Central banks all over the world are using monetary economics to bail out governments whose finances have been wrecked by the coronavirus pandemic of 2020. Monetary policy carried out by the priestly caste of central bankers, who are unelected, has become a means of facilitating fiscal policy, as determined by the politicians. This extraordinary change in the economic landscape is sure to have important implications for investors over the medium to long term, writes Victor Hill.
QE: From adolescence to adulthood
The economist Liam Halligan recently wrote that quantitative easing (QE) started out as an emergency measure in the financial crisis of 2008-09 but has since become a lifestyle choice for central banks. QE was first initiated in order to inject liquidity into the banking sector which was teetering on the brink in the fallout from the collapse of Lehman Brothers in September 2008. It worked, and banks managed to reduce their balance sheets, resulting in a huge contraction in the money supply in most advanced economies which was only partially offset by the massive creation of new money by the central banks. The banking system was saved.
But thereafter, QE was mobilised at every critical moment of economic uncertainty – the European Sovereign Debt Crisis, the Greek bailout, and now the Covid-19 pandemic. Famously, Signor Draghi said in the autumn of 2012 that the ECB would do whatever it takes to forestall financial crisis – much to the dismay of the German establishment which regards QE with extreme suspicion. Since then, QE has bolstered asset prices (nice for the rich) and suppressed bond yields. The latter outcome has had the effect of tempting governments to borrow even more aggressively (because debt is so cheap) and thus drive up their debt-to-GDP ratios even further.
The balance sheets of the Federal Reserve, The European Central Bank (ECB) and the Bank of Japan have all swollen during the pandemic by approximately one third. Everybody’s doing it – even the Sveriges Riksbank (the Bank of Sweden).
By the end of this fiscal year the UK government will have sold about £400 billion of new gilts in order to raise fresh funds and to roll over outstanding debt. It is quite possible that the bond markets will eventually demand a premium return given the avalanche of new paper – and yet for now much of the UK’s sovereign debt (out to seven years’ maturity) is trading with negative yields. The two-year gilt was trading in late July at a yield of minus 0.13 percent.
This increased borrowing results from the financial black hole opened up by the coronavirus pandemic. This results from the cost of the Job Retention Scheme (popularly known as the furlough scheme) and numerous bailouts from the arts to the charity sector on the one hand, and the severely reduced tax-take on the other. It seems that about one half of these newly issued gilts will be purchased by the Bank of England. The economist Roger Bootle reckons that the UK’s money supply has already increased by 35 percent in the first half of 2020.
Another reason for the huge rise in public expenditure in the UK is that the Johnson government is wedded to a massive programme of infrastructure investment summarised by the Prime Minister’s slogan build, build, build. Mr Johnson has talked in the past about bridges between Scotland and Northern Ireland and between England and France though whether these will materialise in the current financial climate is doubtful. I discussed the parlous state of UK public finances in a recent post on the MI website.
The price of QE
QE may get governments out of holes, short-term, but it does nothing to improve productivity or innovation. On the contrary, it creates the conditions where highly indebted zombie companies, which contribute little or less to the economy, are sustained indefinitely. More significantly, there are zombie states – Italy is one of them – which have proven to be incapable of reducing their debt-to-GDP ratios despite near-zero interest rates. There is a growing body of economic evidence – though it is not conclusive – that highly indebted countries grow more slowly than lowly indebted ones. Italy has had a growth problem since the inception of the single currency in 2002.
Also, excessive valuations have become normalised. That has had paradoxical implications. On the one hand, adventurous investors have bid up the prices of high-profile stocks; on the other hand, many traditional equity investors have withdrawn from the equity markets entirely in the expectation of an eventual correction. The latter cohort have also been discouraged by de-equitisation – the phenomenon that the menu of available stocks has become much smaller in most developed markets over the first two decades of this century.
By forcing interest rates down QE also penalises savers who, in the Keynesian model at least, finance investment. This has hit retired folk particularly badly. Provident, hard-working people who saved up a nest-egg for their retirement now receive negligible income from their savings. This has often forced them to seek higher returns in dubious investment schemes – and even scams. It is not an exaggeration to say that QE has mugged elderly savers.
One of the great unsolved economic puzzles of our age is that central banks have desperately tried to inject some inflation into the system by printing money but have generally failed – probably because the newly printed money has gone to bolster asset prices.
True, they have succeeded in avoiding deflation, which looked possible after the financial crisis as banks deleveraged rapidly. Deflation is considered a nightmare scenario by many economists as it ensnares both corporates and governments in a debt trap. Where deflation takes hold – for example in the USA at the end of the 19th century – there can be huge social and political disorder. In contrast, governments benefit from inflation over time to the extent that inflation reduces the value of their debt. On the other hand, higher inflation entails higher interest rates which, in turn, makes servicing the debt more costly. Higher inflation also aggravates government spending costs, for example by pushing up the wages of public sector workers.
