The extraordinary loose monetary policies followed by central banks in the developed countries post the 2008 financial crisis has achieved some of its aims but also caused distortions. Politicians rather need to up their game now.
In Mahabharata, the great Indian epic, Karna has a special astra (a supernatural weapon), given to him by Indra, the king of gods (the Indrastra), that he carefully saves for his nemesis, Arjuna. During the war, though, as Ghatotkatcha, a ferocious giant, fighting for the Pandavas, threatens to destroy the Kaurava forces in one night, he is forced to use this weapon against Ghatotkatcha, so when he finally does face Arjuna, he is one astra short. Karna though, had several other astras saved for Arjuna.
Unfortunately, the largest central banks of the world (the US Fed, Bank Of England, European Central Bank and the Bank of Japan) don’t seem to have this comfort. One key concern that financial markets have today is whether central bankers have run out of ammunitions to face the current global scenario, much less react to the next recession.
A bit of background, the financial crisis of 2007-08 was very different from a regular recession, in that it threatened to disrupt large financial institutions and entire markets (such as the one for mortgage securities). To deal with this, most central banks felt the need to go an extra mile. The response typically included;
- Taking short-term interest rates to zero (known as ZIRP or Zero Interest Rate Policy);
- Buying longer-dated bonds in the market to also keep long-term interest rates low (QE, or Quantitative Easing).
These policies generally helped the large economies to quickly recover from the impact of the crisis.
The positive impact :
- Reducing unemployment: Data shows unemployment coming down from a peak of 10 percent in Oct, 2009 to nearly 5-odd percent by November, 2015, in the US. (However, the labour force participation rate has fallen from 66 percent to 62 percent). Unemployment rate in Japan has fallen from a peak of 5.6 percent to 3.1 percent and in the UK has fallen from a peak of 8.3 percent in 2011 to 5.4 percent now.
- Improving GDP growth: US GDP growth recovered to 2 percent+ (2014) from -2.8 percent, Japan’s from -5.5 percent to 1.6 percent (2013) and UK’s from -4.3 percent to 2.8 percent in 2014.
- Impact on asset prices: FTSE (the UK stock benchmark), recovered from 3,530 to a top of 7,089 in Apr 2015, S&P 500 from 683 to 2,100s and Nikkei from 7,173 to a top of 20,724. Real estate price indices, especially in some pockets showed strong growth. Bond yields of all developed countries have fallen, so prices have increased.
But all this came at a cost
- Savers v/s spenders: Think of a retiree dependent on pension income for survival. Assume that the pension income is tied to interest rates for the most part (quite realistic really). The QE programs pushed yields so low that it became impossible to get meaningful yields without taking substantially higher risks compared to the past. Even today, a 10-year US government debt gives you less than 2 percent, compared to 4 percent or so historically. This resulted in substantially lower incomes for pensioners. On the other hand, lower interest rates would make borrowing and spending easier (so good for spenders).
- Risk taking: The logical extension of the above has been compromised on risk management policies in the search for yield. As an example, think of a pension fund starting to invest in riskier assets such as junk bonds (bonds rated below investment grade by rating agencies). In fact, the most popular junk bond ETF rose 30.5 percent between March 2009 and July 2014. Valuations in equity markets also rose to record highs with S&P 500’s PE ratio rising to a high of 20x (in 2015) v/s a 100-year average of 15x.
- The Central Bank Put: Another result was suppression of volatility. VIX (a measure of volatility), which averaged 20 percent from 1990 to 2011, averaged just 15 percent since 2012 to 2014. This resulted in a strategy to bet against volatility and an unsustainable hope that central bank would boost easing with every market correction.
- Market signals: Again betting on easing to support markets led markets to correct with every good news on the economic front (with an expectation of higher rates/QE cuts) and cheering every bad news, leading to a ‘bad is good,’ market reaction.
- Productive investments vs capital returns: As per S&P Capital data, while capex budgets for S&P 500 have grown 44 percent since 2009, dividends have grown 80 percent and buybacks have jumped fivefold (the latter largely funded by cheap debt). The logic is easy, low cost of funds v/s dividends mean companies can borrow to buyback shares, thus saving on dividends and getting tax saving on interest payments. Low long-term investments (capex and R&D) means low prospects of future growth.
- The M&A boom: “A heady cocktail of ultra-low financing costs and the search for growth across sectors propelled US M&A growth up 60 percent (yoy) to $987.7bn (in 1H 2015), the strongest first half since records began in 1980,” an article in FT said. Global M&A also rose 38 percent. Average deal valuation of US deals rose to a record high. M&A appetite also hit a high. An E&Y study in Oct 2015 found that, of more than 1,600 executives from 53 countries, 59 percent had plans to make an acquisition in the next 12 months.
