FYI | Oct 06 2010
By Greg Peel
Remember the expression “moral hazard”? We haven't heard it for a while. It began being bandied about early in the global credit crunch and then became very popular when the GFC hit in earnest. In short, the moral hazard argument was targeted at the policy of “saving” the very financial markets which had, through their greed and mismanagement, caused the GFC, with the taxpayer, who for the most part was the innocent victim, picking up the tab. In the US case, it was one of Main Street paying for Wall Street's destructive excesses.
It was an argument more specifically put forward against bank bail-outs, and bail-outs of other organisations including Fannie and Freddie, AIG and General Motors. It was their own fault, the moral hazardists argued, so it is they who should pay, not the taxpayer. Failing institutions must be allowed to die so that a new, more frugal regime can rise from the corpses.
A fair argument, but the problem of course was that the inevitable global depression would have been so severe as to render any arguments of morality misguided. Main Street would not have been paying with taxes, but it would have being paying with jobs, businesses and livelihoods. So instead, representatives of the major world economies – the leaders, finance ministers and central bankers of the G7 and the wider G20 – got together and agreed upon a coordinated attack through fiscal and monetary policy stimulus.
And so QE1 became part of the arsenal, which included a US$1.7trn Treasury bond and mortgage security purchase plan by the Fed atop a cash rate cut to zero. The Bank of England also commenced QE, and the European Central Bank and Bank of Japan began providing cheap loans to banks. Across the globe, cash rates were slashed and budgets plunged into deficit from stimulatory hand-outs.
And it worked. At least, it worked in preventing the Great Depression II and then it worked in effect that the global economy did indeed begin to recover, thanks to a little help from China and other emerging economies. The “moral hazard” argument mostly faded away.
But now that the fiscal stimulus has been removed, and in some cases QE1 measures wound back, developed economies are merely slipping into the mire once more. It can all be crystallised down to a failure, in the large developed economies, to reduce unemployment.
The history of past recessions shows that it is normal to have a bit of a stimulated honeymoon period followed by a slip back to slow growth, but it also shows that (apart form the Great Depression) the global economy post-2008 should have recovered by now. It hasn't, and that is why the world is reconsidering, or re-implementing, QE.
“The patient's not responding doctor.”
“Then double the dose”.
It was a couple of months ago now that the Fed first began touting QE2 in response to suddenly weakening US economic data. The ECB had already been forced to deliver its own version of QE2 in the form of bail-out funds against potentially defaulting sovereign debt, and the rest of the world had seen any growing confidence nipped in the bud by the European crisis. Ironically, the ECB has now been slowly withdrawing that stimulus. But in the US, UK and Japan, the impact continues to linger. It is likely that even without the European crisis the developed economies would still have begun losing their recovery momentum.
When Japan's Ministry of Finance began intervening in currency markets last week to prevent the yen running too far, too fast, economists assumed this would be backed up with some extra monetary policy measures. So far the BoJ had been providing cheap credit facilities on three-month and six-month maturities in a similar vein to the ECB, and its QE program had totalled Y30trn (about US$360bn). The BoJ had held its cash rate steady for a long time at 0.1%.
But last night the BoJ surprised economists by announcing a larger suite of measures. The cash rate would be dropped to a range of zero to 0.1%, the QE pool would be expanded from Y30trn to Y35trn, and while Y3.5trn of the extra would be used to buy Japanese bonds, the balance would be used to buy corporate bonds, exchange-traded funds (ie stocks) and real estate investment trusts (ie property). The BoJ will be buying “Treasuries” and financial assets, all in a hope to re-stimulate its long-sluggish economy.
It sounds very aggressive, but the economists at Danske Bank argue it's not really that aggressive. The extension from Y30trn to Y35trn and the addition of some smallish asset purchases is not really “shock and awe”. But it does open the way for the BoJ's balance sheet to be expanded even further down the track.
Wall Street nevertheless took the view that the BoJ's move will only provide a “hurry-up” for a Fed which has been talking about, but not implementing, QE2 for a while now.
In the meantime, the Bank of England has held its cash rate steady at 0.5% for some time and has maintained a balance of GBP50bn (about US$80bn) from QE1, while all the while debating whether QE2 might be necessary. Like the Fed, the BoE has implied it stands ready but would only pull out QE2 if things really began to deteriorate. The BoE managed to keep QE2 holstered all through the European Union's (of which the UK is a member) eurozone crisis.
