The Only Game in Town
The impact of QE on markets has been profound, and in sharp contrast to the performance of real-world indicators. From the first announcement of quantitative easing by the US Federal Reserve in 2009 to October 2018, the Standard & Poor’s (S&P) 500 Index is up nearly 270 percent, the European high-yield benchmark is up 230 percent, and the Morgan Stanley Capital International (MSCI) Emerging Markets Index is up 150 percent, as compared to only 20 percent aggregate rises in inflation, wages, and house prices across the United States. Understandably, then, financial markets are entirely in thrall to the priming of central banks, and to a large extent “playing” QE has been an enduring investment theme for investors across asset classes. It is no exaggeration to say that central banks have become “the market” in many different respects. First, they simply own large swathes of financial markets, mostly debt (and, in the case of the Bank of Japan, also equity: it owns 3 percent of the total Japanese equity market capitalization and 60 percent of exchange-traded funds in Japan and is ranked as a top-ten shareholder in 833 companies in Japan).
Second, they have turned many markets into one-way, crowded investment positions. It is very difficult for investors to trade against central banks or to try and engage in arbitrage activity in markets. For instance, an investor worried about the economic and political outlook for France might sell or even take a short position in French bonds, but the impact of QE may well render this strategy highly unprofitable. As a result markets are desensitized to fundamental data and to risks in the world economy. The market reaction to Brexit is a very good example. Stock markets initially fell but then rallied as central bank chiefs reiterated their supportive stances for accommodative monetary policy and as the Bank of England cut interest rates to the lowest since it was established in 1694.
More broadly, the ongoing presence of QE produces a confusing investment climate where fundamental factors become less relevant in investment decision making and where investors are induced to follow the activity of central banks. As QE drives down long-term interest rates, there is greater demand for assets with a yield. In many cases, high-dividend-yielding equities and riskier corporate bonds fit that category. Capital may then be misallocated in that investors who would normally buy government bonds (like Treasuries) for the yield they offer are forced to buy other yielding assets (because QE has pushed down the yield on government bonds, making them less attractive). The problem is that the other yielding assets—risky company debt (high yield), risky country debt (emerging-market debt), and equities—are not as safe as government bonds, so investors may end up holding a riskier asset than intended. Some companies reinforce this, in some cases by issuing debt to pay higher dividends that make their equity securities more attractive, even though the process may make the company more vulnerable in a downturn.
One implication of this is that pension funds and insurance companies, who rely on a supply of yielding assets in order to match them against the stream of liabilities they face, can no longer find yielding assets to buy at reasonable prices. This may in turn accentuate future pension liabilities. Another issue is that the low-interest-rate environment has allowed many zombie companies to tread water, prolonging economic risks and suppressing productivity.15
Central banking, as I hope you now can see, is on the one hand, arcane and complex, and on the other, relevant to our daily lives, even though we barely feel its presence.16 In the past ten years, central banks have reigned over bank systems, the wealth held in pension funds, the sanctity of multilateral organizations such as the eurozone, and the rise and fall of currencies.
The collective response of central banks to the global financial crisis undoubtedly staved off greater chaos in markets and potentially prevented a deeper recession worldwide. A more serious criticism is that central banks have simply delayed the reckoning of deep-seated economic fault lines, have not boosted economic potential, and have created new risks in financial markets and international economies. As their role and importance have grown, they have sapped the power of markets and governments. The now dominant role of central banks makes them a central player in the levelling of the international economic order. In this respect, they are central to several fault lines.
Fault Lines
One fault line is that quantitative easing has dramatically exacerbated wealth inequality, which is at its worst levels in decades. In theory, the aim of QE was to lower long-term interest rates so that households could have access to cheaper capital. However, in the context of a toughening regulatory regime, the effect of the credit crisis on lending standards of banks and the fact that many households and businesses were already overburdened with debt or were risk averse meant that very few households could get access to loans at low interest rates or had the spare capital to buy cheap post-crisis assets.17
For example, in September 2016 Italian government bonds traded at a yield of 1.1 percent but Italian mortgage rates were closer to 7 percent. In essence, this meant that only those who already had access to capital could benefit from QE by borrowing at low interest rates to buy cheap assets; ordinary households had to borrow at 7 percent. In some cases, the purchase of real estate by property funds (which were also able to access cheap capital) drove up property prices, putting pressure on affordability.
In many countries wealthier people tend to hold more securities (e.g., equities and corporate bonds), and they have clearly benefited from QE, to the extent that in 2018 equity valuations were close to the most expensive end of their historical range (touching levels only seen in 1929 and 2000); the same was true of corporate bonds. From a relative wealth point of view, this again helps those with existing securities portfolios, though it must be said that investors deserve some compensation for holding risky assets in uncertain times. Underlying this, in May 2017, when ECB president Draghi testified on quantitative easing to the Dutch Parliament, he was presented with a solar-powered tulip (by Pieter Duisenberg, son of the first ECB president, Wim Duisenberg) to underscore to him the parallel between the tulip-mania asset price bubble of the mid-seventeenth century and the price of eurozone financial assets (government bonds).
