"Financial Repression" should be at the forefront of every investor's lexicon.
- Caps or ceilings on interest rates
- Government ownership or control of domestic banks and financial institutions
- Creation or maintenance of a captive domestic market for government debt
- Restrictions on entry to the financial industry
- Directing credit to certain favored industries
The Fed and Treasury have accomplished all of the above. This should not be surprising, given Bernanke's philosophy of activism.
Why Interest Rates Are Not To Be Meddled With
Keynesian theory posits that governments should attempt to manage the business cycle by lowering rates during recession and raising them should the economy "overheat." (Counter-cyclical policy) Some suggest they should even actively pop asset bubbles.
The Austrian School of economics warns against such central planning.
Interest rates are supposed to reflect the time preference of money. As Murray Rothbard describes in "For A New Liberty," (pg. 233-4):
Time preferences determine the extent to which people will save and invest for future use, as compared to how much they will consume now.
If people's time preferences should fall, i.e., if their degree of preference for present over future declines, then people will tend to consume less now and save and invest more; at the same time, and for the same reason, the rate of interest, the rate of time-discount, will also fall.
Economic growth comes about largely as the result of falling rates of time preference, which bring about an increase in the proportion of saving and investment to consumption, as well as a falling rate of interest.
But what happens when the rate of interest falls not because of voluntary lower time preferences and higher savings on the part of the public, but from government interference that promotes the expansion of bank credit and bank money?
What happens is trouble.
The Austrian School posits that market computation is superior to the agenda of individuals within government, and any interference will create false price signals and mal-investment, misrepresenting the amount of savings ready to be invested and channeling it into the wrong ventures.
The Keynesian school posits that sufficiently depressed markets cannot revive themselves, the business cycle should be massaged, and government intervention is necessary.
Regardless of which perspective you see, there can be no denying that these ultra-low interest rates are historically without precedent.
The Federal Reserve aggressively entered the bond market under the auspices of averting catastrophe in 2008, and has done so every year since.
Consequences of Current Policy
In a free market, low interest rates signify to the markets that savers are willing to postpone consumption and allow entrepreneurs to invest their savings in future consumption.
Artificially lowering interest rates during a recession has the following consequences:
Entrepreneurs are led to believe that the conditions are ripe for risky ventures; it's much easier for a business to survive when paying 1.5% than 6% on its debt. When these unsustainably low rates change, businesses fail.
2) Consumer credit explosion.
Since the 1970s, real wages have been stagnant. In order to accommodate a steadily rising standard of living ("American Dream"), consumers bought on credit.
Credit has a positive GDP multiplier when channeled into production; debt results in a temporary boost in consumption followed by a drag on overall economic activity later (its severity is determined by the average interest rate over that period. With some consumers paying 20% on their credit cards today, this drag might be considerable).
(For more on effects of wealth disparity, see Stiglitz' "The Price of Inequality.")
3) Increased risk / overvaluation.
Investors and financial institutions are incentivized to invest in riskier assets. We are seeing this right now with dividend-paying equities and risky debt securities like municipal bonds and junk debt.
Classically, money flows from fixed income will find their way into other assets: equities, commodities, derivatives, etc… The tendency is an overvaluation of non-debt securities alongside the artificially high prices in government bonds and other debt securities. Today, we see a veritable bubble in treasury bonds and a moderate overvaluation of equities.
Some types of investors depend on interest from fixed income. These include pensioners, retired people, university endowments, sovereign wealth funds, insurance companies, and anyone that has a need for low volatility, liquid assets and/or considerable cash on hand. Some funds, realizing the negative real yields of treasuries, gilts, bunds, etc., have been diversifying into land, dividend-paying equities, and commodities.
This is impossibly risky in a global financial system that is perpetually inches away from the precipice of catastrophic failure, and the solvency of these big, slow moving capital pools is integral to the stability of the real economy.
5) Ultra-low rates punish savers.
This one is straightforward: if someone saves a dollar today that will be worth less tomorrow when they want to invest it, the aggregate potential of future investment drops. Cash savings (how most people save) are destroyed. If too much savings disappears into the black hole of inflation designed to finance government ponzi spending, the capital formation process will falter.
6) Finally, and receiving the most fanfare, is runaway currency devaluation.
Many investors fail to grasp how money is created: under this system of "modern money mechanics," central banks create currency and exchange it with the Treasury for interest-bearing bonds. In order to lower bond rates, the central bank must (through private banks and primary conduits) buy already-issued bonds from the open market, raising the price and lowing the yield. (The central bank can also collude with Treasury and primary dealers at auction).
In order to lower yields, the Fed must issue currency. (Central banks also often sterilize their purchases, meaning they sell certain bond maturities to buy others -- resulting in a net zero effect on the money supply).
