One thing I would like to touch on before I highlight excerpts from that text is that high levels of debt and misallocations of capital may well be a feature of many a boom, but what makes the current situation much different is the fact that interest rates lie on a lower bound, almost incapacitated by a higher bound debt level, itself tied to highly valued asset markets. High debt levels and weak growth dynamics are dangerous, irrespective of whether you are undecided as to whether high debt led to growth or low growth to high levels of debt, although I tend to believe that the reality is that weakening developed economy growth dynamics accompanied the debt build up prior to the onset of the crisis. Beyond that point in time, high debt levels I would say are clearly impacting growth.
Whereas all significant debt misallocations have an impact on subsequent bank lending and new credit growth (the stock of broad MS is tied to these low or non performing loans), not all such instances have occurred at such low interest rate levels. I think this is key, critical and as the Geneva report suggests “poisonous” intersect, although the report itself strays from emphasising what I consider to be the greater risk of high debt levels at low IRs..
Another point that I have laboured is the present value of future output growth or national income relative to debt is out of balance and this is the first time I have seen explicit reference to this in any other document I have read.
The primary interest rate conflict is not between inflation and growth, but between asset prices and a potential asset price shock to growth and the financial system. Increasing income inequality and weak wage growth keeps the US and other economies within a debt/asset value/IR bounded endogenous money supply chokehold. A successive series of debt/asset bubbles and interest rate lows are not a succession of unrelated incidents but a tightening of an extremely dangerous grip.
In the most recent Federal reserve Bank of Chicago Missive, Patience Is a Virtue When Normalizing Monetary Policy, much interesting information was imparted on employment trends…but there was little comment about interest rates and their relationship with the build up of asset focussed money supply growth……this build up of broad MS was and still is reflected in highly valued asset markets and global debt accumulation. Its magnitude can be gauged by the large surge in broad MS growth over and above nominal GDP growth.
“With the economy undershooting both our employment and inflation goals, monetary policy does not presently face a conflict in goals;
I foresee a time when a policy dilemma might emerge: Namely, we could find ourselves in a situation in which the progress or risks to one of our goals dictate a tightening of policy while the achievement of the other goal calls for maintaining strong accommodation.
I am just parsing through a simple model of QE attempting to bring together the disparate strands and thoughts…
One point that is worth pointing out is the extremely large increases in money holdings in the US economy, especially over the last 12 years with regard to their differential with nominal GDP growth. I dealt in detail with the physics of changes in money supply and its distribution between expenditure and asset portfolios in a document I wrote in 2008.
The blog title is taken from a recent VOX column and an excerpt is noted below. Why am I emphasising this article? Well the IMF has raised the same point about the Canadian economy and the Bank of England seems to be taking the same tack too with the UK. But I have also raised concerns myself about the consequences of such misallocation of capital in the past (and I am not just talking debt but also more structural footprints), so the empirical evidence is interesting:
US Central Bank credit has increased 1.075trillion (End 2008 to 1 May 2013) and reserve balances with the Federal Reserve have increased 958bn over the same time frame – source data H8 and H4.1 reports of the Federal Reserve.
Low interest rates and quantitative easing could deter new capital investment projects. QE is no doubt helping asset prices rise, but it is also forcing down the cost of capital at a time when the return on capital should, arguably, be higher, given the risks. Returns on the different components of the cost of capital equation should justify the risk, and cash and bonds are both important components.
Paul Weller: “I stood as tall as a mountain; I never really thought about the drop; I trod over rocks to get there; Just so I could stand on top; Clumsy and blind I stumbled;…I didn’t stop to think about the consequences; As it came to pieces in my hands.”
The 2008 crisis told us that there was a mismatch between asset values and debt, asset values and future return, and debt and economic growth as well as some rather large structural economic imbalances.
We have tried to delay the eventuality implied by the difference in the hope that the “true” magical economic growth rate should return. Have we built up a bigger monster, and if so, how do we slay the beast?
Central banks are a bit like doctors charged with getting their patients back to health armed only with medications, but with little else to influence physical health. But what if the medications are not working, do you just increase the dosage?
August data is out and the only monetary aggregate that has shown an increase has been the narrower M1: M2-M1, M3-M2, and lending aggregates all showed either reduced rates of growth or increased rates of decline.
The world’s QE bet is all about closing the potential output gap, and for many this accumulated gap, built up over the last 5 years is pretty large. Not large enough however to soak up all that cash the Fed has injected, but the Fed wants to deal with this crisis later.
I am not so sure that such a narrow focus on the monetary base as the de facto cause of current economic problems is a safe way to be conducting monetary policy. Agreed, in a general equilibrium, and in most normal economic scenarios, increasing the monetary base is going to stimulate economic activity – give banks more deposits to lend at an acceptable margin and they are likely to do so – but I am concerned that today’s monetarists have lost the plot.
I am genuinely interested in what he would have said, but not about quantitative easing per se, because he was obviously pro quantitative easing if there were issues about insufficient growth in the monetary base.
I think it is highly possible that the Fed know they have people guessing: they see the stock market moving on up and, wow, QE works. Well, it is plausible that QE has had some marginal benefit to the economy because of this, but the regularity with which new phases of QE need to be implemented suggests quite strongly that the impact of QE has been weak, given the fundamental head winds.
I hate the phrase quantitative easing, it is a bit like calling an apple, Malus Domestica-Borkh. But QE is no apple, it is a rigged game as far as investors are concerned, and the Fed is playing on the market’s irrationality, and its passion for the short term, to pump a little more blood into the valves.
As previously discussed, a rise in narrow money supply might lead to a rise in economic activity for a number of reasons: narrower money supply measures tend to be reserved for near term expenditure and a rise might suggest a move from delaying expenditure (longer term time deposits to shorter term easily accessible accounts) to spending more.
A rise in narrow money supply may also be a sign that the money multiplier has been expanding in recent months and lending growth has fed back into the banking system (people have more money), likewise implying a) growing economic activity and b) the potential for more expenditure.
In a recent article, Ambrose Evans opined that a rising narrow money supply (M1 to be exact) presaged a rise in economic activity.
Usually this might be the case as an increase in shorter duration/easier access narrow money might imply a) an increase in bank lending that creates deposits via the money multiplier (implying higher current and/or future economic expenditure), and/or b) a shift from longer duration money with the intent of spending (which implies a reallocation of money from future consumption to current consumption). It may also very well mean just an increase in money supply occasioned by quantitative easing. Continue reading →
At a very basic level, all QE does is exchange “new money” for fixed interest assets (up till now high quality government bonds of varying maturities and some corporates (UK)).
QE is meant to lower bond yields through the initial demand and the reduction of supply, but this is not a necessary condition (i.e the interest rate change on high quality securities), since the real prize is the rise in the price of risky assets through portfolio adjustment of cash percentage allocations.
Reducing the supply of high quality assets and increasing the supply of money aims to increase the liquidity in the market for less liquid risky assets.
Ostensibly, since the rise in the price of risky assets is also a proxy for those loans and leases on the books of the banks, QE is also intended to increase confidence in the banking system and the banking system’s confidence in its ability to make loans. Continue reading →
But this type of industry thinking is also likely to scare away the retail investor, through rational cognitive dissonance or otherwise.
Apparently, we are set for a big rally, once Greece leaves the Euro, as Central Banks the world over pump yet more liquidity into the financial system. This will either be via LTRO Repo type (temporarily exchange your securities for cash) transactions or the better for the banks and sovereigns, QE (buy your duff securities for a price you would not be able to dream of otherwise).
Here is my very quick, write it as you think it, opinion on this “play”. Continue reading →