Other reasons for the failure of central banks to trigger inflation are long-term secular trends: in particular, that of an ageing population and the glut of savings pushing down on equilibrium interest rates. Furthermore, under the Basel III bank capital adequacy regulations that were introduced after the financial crisis, banks are required to maintain substantial liquidity buffers which are mostly composed of sovereign debt (i.e. government bonds). This again has pushed government bond yields down.
Many central banks, the Bank of England amongst them, have an inflation target of around two percent. If inflation exceeds that level, then the Governor is required to write to the Chancellor of the Exchequer (the UK Minister of Finance) to explain what measures will be taken to restrain it. No such letter has been sent since the financial crisis.
Why would the Fed buy Apple’s bonds?
Under its Secondary Market Corporate Credit Facility (SMCCF) the Federal Reserve is buying the individual bonds and exchange traded funds (ETFs) of about 800 investment-grade entities. High up on the list is one of the biggest corporations by market capitalisation of them all – Apple (NASDAQ:AAPL) which is currently worth around $1.5 trillion. But then why does Apple, which famously has a cash mountain of around $200 billion, need to issue bonds at all? Probably because much of that cash is held offshore by subsidiaries in places like the Republic of Ireland and if it were to be repatriated to the USA it would be subject to a levy of 35 percent.
Other eligible companies under the SMCCF include Volkswagen (ETR:VW), Ford (NYSE:F), IBM (NYSE:IBM), Walmart (NYSE:WMT), BP (LON:BP), AT&T (NYSE:T) and Coca Cola (NYSE:KO).
Under the SMCCF the Fed will buy up to $750 billion of debt obligations. In so doing the Fed is likely to push down interest rates across the debt markets, making it cheaper for businesses to raise new finance by injecting additional liquidity. This scheme sits alongside others designed to lend to small and medium sized businesses.
The Bank of England includes Apple, EDF (EPA:EDF) and Siemens (ETR:SIE) as eligible bond issuers under its own equivalent scheme, the Covid Corporate Financing Facility. The Bank has stated that it wants to support all creditworthy businesses with UK activities – regardless of domestic or foreign ownership or industrial sector.
Bond cancellation and other tools
One proposal which has had central bankers scratching their heads is that central banks could be induced to buy government bonds with invented money – which is credited to the government’s bank account – and that the government could simply cancel those bonds at the stroke of a pen (or the click of a mouse). That would mean that the bond asset would disappear from the central bank’s balance sheet and its capital account would be written down by the same amount. Hey presto! The government gets its cash without increasing the national debt. Most of us, however, would be left feeling uncomfortable by this kind of monetary magic. Isn’t that kind of cheating? And if it is cheating that means that someone is going to lose out.
Andy Haldane, the Bank of England’s Chief Economist, told the Daily Telegraph in May this year that the optics of bond cancellation “look absolutely horrific”. He said: “I don’t think bankrupting your central bank and having to recapitalise it is a good look right now”. This suggests that there would be resistance to bond cancellation by the current management – but that does not mean that this kind of monetary sleight of hand could be ruled out in the future. The Bank of England has reserves (capital) of over $100 billion.
Just two years ago in June 2018 the UK Treasury paid £1.2 billion to the Bank of England to bolster its capital so that it could play a more active role in stimulating the economy. The then Governor, Mr Carney said a larger balance sheet would make it easier to start selling off the £435 billion of government bonds it had bought under numerous QE programmes since 2009[i].
Another tool available to central banks is yield curve control. The Bank of England may wish to follow the example of its Japanese counterpart and adopt this. That is to say, it could buy bonds at the far end of the borrowing curve in order to lower rates overall. It should be noted that this would have the effect of lowering annuity rates on which most people in the UK who have defined contribution pension schemes depend. Annuity rates have fallen dramatically since the financial crisis for people in their sixties and seventies such that many are retiring on smaller pensions than anticipated.
The gilts that the Bank of England has bought in the open market and which reside on the assets side of its balance sheet could, in turn, be sold off to third parties in exchange for cash. That would have the effect of reducing the money supply – in effect, it would be QE in reverse. That would drive up the yields on those bonds and so could prospectively increase the government’s funding costs. But few commentators see that happening quite yet.
QE Case Study: Japan
The contemporary dependence on QE as an economic tool began in Japan. In the late 1980s Japan was booming with stock and property prices bid up to insane levels. Famously, the grounds of the Imperial Palace in Tokyo (about five hectares) were thought to be worth more than all the real estate in California. But after the boom came the bust and Japan spent virtually all of the lost decade of the 1990s in economic stasis with almost no growth at all.
In a bid to forestall imminent deflation interest rates were set to near-zero in 1999; and, in 2001, the Bank of Japan first conjured with the dark arts of modern monetary policy. There was some respite after 2006 but QE was resumed after 2008 and has been almost continuous ever since. The balance sheet of the Bank of Japan now stands at about 90 percent of the country’s GDP and has grown more than any other. And yet there has been no inflationary outcome. Since 2000, Japan’s average inflation rate has been 0.1 percent, despite the official inflation target of two percent.
