Wealth Strategies

Populism Forces Central Banks' Hands - A View From Lombard Odier

Salman Ahmed, 7 June 2019


Lombard Odier Investment Managers ponders the need to understand "behavioural macroeconomics" as central banks grapple with the impact of rising political populism.

This publication is looking at the whole field of behavioural finance and economics in the next few weeks. It is a growing field and perhaps garnering fewer column inches and press releases than ESG investing, but arguably just as important, if not more so. 

Behavioural economics gets away from the idea of humans as unemotional decision-makers, noting that regrets about losses can be greater than pleasure at gains, and it observes how “crowd behaviour” drives markets in some ways. Any analysis of booms and busts, or indeed political, social and cultural trends, draws on these insights. 

A few weeks ago, behavioural economics trailblazer Richard Thaler, who in 2017 won a Nobel Prize in Economics (joining an illustrious list of Chicago university Nobel winners, such as Milton Friedman), gave the area new prominence. Dr Thaler’s work on the subject has inspired writers such as Michael Lewis, writer of The Big Short and other books, to look at the actual conduct of people in markets. It is an evolving field, and remains controversial. (Like all such ideas, how it is used is important.)

These insights apply to politics. And the rise of political populism (a term that can be notoriously vague) in countries such as the US, Italy and France, calls forth policy responses. What, for example, should central bankers do if there are calls for higher public spending, tax changes and regulations that might affect inflation, growth and unemployment? When a “populist” such as US President Donald Trump hikes tariffs, what should central banks do beyond just turning on the taps?

To try and answer some of these questions is Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers. The editors of this news service are pleased to share these views with readers and, of course, those who want to respond can do so. Email the editors at tom.burroughes@wealthbriefing.com and Jackie.bennion@clearviewpublishing.com

Monetary policy is ripe for a paradigm shift. Developed market central banks are underestimating the impact that populism could have if monetary policy does not take into account income inequality, and fast. Monetary Policy frameworks need to incorporate a "behavioural macroeconomics" based approach that directly takes into account the emotions and psychology of economic agents.

Despite three decades of unprecedented global growth, rising consciousness around inequality is reshaping the economic and investment landscape. The rich have been getting richer almost everywhere over the last 35 years, but, generally speaking, neither the middle classes nor the bottom half have fared well in major developed or emerging economies. Globalisation and technology are partly to blame for unevenly rewarding skilled labour and changing the interplay between capital and labour returns. But the debate around central bank’s role in exacerbating inequalities is certainly getting more attention – and rightly so.

Consumer price inflation has been the key macro variable driving monetary policy since the early 1990s and it is now the framework for many central banks across the world. However, since the 2008 financial crisis, monetary policy has expanded beyond simply setting interest rates as the policy response focused on protecting economies from depression-type conditions.

It is now well accepted that quantitative easing, for example, has worked through a portfolio rebalancing effect as central banks tried to reignite “animal spirits”, incentivizing people to hold riskier assets. Key architects of QE, such as Ben Bernanke, have downplayed the impact that such aggressive monetary policy has had on inequality.
David McWilliams argued in the Financial Times recently that the Federal Reserve’s effort to stave off a depression sowed the seeds of generational revolt between the Baby Boomers and Millennials. 

Rising inequality has been an important factor in the sharp upturn in US and European populism. The ascent of the “Trump phenomenon” now appears more than an aberration as it spreads to the hard left and strengthens. In Europe, the ascent of populism in Italy is clear cut, whilst, in Germany, the far-right Alternative for Germany party has enjoyed a resurgence following the 2015 migration policy change. In France, images of ‘gilets jaunes’ protests have been sobering.

These shifts will likely have long-term implications for western political and economic order, which central banks are not immune from.

For example, the Fed’s quick and profound pivot during the first quarter of 2019 came against a backdrop of intense presidential pressure, despite the Fed protesting its independence. Fed Chair, Jerome Powell, down-played the role of equity markets in determining financial conditions in December, but by March, the rhetoric completely reversed and the Fed made a significant leap towards employing consumer price-level targeting. This is the most rapid and profound shift we have seen outside recession years.

In today’s populist era, central bank policy in liberal democracies needs to incorporate consideration of inequality-driven anger because it will likely be a strong influence on future political realities. In financial markets, the case for behavioural finance is well understood, and central banks can learn from this approach to incorporate behavioural macroeconomics into their reaction functions.

This is particularly important in Europe where there is complete aversion to meaningfully altering fiscal policy, even though tax policy plays a critical role in ‘correcting’ unfair income distribution effects resulting from monetary policy.

A major rethink of the European Central Bank’s (ECB) reaction function is urgently required. The bank needs a more focused, credible and visible commitment towards fulfilling its 2 per cent inflation target. It also urgently needs a broader set of policy tools such as targeted large-scale credit deployment to SMEs and mid/low-income groups, in spite of the potential risk of capital misallocation. This is especially true if the likelihood of another economic downturn continues to rise. Indeed, milder versions of money-financed fiscal policy, such as that seen during wartimes, needs to be put on the table as a serious option.

It is important to remember that if a serious downturn were to hit the single currency area, the consequent political implications would be more forcefully charged by the current rise in populism. The nature of democratically-elected government implies that if technocratic institutions such as the ECB continue to interpret their mandates in a narrow way, they may inadvertently add to the populist pressure.

Indeed, if this plays out, as we are seeing in Italy, it could have powerful knock-on effects on the shape and scope of the central bank’s mandate going forward, if not the future of the union itself.

All in all, avoiding a recession is an economic and political imperative as current paradigms are under serious threat of being permanently dislodged. The time has come to rethink central banks’ reaction function to reflect behavioural macroeconomics.

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