Furthermore, because valuations for asset classes like equities and corporate bonds are now so high, the future returns they produce will inevitably be limited, thereby limiting the growth in the value of pensions. There is also a growing dilemma for millennials, who will struggle to find assets that generate a decent return around which they can build a pension. It should also be highlighted that households who have traditionally been savers and who may fear investing in financial markets have been financially disadvantaged by the race to lower interest rates.
Most importantly from the point of view of the levelling, there is also an important link between QE, markets, and politics. In some quarters, ranging from academia and journalism to politics, people may believe that financial markets are big casinos (in 2002 the Japanese finance minister, Kiichi Miyazawa, referred to the Japanese market as a gambling den)18 or mechanisms through which wealthy people manipulate events and fortunes. This is not quite true. Markets play a very important role in signaling. The movements and levels of market prices tell us a great deal about the health of companies and countries and the state of the world we live in.
Markets are important warning mechanisms, especially when it comes to bad economic policy. Famously, Bill Clinton’s political adviser James Carville said that if he were to be reincarnated, he would like to return as “the bond market” because it is so powerful.19 In the past, market strategists, such as Ed Yardeni, have spoken of “bond vigilantes,” referring to the fact that the bond market curbed excessive borrowing (and inflation) by governments by penalizing them for reckless borrowing with higher bond yields.20
A good example of the role bond markets play in signaling economic health is the information in bond yields across the eurozone countries. Let’s pick on Italy again. For a long time the bond yield of Italy traded some way above that of G
ermany (in the mid-1990s the difference between Italian and German yields was close to 8 percent, signaling that Italy had more inflation than Germany and was a riskier economy). In 2017, for example, Italian bond yields traded at a yield differential to Germany of just above 1.5 percent, which suggested that markets thought Italy was nearly as safe an investment proposition as Germany, but in reality that would be strange for a country with an enormous debt load and little growth. Ask yourself whether a household already laden with debt and whose main bread winner was barely bringing in enough money to cover the mortgage interest payments would get such a generous interest rate from a bank. It is unlikely to happen, though in the case of Italy and other eurozone countries like Portugal, this kind of anomaly is ever present. One might ask whether the market is mispricing the risks of Italian debt or whether it is simply soporifically following the bidding of the ECB. The answer is that investors are not pricing risks as they should but are simply following the lead of the central bank.
European central bankers would argue that artificially low interest rates for Italy are a necessary evil. Their view would be that higher bond yields for Italy would hurt its economy, delay necessary economic and political reforms, and lead to further instability in its banking system. A cynic would argue that bond buying by the ECB is a complex form of a Band-Aid: an improvised attempt to cover up the shortcomings of the euro system. The cynic might point to the lesson offered by the various episodes of the eurozone financial crisis in which Europe’s politicians only seemed to act when pushed to do so by market volatility. The logical extension of this is that a market crisis is required in order to advance policy in Europe. This might seem strange and counterproductive to American or Asian ears, but the construction of the European Union has habitually required crises in order to move it forward, because the many nations of the European Union have different aims and priorities, and these only become aligned in the most pressing of circumstances.
Nevertheless, making policy under duress is still the worst way to do so, and an emergency is the worst circumstance under which to implement it. The austerity programs in Greece and Ireland are good examples of this. An alternative would be a marketplace free of the sedative of QE (or even a marketplace where QE was only triggered at certain yield levels so as to prevent chaotic runs on bond markets). Such a market climate would also be one where politicians and policy makers had the moral courage to stick to the rules laid out in the framework governing the euro. In this circumstance, bond markets would more accurately signal the true health of economies and country balance sheets. In turn, this would probably force politicians to enact economic reforms and lead investors, corporations, and to a degree households to act in a more responsible and careful way in terms of the amount of debt they take on.
The Future of Central Banking
In 2018, the Federal Reserve began to step slowly, carefully back from quantitative easing programs, and other major central banks hinted at an era of policy normalization. The next recession or financial crisis will test their mettle. Have they simply throttled back extraordinary monetary policy, ready to rev it up again, or are they willing to step back in principle from the positions of overwhelming power they find themselves in?
There are three avenues down which central bankers can travel. The first is more of the same: to continue to use central bank balance sheets to curb markets and to try to stimulate growth. Under this option there will be plenty of talk of “adding to the toolbox,” that is, inventing new measures to try to coax growth out of sluggish economies.21 The results may simply be more market distortion, a dwindling sense of urgency among politicians as to their task lists, and an undermining of the credibility of central banks as independent public institutions.