Governments love low interest rates: it allows them to finance outlays, the domestic economy grows, the currency weakens (boosting exports and devaluing outstanding debt), and the persistent low-level inflation prevents the masses from being completely rendered debt-peons (some natural rate of debt peonage is acceptable, of course).
Just as the zero-interest rate policy (ZIRP) is historically unprecedented (and on a global scale, no less), so are these levels of excess reserves held by banking institutions.
In a statement in July, the Fed considered lowering interest paid on bank reserves (below 25 basis points), even after Bernanke suggested it was too drastic in February.
This measure is intended to cajole banks into making loans again. But the demand for credit is low to begin with, so they end up speculating in derivative markets (London Whale) and manipulating key facets of the global financial system (LIBOR) instead. They might even manipulate precious metals markets on behalf of the government.
It is doubtful that this measure will spur economic activity enough to justify the damage visited on the type of fixed-income investors already mentioned.
Brief History of Fed Interventions
|Sept '-07today||The Federal Reserve cuts interest rates from 5.25-0.25%|
|'08March||The Bear Stearns deal: Fed assumes $30 + billion in junk mortgage securities|
|'08March||The Fed opens up various lending windows to investment banks|
|'08July||SEC The proposes banning short selling on financial stocks|
|'08July||Hank Paulson gets blank for check Fannie/ Freddie but promises not to use it|
|Sept '08||Hank Paulson uses the blank check with Fannie / Freddie spending $4 billion in the process|
|Sept '08||The Fed takes over $85 billion for AIG (AIG)|
|Sept '08||The Fed doles out $25 billion for the automakers|
|Oct '08||The Feds kick off the $700 billion Troubled Assets Relief Program (TARP) with the Government taking stakes in private banks|
|Oct '08||The Fed offers to buy commercial (paper-non bank) debt from non-financial firms|
|Oct '08||The Fed offers $540 billion to backstop money market funds|
|Oct '08||The Feds agree to back up to 280 billion of Citigroup's (C) liabilities|
|Nov '08||$40 billion more to AIG|
|'09Jan||Feds agree to back up to $140 billion of Bank America's (BAC) liabilities|
|'09Jan||Obama's $787 billion stimulus|
Timeline by Graham Summers of Phoenix Capital Research (Source)
Add to the list September 2011 and the start of Operation Twist, a plan to purchase $400B in bond maturities between 6 and 30 years and sell short-dated bonds with maturities under 3 years, extending the average maturity of the Fed's balance sheet.
The dollar swap lines that the Fed opened to European banks in November 2011 might also be included.
To evaluate the effect of quantitative easing on the equity markets and treasury yield:
Because it is a counterfactual, we cannot know what would have happened absent the Fed interventions. Policymakers have models, but there is no way to truly know. Your humble analyst believes that, indeed, the result would have been bank failure, debt restructuring, asset fire-sale, and possibly deflation.
But Joseph Schumpeter would applaud the creative destruction of bankruptcy; it allows competing, solvent firms to buy up the dead firm's assets and use them more efficiently. "Catastrophe" also clears odious debts and lowers commodity prices.
Granted, creative destruction might have been less than creative in 2008 because the banks were interlocked, represented a huge proportion of the financial market, and were otherwise "Too Big to Fail."
A banking collapse is admittedly different from, say, Pets.com or Blockbuster going under, but moral hazard remains.
Whether the Fed Member Banks should have received no-strings-attached taxpayer bailouts and access to the discount window (including European banks) is another matter entirely.
The Slippery Slope
The stimulating logic of fiscal policy is being haphazardly applied to monetary policy. Lowering interest rates does not spur real growth as expenditures on infrastructure and public services do.
There is some evidence that fiscal stimulus is effective at averting catastrophe in the real economy. Basically, it gets people working and kick-starts aggregate demand. The effect is upward pressure on wages and the price level -- pretty straightforward. (The government may not be as efficient as the private sector in terms of development costs, however).
Monetary stimulus is more nuanced; like pushing on a string, the certainty of success is low, and the consequences of negative real interest rates are far-reaching (particularly in the money market).
The payoff may not justify the cost, and investors are skeptical of manipulation because the authorities were largely to blame for the crisis in the first place.
Bill Gross on the farcical state of affairs in debt markets:
The global monetary system which has evolved and morphed over the past century but always in the direction of easier, cheaper and more abundant credit, may have reached a point at which it can no longer operate efficiently and equitably to promote economic growth and the fair distribution of its benefits. Future changes, which lie on a visible horizon, may not be so beneficial for our ocean's oversized creatures.
Policy responses by fiscal and monetary authorities have managed to prevent substantial haircutting of the $200 trillion or so of financial assets that comprise our global monetary system, yet in the process have increased the risk and lowered the return of sovereign securities which represent its core. Soaring debt/GDP ratios in previously sacrosanct AAA countries have made low cost funding increasingly a function of central banks as opposed to private market investors.
