however, there has been little disruption in net international trading patterns.

The same pattern of dramatic disruption is seen in every region.

First in the US:

And in Germany:

And in Japan:

The key unknowns for each sector are:

1. Households. Households will emerge from the pandemic with their balance sheets in a surprisingly good state of repair, but with a much-reduced consumption habit. Will they a) relish and protect their improved balance sheets; or b) spend it all on a splurge of 'catch-up' consumption?

You have 'have a view' on this - my 'I reckon' view skewed towards the 'catch-up splurge' in the immediate aftermath of getting the vaccine. A week later, I'm less sure. Maybe the likely structural change in working patterns and places will by itself reduce the 'necessary' spending on rail fares, bad sandwiches, bad suits? Who knows? I don't, you don't, and policymakers don't either.

2. Businesses. Businesses too will exit the pandemic with far more cash on the balance sheet than they had at the start. Will they want to use this cash to re-invest in their businesses, or will they focus instead on the collapse in their asset-turns which the pandemic wrought, and the likelihood that nominal GDP, and hence their nominal revenues will likely be smaller in 2021 and 2022 and onwards than they had planned for back in 2019? Will there be a lingering impact from the generally declining returns on capital seen in the US, in Germany, in Japan (and elsewhere) in the years immediate prior to the pandemic? Is that pre-pandemic business cycle dynamic still relevant, or is it forgotten? Who knows? I don't, you don't, and policymakers don't either.

3. The Rest of the World. The pandemic had surprisingly little impact on the net balances of trade seen in the US, Germany and Japan. But will that stability survive if the exit from the pandemic happens in different countries at different paces? Will that stability survive if the (unknown) responses of households and businesses differ from country to country, from region to region. Probably not. But that's something we can't at this stage know or even sensibly second-guess. I don't know, you don't know, and policymakers don't know either.

The Policymakers' Dilemma

Given these absolutely fundamental 'unknowns', policymakers really have little choice: they have to prepare for the worst - ie, for the likelihood that consumption will stay depressed, leading to increasing unemployment problems; and that net investment will remain sub-par, and that nothing good can be expected from net exports.

Even if they truly believe and expect that consumption spending will rebound dramatically, and that investment spending will pick-up in response, and that this will happen so generally and simultaneously around the world that trade balances remain relatively stable, the costs of being wrong are so dramatic that they cannot be risked. Policymakers everywhere will, must, assume that it will be necessary to maintain the major part of the fiscal and monetary underwriting adventured in 2020. The rescue packages cannot be withdrawn at this stage - only re-purposed.

Consequences

A moment's thought is enough to sketch out the consequences of this particular policy-failure. What if in the US, say, consumption rebounds in line with 'pent-up demand' theories, and this is answered by a vigorous private investment spending boom, even as massive fiscal stimulus is poured into the economy? In these circumstances, the simple maths of the situation demand a dramatic widening of the US current account deficit, which in turn invites either a weaker dollar, or higher interest rates, or a rise in inflation. Or all of the above.

Most likely, however, it implies an early and tough tightening of fiscal and monetary policy.

Repeat similar thought-exercises in all parts of the global economy.

Conclusion: Reasons to be Cheerful

Let's be cheerful. It's not impossible that the world's economic policymakers will be sufficiently alert, flexible and responsible that they will be able to react swiftly and appropriately as the new shape of the fundamental economic flows emerges throughout 2021. Even if the default starting position is one of almost inevitable error, there is no a priori reason why policies cannot respond appropriately as the number and scale of the post-pandemic unknowns begin to fall.

But even if this blessed wisdom is granted to our policymakers, it raises a secondary challenge: can financial markets, so used to relying on 'guidance' also manage to cope with a year of likely fundamental policy changes with equanimity? As investors, that's our challenge.