If anything, recent pronouncements from central bankers suggest that, in the case of a recession, the consensus view among monetary economists supports more aggressive bouts of monetary stimulus rather than the disengagement of central banks in favor of fiscal-policy-led solutions to low growth.22 Public discussions by central bankers in the United States and Europe, for example, point toward a mind-set that is now set on zero and negative rates as the default policy stance of major central banks. My worry is that these seemingly aggressive policies will prove ineffective in the face of a serious economic shock, such as a full recession in China, which would sharply curb economic demand globally.
The second avenue is for central bankers to step back and let politicians use fiscal policy more actively. The rationale here is that active fiscal policy in the context of cheap money would stir the embers of the world economy. In certain cases this might work, but it comes too late. Fiscal policy like infrastructure programs tends to work with a lag. For this reason it is often best deployed at the bottom of a recession because it cushions the blow of a downturn and helps provide the basis for a recovery, particularly if money is wisely spent. At the time of this writing, some large economies—the United States and China—are heading toward their next natural, or likely, recession. In this case, their fiscal powder is best kept dry for a couple of years rather than being ignited unproductively now. The other side of fiscal policy, structural reform (such as making labor markets more dynamic), is something for which most politicians have little appetite.
A third option is to stop the range of extraordinary measures being deployed by central banks altogether. A very bold framing of this would be an agreement or world treaty on risk, crafted along the lines of large-scale environmental or nuclear weapons deals. Under such an agreement, the world’s major central banks would agree to use extraordinary measures like QE only under preset conditions (great market and economic stresses). It would, of course, be much more appropriate if the political masters of central banks were the ones to sign and seal such an agreement rather than again leaving central bankers with the responsibility. The effect would be that markets would properly price risks and that, in turn, politicians would therefore act to address economic risks and fault lines. If extraordinary monetary policy needed to be launched, it would be more effective. This scenario is my own preference, though I suspect that most central bankers would still opt for the first scenario, in which the central bank acts as a monetary Death Star.
A Treaty to End All Treaties
The most crucial challenge for central bankers over the next decade will be navigating the transition from globalization to a multipolar world in the context of low growth and high debt. The passage from a free-flowing globalized world to a more level one where multiple political economic poles exert growing influence is likely to be noisy and tense. It will be further marked by a natural recession in the United States caused by a mixture of rising rates, credit stresses in student loans (which have now shot past $1.5 trillion) and auto and real estate loans, corporate debt and governance issues, increasingly conservative consumption patterns, the risk of protectionism, and the threat of a global demand shock from a significant economic crisis in China, to list just a few scary scenarios.23 The ability of the United States and China to digest economic weaknesses and emerge in better shape will shape their competitive relationship for the next twenty years. China in particular faces a bigger risk than the United States because it has not had an official recession since at least 2000 and will probably be confronted with a slowdown in its property sector, and such downturns (i.e., in housing or credit) tend to be more severe than normal cyclical recessions.24
In that respect, the rate of China’s economic progress may be checked for some time. Against the international landscape, a debt-based recession for China would represent the logical end of the mixture of globalization and debt cycles we have witnessed since 1990. The Anglo-Saxon countries were the first to experience their debt crises in 2008 and are now seeing the political fallout. Then came Europe’s turn in 2011, and its political class was slow to respond. For instance, it took five summits of EU heads to decide on measures that would stanch the financial and economic damage of the eurozone crisis. Against this backdrop,
a third crisis in the near future centered on China would have a certain logic if not inevitability.
Old Debt in New Economies
A crisis in China’s economy would also mean that the three great regions had, with near-biblical significance, been touched by the painful implications of taking on too much risk and too much debt. As Europe and, still, parts of the US economy show, the burden of high debt levels can be severe in its impact on trend growth and on social issues. “Old” debt—that is, debt taken on in a previous business cycle—and the ways in which it is resolved can act as a handbrake on an economy, or, to use a different analogy, old debt is like fat clogging the arteries of the economy and at some stage will need to be operated on.
After the global financial crisis, international debt levels initially dropped (especially in the financial sector), but they have risen again, encouraged by the effects of quantitative easing. World indebtedness (households, companies, governments, and finance companies) stood at over 320 percent of world GDP at the end of 2018, above the 2008 peak of 300 percent. Between 2014 and the end of 2018 we saw government debt rise, bank debt fall, and corporate debt mount.
Household debt in emerging countries has also risen steadily: during the Asian crisis of the late 1990s it reached 75 percent of GDP but is 90 percent today, which is a sign of the consumer and housing boom across many emerging countries. China itself carries a historically large debt burden. Total debt in China now stands at 250 percent of GDP according to the IMF, which notes that a sharp rise in credit, like the one China has enjoyed, is often a precursor to financial and housing crises.25 The Spaniards and the Irish would, with the benefit of hindsight, agree with this view. As debt has grown in China, its contribution to growth has incrementally slowed in the sense that an extra renminbi of debt taken on today has much less impact on growth than it might have had five years ago.26
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