QEs and LTROs totaling trillions have been publically spawned in recent years. In the process, however, yields and future returns have plunged, presenting not a warm Pacific Ocean of positive real interest rates, but a frigid, Arctic ice-ladened sea when compared to 2-3% inflation now commonplace in developed economies.
Both the lower quality and lower yields of previously sacrosanct debt therefore represent a potential breaking point in our now 40-year-old global monetary system.
China, for instance, may at the margin shift incremental Treasury holdings to higher returning commodity/real assets which might usher in a gradual or somewhat sudden reconfiguration of our current dollar-based credit system. Having a reduced incentive to purchase Treasuries and curtail Yuan appreciation, the Chinese and their act-alikes may look elsewhere for returns. In addition, previously feared but now tamed private market bond vigilantes like PIMCO have similar choices, if clients with their index-bounded holdings begin to broaden their guidelines.
Together, there is the potential for both public and private market creditors to effect a change in how credit is funded and dispersed - our global monetary system. What that will look like is conjectural, but it is likely to be more hard money as opposed to fiat-based, or if still fiat-centric, less oriented to a dollar-based reserve currency. In either case, the transition is likely to be disruptive and an ill omen for seafaring investors.
The world's financial markets currently seem obsessed with daily monetary and fiscal policy evolutions in Euroland which form the basis for risk on/risk off days in the marketplace and the overall successful deployment of carry and risk strategies so important to asset market total returns. Euroland is just a localized tumor however.
The developing credit cancer may be metastasized, and the global monetary system fatally flawed by increasingly risky and unacceptably low yields, produced by the debt crisis and policy responses to it. The great white whale lies waiting on the horizon. Investors should sail carefully and the Wall Street 1% should put on their life vests if they expect to weather the inevitable storm that may threaten the first-class cabins they have come to enjoy.
Avoid bonds with negative real yields (and be skeptical of officially reported inflation data). Long-term investors should not buy U.S. government securities (TLT), or those of Germany, England or Japan.
Commentators naively suggest that government bonds are somehow compatible with "return-of-capital" mindset. That presupposes that yields will not rise (causing prices to fall, incurring a loss of principle). That strategy also assumes inflation will remain contained.
Major treasury holders like the People's Bank of China have been extremely vocal about their intentions to diversify out of treasuries.
As I described in a past article, the breaking point may be near at hand, with the Fed having monetized 61% of U.S. government debt in 2011.
"Long-term government debt of the U.S., U.K., Europe and Japan probably will be the worst-performing asset class over the next ten to twenty years. We make this recommendation to our friends: if you own such debt, sell it now. You've had a great ride, don't press your luck. From here it is basically all risk, with very little reward.
Three and a half years after the bust, the massive spending, guarantees and money printing have left America with 8.2% unemployment (which vastly understates the actual level, since millions of people have simply left the workforce, while others have migrated from receiving unemployment benefits to getting long-term disability payments), sluggish growth, $5 trillion in additional federal debt, and $3 trillion of freshly-printed dollars on the Fed's balance sheet.
This is not a success. This is a national tragedy, in a society in which the world's greatest engine of prosperity has historically been fueled by innovation, optimism, entrepreneurship, flexibility and opportunity.
We believe that relying on monetary authorities to pick up the considerable slack in growth by printing money by the boatload is completely wrongheaded. It distorts both the price of money and the risks of holding long-term claims denominated in paper money, builds a future risk of large inflation, supports economic activity only in an oblique and unfair way, and creates something that is going to be very hard to unwind.
A loss of confidence in paper money could result in searing and startling inflation, evaporating life savings and turning every stolid worker into a frantic speculator.
If that were to occur, nobody could possibly say in hindsight that the conditions for such a sorry state of affairs were not in place.
The people who are telling us now that inflation is impossible because there is slack in the global economy, and that central banks can print trillions of dollars more without a significant risk of inflation, are the same folks who not only failed to predict the financial crisis, they did not even have a clue that a crisis of such kind was possible.
Investors should seek out select equities with strong balance sheets and international operations. They should also consider high quality sovereign debt with positive real yields, like that of Australia (FAX), Norway, Malaysia, the Philippines, and scarce others.
"If the world gets better, I know I'm going to make money on commodity demand. If it doesn't get better I'm going to make money on commodities because they're going to print money. In the seventies, most stocks did badly, the only stocks that did well were commodity stocks. That's going to happen again. The farmers are going to be driving the Lamborghinis."
"May you live in interesting times" happens to be considered a curse in Chinese culture… best of luck.
Note: For a more in-depth description of Financial Repression, see "The Liquidation of Government Debt" by Carmen Reinhart and M. Belen Sbrancia.