Over the same period Japan has become one of the most indebted countries in the world. At the beginning of this year its debt-to-GDP ratio stood at 240 percent. Most analysts are not too spooked by that because most of that debt is held by domestic financial institutions. More surprisingly, the huge expansion in the country’s money supply (it has quadrupled even since 2013) has had little effect on bank lending. And the government has still tried to contain the expanding fiscal deficit, even by hiking indirect taxes.
Part of Japan’s tug towards deflation arises from demographics: the country has an ageing population which has actually begun to decline. A recent report by the University of Washington and published in The Lancet estimated that Japan’s population is projected to fall from a peak of 128 million in 2017 to less than 53 million by 2100.
Japan may not necessarily be a role model – but nor does it stand as a warning of the dangers of excessive reliance on monetary economics.
QE in Emerging Markets
Until recently QE was an esoteric practice unique to the cosy club of the G-7’s central bankers. But now we know that even some developing countries have jumped on the bandwagon.
During the week of 06 July, Bank Indonesia agreed to buy Indonesian Rupiah 574 trillion of government bonds in the primary market at below market interest rates, thus beginning the direct monetary financing of the Indonesian government’s fiscal deficit. That equates to US$ 40 billion or 3.6% of the country’s GDP. Indonesia’s parliament suspended the legal limit on the government’s fiscal deficit to three percent earlier this year.
Bank Indonesia’s move takes QE in the emerging markets in a new direction. Faced with this year’s Covid-19 pandemic many emerging market central banks have started to use QE to stimulate their economies. Hitherto, they had been highly circumspect. With only shallow pools of domestic institutional savings, most developing countries have been concerned to reassure the foreign investors who have traditionally funded much of their governments’ fiscal deficits.
The Philippines’ and South Africa’s central banks have previously characterised their secondary market purchases of government papers as a strategy to smoothen short-term market volatility, rather than to fund government borrowing. In Brazil, the central bank president has resisted using his new powers to undertake QE so long as local interest rates remain above zero. And in India, Narendra Modi’s government has favoured the use of loan guarantees and other liquidity support measures over any recourse to QE.
Thus far, Bank Indonesia’s initiative with has not incited any negative market reaction. The yield on the 10-year local currency government bond fell by ten basis point, while the rupiah remained stable. In part this reflects relief that Indonesia’s proposed plan is relatively modest. Although Jakarta’s 2020 fiscal deficit is now projected to hit 6.3% of GDP, up from earlier estimates of 1.8%, it will be considerably smaller than the double-digit deficits expected in Brazil and India.
Over recent years Indonesia’s monetary aggregates have been growing in line with nominal GDP, analysts suggest; so extra fiscal spending is unlikely to create any additional demand pressure. Therefore, there is little immediate risk that Jakarta’s fiscal expansion will unleash inflation.
However, the potential impact on Indonesia’s external position is a cause of concern. With only a thin base of domestic savings, Indonesia has long been dependent on foreign capital to finance government spending. This foreign funding is sensitive to external liquidity conditions. All emerging market economies are at risk of financial shocks which trigger a flight to quality. In March, for example, the central bank of Turkey burned through about half of its foreign exchange reserves to prop up the Turkish Lira. Without a deep domestic institutional investor base, which has stabilising effect, any combination of rising yields and a weaker currency could precipitate forced selling by foreign investors who wish to reduce their risk exposures.
Overall, if more emerging markets embrace QE, that will not necessarily result in inflation, but will likely make those markets more volatile, not less. On the other hand, if emerging markets can print money to buy up local bonds, then solvency risk on domestic currency papers (both government and corporate) will fall – though inflation risk (and therefore currency risk) will rise.
Conclusion & Action
We still don’t know if, long-term, the universal adoption of aggressive monetary policy by central banks will result in a new wave of inflation. But the risk that that could occur is rising. Thus far the forces of deflation and inflation have been tightly balanced. Traditionally, the ultimate hedge against inflation has been gold. Thus, the stocks of gold miners and the price of bullion have done well of late. But the case for gold is even stronger than that. Investment guru Doug Casey thinks that the era of QE, with China vigorously promoting the renminbi, will inevitably end with the return to the gold standard. My own view is that it is likely to be a digital gold standard – i.e. a universal digital currency which becomes the benchmark for all commodities. I’ll unpack that idea elsewhere.
In a sense, the escalation in the price of big tech stocks is also a symptom of rising inflation risk as investors favour large firms with strong cash flows that seem to be inflation-proof.
Economic policy globally is being set on the basis that interest rates will remain at near-zero levels indefinitely. That is not realistic – unless global deflation further to population decline kicks in earlier than expected, which is going to happen in Africa soon. MoneyWeek’s Merryn Somerset Webb recently recommended for summer self-isolating reading The Shock of Population Decline. I’ll have more to say on that soon.
Suffice to say that it reinforces the case for non-financial assets such as agricultural land (my personal preference) and precious metals – gold, and of increasing interest, silver. As I sign this article off (27 July) gold has reached a record high. Something significant is afoot.