But the UK has been forced to join the rest of Europe in implementing austerity measures in the face of excess sovereign debt which amount to cuts in fiscal spending. Cuts in fiscal spending may ease government debt burdens, but they only serve to crimp the private sector and the end-consumer. The hope was that the UK economy could recover enough under its own steam to avoid QE2, but with the UK economy now looking like coming in for a “hard landing” and house prices once again beginning to fall, the need for added monetary policy measures to offset reduced fiscal policy measures is becoming more urgent.
That's why Danske Bank believes the BoE will, at its scheduled monetary policy committee meeting on Thursday night, announce QE2. The Danske economists note they are the only group on Bloomberg's survey list that expect this outcome. In other words, it will be a surprise to most.
Danske is not predicting a BoJ-style tick-up in QE spending, but a big jump from GBP50bn to GBP250bn.
Danske notes that the market has not been expecting any QE2 move from the BoE until after the the third quarter UK inflation report is released in November, but realistically the BoE does not have an inflation mandate. The central bank does not have to spend the extra GDP250bn in one hit, Danske points out, but it can at least announce the arsenal is ready.
And that's one important point to remember about monetary policy. Central banks don't move financial markets by implementing monetary policy measures, they move markets by suggesting they will implement monetary policy measures. It's not a lie – it just means if the markets spring into action then it may be that the knowledge that funds stand ready if need be is enough to achieve a specific goal without ever having to use all the funds.
Danske suggests that, to a large extent, the BoJ's move last night was more of a PR exercise in this vein than anything else given it was not as aggressive as it appeared.
So the BoJ has moved, and if the BoE moves, one can only expected the Fed is next. Not that the Fed is likely to be forced by other central banks, but it's been talking about it long enough, and the risk is that the US dollar could rally if everyone else is devaluing and thus stymie the improving US export sector upon which a lot of faith is based. But if everyone who feels they have to move to QE2, will it work? Obviously it didn't work the first time.
Well, a simple argument would be that QE1 did actually work but not enough, so more is needed before QE in total can really have its impact. And funnily enough, there hasn't been a lot of “moral hazard” talk bandied around this time. But Citigroup's North American equity strategists warn that QE2 in the US could have “unintended consequences”.
The rule of thumb, notes Citi, as derived from previous recessions and subsequent monetary policy easing exercises, is that there is a nine-month lag before a lower cost of debt translates into corporate investment in plant and labour and capital programs – economic growth. We recall that the Fed first applied QE1 in March 2009 and by the December quarter the US economy was back posting positive GDP growth. However, it all depends on corporations doing what the Fed intends them to do.
Consolidation across companies and sectors is an inevitable factor post any recession as the strong swallow up the weak, but Citi argues access to cheap funding only provides further impetus for such mergers and takeovers. An important factor in M&A is the capture of cost synergies, which can include consolidating two workforces into one that is smaller than the total.
It is important to note that US corporations can currently, even before QE2, raise long term funds at historically low rates. Some corporates are even borrowing at a rate lower than they're paying in dividend yield. And in some cases those funds are being used to finance M&A while precious cash is being preserved. And M&A activity has picked up considerably.
Corporate borrowing rates are ridiculously low because Treasury rates are ridiculously lower, given monetary policy. Hence corporations have an incentive to “buy rather than build”, acquire another company, and sack half its workforce. That's hardly going to reduce unemployment.
It is also important to note that while low interest rates are intended to stimulate, low interest rates also mean lower incomes for those with interest-bearing investments. Clearly low interest rates reduce mortgage costs, which encourages house purchases and also keeps the wolf of foreclosure from many a door. A consumer is more likely to spend if his mortgage is secure. But then an investor in interest-bearing securities will have less income, and is thus less likely to spend.
If you consider that it is lower income (and thus lower spending power) consumers most likely to have mortgage problems, and higher income (and thus higher spending power) consumers liked to be invested, then it may be you are actually reducing the net amount of spending power through easier monetary policy, as Citi warns.
This investment income argument can be extended to “mega” corporations which employ thousands of workers on pension plans which they're finding more difficult to service in a low interest rate environment.
And finally, if the US economy is weak but emerging economies are strong, the incentive is there for US equity investors to invest offshore and not onshore. US corporations can tempt back US investors by offering handsome dividend payments that they can't get offshore. Where might one find the money for such dividends? Easy – just borrow it. So that cheap corporate money may well not find its way into plant and labour at all, but into the pockets of investors.
Of course, such arguments can be put up for QE across the globe and not just in the US. It appears the world is now set to move into a Phase Two of monetary stimulus. As to whether it will have any benefit, other than pushing up the price of gold, is yet to be seen.
