At the recent central banker conclave in Jackson Hole, Wyoming, the two most powerful central bankers in the world, Janet Yellen, chair of the U.S. Federal Reserve, and Mario Draghi, president of the European Central Bank (ECB), gave back-to-back addresses on the same subject.
It was like a controlled experiment in the attitudes and capabilities of the two leading financial powers in the world.
The contrast could not have been more striking. Draghi was nuanced, technically proficient, and had some excellent policy suggestions. Yellen was rigid, backward-looking, simplistic, and made disastrous policy prescriptions.
A close examination of the two speeches is a master class in the current state of central banking and a window into a distressing economic situation facing the world today...
This Debate Is Really About Central Bank Intervention
The topic they both addressed is arguably the most important policy issue facing central banks and governments today. Draghi and Yellen considered the extent to which unemployment is cyclical or structural. If unemployment is cyclical, it means that it is due to temporary factors that monetary policy can help to correct. If it is structural, it means that unemployment is due to deeper, more permanent factors that only structural policy changes can ameliorate.
Structural changes involve things such as tax, regulatory, healthcare, environmental, and other policies usually handled by legislatures. Since central banks cannot make structural changes, it means that monetary policy cannot solve the unemployment problem.
The debate over the cyclical versus structural causes of unemployment is really a debate over whether central banks can help or not.
Unemployment is the major economic problem facing advanced economies today. Five years after the end of the severe recession that struck the world in the wake of the 2008 panic, economic growth in Europe and the United States is not only sluggish, but occasionally negative.
In parts of Europe, growth has already dipped into recession. Tepid growth has not been enough to undo the damage of the last recession let alone absorb new entrants into the workforce or absorb vast numbers of unemployed youth and minorities. All economists agree that both cyclical and structural factors are at work.
The question is what is the mix of the two? Is the problem predominately cyclical or structural? Economists do not agree on the answer, and have produced varying estimates and research reports. This is the most important debate in economics today.
Draghi's Actions Speak Louder Than Yellen's Words
Draghi said that monetary policy can help prevent deflation, and that he was prepared to use unconventional monetary tools such as negative interest rates and quantitative easing to fight it. But he said that unemployment is largely a structural problem and it was up to the governments of the Eurozone and the EU itself to solve that problem through unified bank regulation, coordinated fiscal policies, improved labor mobility, and other policies not controlled by central banks.
Draghi also showed a good grasp of complexity theory and was properly wary of some of the unintended consequences of overly loose monetary policy. He was concerned about asset bubbles and inflation risks if monetary policy was too loose for too long.
In short, he acknowledged some role for the ECB, but was concerned about bubbles. He put the need for action squarely on the shoulders of the governments of the Eurozone members.
Draghi once again demonstrated that he is a master of the art of central banking, which involves saying little and doing less. He says what needs to be said to reassure markets at key junctures, and then says little else. He does not act at all if words alone are enough. This is the gift of great central bankers. Draghi seems to be the only central banker left who still possesses the gift.
Yellen's speech was the opposite.
She began with the same recognition as Draghi that the unemployment problem has both cyclical and structural causes. But then she came down emphatically to the view that the cyclical component was large, and there was much the Fed could do to alleviate unemployment.
She paid lip service to the idea of asset bubbles, but said they were not a serious problem at the moment and showed little concern that the Fed might actually be creating asset bubbles by its quantitative easing policies. She gave no guidance at all to Congress or the White House with regard to potential structural changes they could make to deal more directly with the problem.
As usual, Yellen was an intellectual prisoner of standard equilibrium models that have failed time and again. Yellen demonstrated none of Draghi's nuanced understanding of how economies work in the real world. For Yellen, the world is a model and she does not care to venture outside her world. It's too bad her model is deeply flawed because it makes no room for complex feedback and unintended consequences.
The difference between Draghi and Yellen is rooted in the ECB's single mandate of price stability, versus the Fed's dual mandate of price stability and job creation. Yellen says that the dual mandate gives her degrees of freedom to ignore price stability and to risk inflation while she pursues the goal of reducing unemployment by stimulating the economy.
Yellen has two enormous blind spots. The first is that even if you have a dual mandate that does not mean you can do anything to effect it. Congress can give the Fed a "mandate" to stop the sun from shining, but that does not mean the Fed can actually do it. It's the same with unemployment. Just because the Fed has a mandate to reduce unemployment, that does not mean they can actually do it.
In fact, if the problem is largely structural, as Draghi correctly concludes, then there's nothing the Fed can do about it.
This brings us to Yellen's second blind spot. She believes she is balancing risks between inflation and unemployment, but there's a third, even bigger risk that she is ignoring. That risk is the collapse of the asset bubbles the Fed is creating with easy money. When the stock bubble bursts and prices collapse 30% or more in a matter of weeks, that will do more damage to the real economy and employment than all of Yellen's feeble efforts to help.
Here's Our Way to Hedge the Coming U.S. Market Trouble
Both Europe and the United States are going through hard times right now, but for different reasons. Europe is making slow, painful structural adjustments that hurt growth in the short run but leave them much stronger in the long run. The United States is not making structural adjustments, but is relying on money printing and asset bubbles to prop up whatever weak growth the economy can muster. When the Fed bubbles burst, the U.S. economy will be thrown deep into its second recession of the long depression it is in. In contrast, Europe will be well positioned to receive capital inflows from China, and to emerge as an investment and export-driven powerhouse.
Investors should use the current weakness in European stocks and the euro to rotate out of bubbly U.S. equities and into select, high-quality European companies in technology, manufacturing, and the financial sector. A 10% allocation to gold will also act as good insurance when the U.S. bubble bursts and the dollar goes in reverse.
James Rickards is the author of The Death of Money (Penguin Random House 2014) a New York Times best seller, and Currency Wars (Penguin Random House 2011) a national best seller.