Team Financial Repression Having a Laugh At Our Expense

The definition of insanity is doing something over and over again and expecting the same result.

Albert Einstein (well, not really, see here)

Central banks continue to use the same ineffective tools to manage monetary policy, namely quantitative easing and negative interest rates. There is absolutely no empirical evidence these tools have had any positive effect. There is plenty of reason to think they have done harm.

The Evidence

Japan began the Quantitative Easing experiment in 2000. They have done many iterations since. The Fed followed in 2008 while the ECB waited another year and just started a new round last week.

When Japan began QE, the 10 year JGB was at 1.5%. It is now negative. Inflation over the last 20 years has pretty much been 0. GDP growth has been above 2% only three times. The results have been no better in the three years since Japan introduced negative overnight rates. QE has failed to solve Japan’s financial challenges.

The results are much the same in the US and EU. Both economies had 10 year rates in the mid-high 3s at the beginning of QE. The US is now below 2% and the EU, of course, is negative. Inflation and GDP results continue to disappoint. For example, the US has yet to achieve 3% GDP growth since the beginning of QE.

OK, so unconventional Fed policy hasn’t helped, but we had to try something, right? This is only true if there was no cost. However, there are several categories of cost that are too often ignored, because the harm only becomes apparent over time. The Global Central Banks (GCB) have shown a repeated disregard for unintended consequences.

Systemic Risk

This is probably the most obvious. By providing ultra cheap borrowing costs, central banks encourage investors to add leverage. Emboldened by their success so far (look at asset returns over the last 10 years), investors continue to lever up in riskier and riskier positions. Eventually, the whole house of cards comes crashing down.

This behavior is exacerbated overseas where we see negative interest rates. When corporates can get paid to issue debt, they have little incentive to be disciplined with their spending. Even the dumbest project can look brilliant! Capital gets misallocated which leads to future drags on the economy when these ventures prove to be impracticable.

An obvious example of all of this in practice is WeWork (sorry, “We”) which used ultracheap capital to grow too fast in dumb projects. Now, they need more capital and the market doesn’t want to fund it. WeWork was effectively created by central banks. It never would have gotten off the ground without them. There are many more WeWorks out there. They are just not as high profile. They all eventually have to crater. When they do, what tools will the Fed have left to save the economy???

Enablement Risk

Everyone remembers the famous Greenspan put! Investors knew Greenspan would cut rates every time the stock market took a dive, so investors would keep taking more risk knowing Greenspan would be their helicopter parent rescuing them before they got into too much trouble.

It is not just hedge funds or corporations who take advantage of loose money though. Governments do too. I’m not specifically referring too locking in long term debt as some advocate. That would be intelligent. Rather, governments use easy money as a substitute for the hard work of reforming their economies to promote long term growth.

If every time a government does something dumb, they know their central bank will ride to the rescue, then they will keep doing dumb things. It seems pretty obvious to me that the reason Trump rips the Fed so much is to pressure them in to subsidizing his trade war. By cutting rates to “reduce the recession risk” from trade, they give the President more ammo to continue hiking tariffs. They are losing a game of chicken!

If, instead, GCBs adopted the mantra that monetary policy is divorced from fiscal policy and we will only react to inputs that affect supply and demand of financial assets, then governments would have to bear the consequences of decisions that hurt growth and employment. Yes, this would create more near term potential for recession, but it would also spur governments to get more serious about economic reform and raise longer term growth. Governments globally have their own version of the Greenspan Put and it is a big reason growth continues to suffer.

Rebellion Risk

It is no coincidence that populism has risen globally during a time of financial repression. People naturally feel like they are being taken advantage of when they see unnatural things like negative interest rates and the investor class being able to take advantage of cheap leverage to increase wealth while the working class doesn’t see raises because of a lack of economic growth. To say it more simply, “unconventional” monetary policy favors the wealthy (who benefit from investment returns) over the working class (who depend on economic growth to improve their standing).

So, yes, I am blaming the GCBs for many of the election results we’ve seen in the last five years. While the banks love to say they are “independent”, their actions change the political winds and thus, they are culpable for political outcomes. If they are going to cause a political impact, I will again suggest it is better to create an incentive for governments to reform because they realize they can’t count on a bank to bail them out of every poor decision.

How the Fed Became Feeble

One might guess from my recent defense of Friedman that I am a monetarist. Indeed, I am, though with a caveat. I believe the supply of money is the primary driver of inflation. However, I no longer believe in the Fed’s ability to influence the money supply effectively.

The reason for this is the so-called “shadow banking” sector. These are financial institutions not regulated by the Fed. This isn’t just hedge funds. A large part of it is traditional investors like pensions and insurance companies.

In the past, banks kept most loans on their balance sheets. First, they securitized mortgages and then other consumer loans like auto loans and credit card receivables. Corporations realized public debt markets were cheaper than banks. By the 90s, banks were largely left with small and mid market loans and risky large corporate loans (i.e. high yield).

But over time, much of that market also moved away. The explosive growth in CLOs packaged much of those remaining commercial loans to investors. This left the Fed with little ability to control the impact on the economy from newly created money.

The problem is classical monetary theory is based on the idea that GCBs can effectively manage the supply of money in the economy by raising or lowering the interest rate paid to banks on reserves. Because of the money multiplier theory, banks can lever these borrowings to grow (or shrink) their loans and thus serve as the transmission mechanism to increase (or decrease) the amount of money in use.

Pushing on a String

However, in a world where fewer and fewer financial assets reside on bank balance sheets (because of shadow banking), the mechanism is less effective. Perhaps a more tangible way of demonstrating this concept is with the oil markets.

In the old days, OPEC controlled the price of oil. Today, due to fracking in the US, the growth in supply from Russia and others, OPEC is less important. Think of all the non-OPEC supply as “shadow oil”. Central banks, just like OPEC, have less influence than they used to.

This is why twenty years of unconventional monetary policy has shown no tangible proof that it works. To cite the old banking quip, the central banks are pushing on a string. That, in and of itself, is troubling, but not fatal.

The fatal error is they keep pushing harder and harder. It doesn’t change anything for the better, but it does burn through a lot of dry powder. It is time for new ideas from our GCB leaders that show they understand the full ramifications of their policies rather than continuing to engage in unproven theory with unknowable downside.