Did QE surely contribute to GDP growth: A study by the Institute for Policy Research, UK titled, “A Very Large Gamble: Evidence on Quantitative Easing in the US & UK,” asserts that though QE resulted in GDP growth in 2009 being 1.5 percent to 2 percent higher than it would have been without, evidence on more recent rounds suggests “little impact on real economy.”
For the greater common good?
US Fed Chair Janet Yellen defended easy money policies using the argument of job creation, which benefitted the most vulnerable sections of the society. This in her view, outweighed all costs, but is it so simple? And how sustainable are these policies?
A bit of a reflection on the financial crisis of 2007-08 and its aftermath, the major investment banks, which were instrumental in creating a major bubble in the US housing market had to be bailed out using the tax payers money. This led to a feeling of anger and mistrust in general public towards the financial services industry in general and large investment banks in particular.
Looking at the above problems (of the easy money policies), leads laymen to the criticism that most of the monetary (and fiscal) policies since the crisis resulted in disproportionately benefiting the same people who were responsible for the crisis, while leaving the large majority in a worse off position. This feeling of a “rigged economy” in favour of “Wall Street and the large banks” is clear in the US presidential election race.
The popular criticism
- Growing income inequalities with one study predicting that as much as 95 percent of the income gains between 2009-12 went to the wealthiest 1 percent.
- The focus on stabilizing asset prices for an astounding 7 years by the Fed, which led to protection of wealth of the rich;
- Boost in M&A activity, leading to synergies which then translated as job cuts;
- Impact on retirees – low yields leading to lower incomes;
- While unemployment is strongly down, critics say jobs are of poorer quality: a large proportion of part-time jobs, low paying jobs.
Note: Firstly, common citizens don’t probably attribute some of these problems to central banks as such, but to the establishment in general and secondly I don’t agree with all the above, though inequality could partly be attributed to easy money, quality of jobs has probably resulted from structural changes. However, this is important to note here as this dogma is what further drives political reactions.
While economists are worried about:
- Low productive investments v/s buybacks;
- Poor allocation of resources;
- Growing income inequalities;
- Low inflation globally, possibly a deflationary scenario which could result in a long-term global slowdown.
My take on the above issues is:
The objective of maintaining stability of asset prices for the central banks needs to be seen in the context of ensuring normalcy in the financial markets. If central bankers decide to support markets on every correction, surely, markets would fail to function effectively. The best proof of this thesis is the US stock market, which continued to trade at above average multiple in 2015 even though earnings and revenue were declining.
Secondly, the only reasonable justification one can think of continuation of ZIRP for 7 long years would be competitive devaluation; weaken your currency so your exports become attractive. But wasn’t this same policy adopted by China criticized by the US. Now that Europe and Japan are doing the same, where does this end?
Could optimal long-term decisions be taken by businesses in such an environment at all? What happens to the investment in increasing capacity based on these exchange rates, when the exchange rate advantages reverse? There is increasing agreement that easy money resulted in poor allocation of resources and overcapacity.
Today, the biggest fear policymakers are facing is deflation. Today’s low material prices have probably largely resulted from the fiscal stimulus led investment boom in China during 2008-13. As per one statistic, China used more cement in 2011-13 than the US used during the entire twentieth century.This boom resulted in material producers overestimating demand leading to overcapacity, leading to current collapse in prices. So, in a way, the current deflationary scenario is a direct result of stimulus continuing too long.
Some economists have compared fiscal/monetary stimulus to steroids in terms of their temporary gains resulting in complications in the longer-term. Today, we have a situation where a large proportion of experts – economists, policymakers, and money managers all worried about deflation, recession or even hyperinflation (though this is a minority) which shows the level of uncertainty, a direct result of central bankers’ continuing communication that economies have still not fully recovered from the crisis and hence still need easy money conditions. One may ask if something hasn’t worked for 8 long years, what makes them think it would work now?
In my view, the cause of the current situation is a mix of poor demographics and inability/indecision of the political class. In almost all large economies of the world, possibly except China (where confusion, not indecision seems to be the problem), politicians are too frightened to do what is needed. To quote Jean-Claude Juncker, “We all know what to do, we just don’t know how to get re-elected after we have done it.”
In this situation, onus has repeatedly fallen on non-political institutions such as courts, central banks etc to keep the engine running. Much like Karna was forced to use the weapon by his friend Duryodhana, their political masters kept pressurising central banks for greater stimulus to boost growth. But how sustainable is this? In the fight to defend growth in their respective economies, have central bankers used up their weaponry leaving them helpless when the next recession arrives?