After the financial crisis, a new normal seems to have appeared where growth is subdued, inflation almost non-existent, debt levels elevated and increasing. As we explained in an earlier article, this is a toxic combination that has a tendency to be self-reinforcing:
- High debt tends to reduce spending and borrowing in an attempt to improve balance sheets (deleveraging).
- Deleveraging renders monetary policy powerless (liquidity trap 'pushing on a string').
- A prolonged deleverage process is likely to produce damage to the supply side and thereby affecting future growth through hysteresis effects (the reduction of quality and quantity of factors of production through inactivity).
- The reduced growth, lowflation (or even deflation) and slow decay of the supply side worsens debt dynamics as debt/nominal GDP ratio worsen.
- The worsening of balance sheets can lead to forced asset sales, declining the asset values that underpin debts, thereby worsening bank balance sheets, which is likely to negatively impact the supply of credit.
This is why the world's central banks have pumped inordinate amounts of money into the system, first as direct emergency aid to keep the system from collapsing, then in order to make the deleveraging process less painful.
These policies have met with an almost equal inordinate amount of criticism, but we shouldn't lose sight of the fact that they did indeed greatly contribute to keeping the financial system from collapsing and the world economy from plunging into another Great Depression.
Critics predicted mayhem in the form of runaway inflation, dollar debasement and a crashing bond market. Nothing of that has happened; in fact, quite the opposite.
Take Japan. Their public deficit and debt situation is basically off the chart, their monetary policy super expansionary but they are still basically on the edge of outright deflation and their 10 year rate, well:
It's the first one in the developed world (or any world) to hit negative territory for the 10 year bond. The only part of the prediction that did seem to hold was the weakening yen, although whether this can be called currency debasement is rather questionable, given the zero inflation. And now even the yen is strengthening.
It looks like the deflationary forces are way stronger than many thought possible. One reason is of course already contained in the above, when balance sheets are stretched and many are if not actually trying to deleverage at least not willing to engage in more borrowing and spending, monetary policy itself becomes rather powerless.
While academic research, on balance, showed some modest positive results for QE policies, the crucial transmission mechanism to the real economy, interest rates, is rather muted when balance sheets are stretched already.
While some traction has gotten from the modest effects on interest rates and wealth effects, it has worked mainly via exchange rates, especially in Japan and the eurozone.
But now that the world slowdown has even gotten the Fed worried and the path of interest rate rises that they sketched in December is rapidly disappearing behind the horizon, even that seems to come to a grinding halt:
The euro has rocketed by more than 3pc this week to $1.12 against the dollar. In trade-weighted terms the euro is 5pc higher than it was in March, when the ECB began quantitative easing, showing just how difficult it has become for authorities to drive down their exchange rates. Everybody is playing the same game. [The Telegraph]
Both the yen and the euro are strengthening rather alarmingly against the dollar, reducing much of the boost from unconventional monetary policy. The yen especially is ratcheting upwards threatening to throw Japan back into deflation.
Basically we find ourselves in a S>I world, a world in which savings exceed investment. Part of this is demographics, part is the decrease in cost of capital goods (in part driven by Moore's Law), part of it is rising inequality shifting income from low to high savers.
Perhaps the biggest part is simply the stretched balance sheets almost everywhere.
The result is slow growth, no inflation leading to worsening debt dynamics almost everywhere and the hysteresis effects of persistent output gaps eating away the quality and quantity of future production capacity.
Keynesians have always argued monetary policy isn't the way to combat this, although many (including us) have argued that because of lack of fiscal action (or debt restructuring), it's better than nothing.
We might actually have to revise that opinion and open ourselves up to the possibility that certainly decreasing, and possibly negative returns to unconventional monetary policy are setting in.
QE, like ZIRP, is supposed to work mainly through the credit mechanism, but when balance sheets are already stretched both credit demand and credit supply are likely to be soft, and not interest rate sensitive.
The latest instrument, negative interest rate policy (NIRP) might also not pan out as expected:
The Europeans were concerned about this, based on earlier Danish experience when the central bank started charging negative rates on excess reserves held by the banks at the central bank. The expectation is that this will lead to lower lending rates. But you can easily think of a story where this is not the outcome because those negative interest rates cut the banks' profit margins. And then the question is what will the banks do to restore them? Well, one thing they could do is lower the deposit rate. I read in the Financial Times a few days ago that Julius Baer in Switzerland is thinking about doing just that. But then the worry is that people will take their money elsewhere, take it out in cash or whatever. If this is not possible, then what is possible is increasing the lending rate. What you end up with is a counterintuitive but highly plausible alternative description of what these policies are going to give you. So in the end they may end up being contractionary and not expansionary. ET: Actually we do have some empirical evidence after some central banks adopted NIRP, such as Switzerland, Sweden and Denmark. As interest rates fell, people saved more, which is the opposite of the policy objective. It seems that because people, particularly the older folks, earn less interest they have to save more to meet their needs. [Zero Hedge]
So it's unlikely ZIRP is going to do much, and it might very well do nothing or even be counterproductive. Consider the following:
But the collapse in banking stocks suggests strongly that negative interest rates are not compatible with our current economic institutions. The system relies on the banks, and the banks need to make money, and they struggle to do so in a negative rate environment. Should it be any surprise that the threat of global negative rates is slamming the financial sector? If then zero (or something just below zero) is indeed a practical lower bound, and all major central banks are pulled in that direction, then the scope for policy divergence is limited. [Tim Duy's Fed Watch]
At least part of this explains the cratering bank shares we've seen in global markets.
There is one advantage in an S>I world, which is that increasing spending doesn't have the usual inflationary consequences.
Add to that the fact that mild inflation would actually lessen the balance sheet problems, and we still think spending should be part of the solution. Either that or debt restructuring.
The point simply is, on its own, central banks are unable to create extra spending. This realization is setting in and is a main reason why financial markets are selling off so viciously.
The unconventional policy left is helicopter money. For a fraction of QE, which simply disappears into a dysfunctional financial system, useful stuff can be done (infrastructure, education, research, etc.) that is guaranteed to get traction in the form of closing at least part of the S>I gap and improving the supply side at the same time. But don't expect this anytime soon, and it's not risk free either.
As many balance sheets are stretched, unconventional monetary policy was never going to be very effective. This isn't a surprise to Keynesians at all. In essence, it's the Keynesian liquidity trap.
However, after several years of experience, we might have to arrive at the conclusion that these policies could do more harm than good.
The realization that central banks have run out of ammo is now dawning upon the financial markets, and the result is ugly.
However, in order to improve balance sheets, one of three things (and considering the size of the problem, probably all three) have to happen:
- Increase growth
- Increase inflation
- Restructure and write off debt.
Other policy measures will have to be found to achieve these.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.