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Californication is a brilliant 1999 song by the Red Hot Chili
Peppers. Many of the lyrics reference the often insane, unrealistic,
impossible dream images Hollywood sells to the world.
Quantifornication is the term I coined for what the Federal Reserve
is selling to the world - the unrealistic, insane fiat dream that the
monetary policy employed by the Fed known as quantitative easing (QE), can
fix the predicament we are in.
Once seen as a one-off emergency measure - kind of like an epidermal for
excruciating back pain - QE has become the monetary norm. Not least because
pushing interest rates to zero or even below zero, is great for stock
markets. When the cost of borrowing is low, businesses are more comfortable
taking on debt, thus growing their profits and earnings per share.
The pullback in North American stock markets last fall was blamed on the
Fed’s raising interest rates. Conversely, stocks have rallied since the
central bank in June signaled it will likely hold rates steady or even cut
them, at its next meeting on July 31. Bond markets are anticipating at least
two rate reductions by the end of the year.
This is exactly what President Trump wants, low interest rates and a low dollar,
in order to goose exports and fix the US trade deficit he campaigned on in
2016.
But QE is a lopsided solution to a weak economy; its effects benefit
corporations and wealthy investors but do little to help the average citizen.
It was largely the failure of globalization, including QE in the US and
Europe, that led to the disgruntlement with “elites” such as the politicians
in Washington and Brussels, and the subsequent rise
of nationalism that helped elect Trump and gave rise to
Brexit.
You’d think we would have learned our lesson, but we haven’t. From
Australia through Asia, Southeast Asia, India, Europe and the United
States, quantifornication is back in style. This article tries to
figure out where it might be going.
ECB to cut rates
The US central bank initiated a series of rounds of quantitative easing
between 2008 and 2015, back then seen as throwing a lifeline to the economy
which was drowning in the financial crisis. Other countries, also hard it,
soon followed with their own monetary easing, including Japan and the
European Union.
In 2014 the US Federal Reserve felt positive enough about the US economy
returning to acceptable employment and inflation figures, that it reversed
its QE policy - by gradually raising interest rates and “winding down” (ie.
selling off) its balance sheet of US Treasuries and mortgage-backed
securities - that had ballooned to $4.8 trillion in October, 2014.
The European Central Bank also embarked on a policy of “monetary
tightening” but whereas the Fed began tapering asset purchases in October
2017, the ECB only just pulled the plug on monetary easing this past
December, when officials capped the size of their bond-buying program at 2.6
trillion euros ($2.9 trillion).
The bank’s Governing Council led by President Mario Draghi had been hoping
to continue tightening, following the Fed’s path of interest rate raises that
topped at 2.5% (the Federal Funds Rate), and also wind down asset
purchases, but things haven’t exactly worked out as planned. The EU’s economy
has been slammed by low growth particularly from China its second biggest
trading partner, low manufacturing output, and persistently low inflation - a
sign that the world’s largest trading block has stopped growing and is in
trouble.
The ECB has less room to maneuver than the US, which held interest rates
steady at its last meeting in June, and is strongly hinting of a
rate cut at the end of the month.
While the Fed can start slashing rates from 2.5%, the European Central
Bank’s deposit rate has been at -0.4% since 2016.
Last Thursday Draghi said the ECB expects borrowing costs to stay at
present levels “or lower” (the interest rate cut signal) through the first
half of 2020. Officials also indicated they will restart their bond-buying
program (QE) if needed. Economists surveyed by Bloomberg think the ECB will
cut rates by 10 points in September and start a round of monetary easing in
January.
“Draghi came into office with a bang, cutting interest rates at
his first meeting, and he’s likely to go out with a bang too. We expect him
to begin setting the stage for his final act... But we’ll probably have to
wait until September for the real drama,” they said.
The news from Germany is particularly bad. The engine of the EU’s economy
is showing the weakest business confidence in over six years, its
manufacturing sector in a deep funk. Some of the country’s largest companies
including Continental, Daimler and BASF are issuing profit warnings.
Bloomberg reported industrial demand and production are falling as
German car-makers and suppliers deal with slowing demand from
China. The US-China trade war and the prospect of the EU making a disorderly
exit from the EU at the end of October is also taking its toll.
China opening
Speaking of China, officials in the Chinese government are finally
addressing complaints that the benefits of free trade have only flowed one
way since China was admitted into the World Trade Organization in 2001.
The country is opening up its financial sector to more foreign
investment and competition. Among measures announced last Saturday, China
will scrap foreign ownership limits of financial firms a year earlier, in
2020 versus 2021, and foreign insurers can hold more than a 25% stake in
Chinese asset management companies.
The idea behind the opening is to boost demand and create new growth
drivers in an economy that, by China’s standards, is faltering. At 6.2%,
growth in the second quarter was the weakest since 1992 when the
country starting collecting data. Chinese imports in May fell to
the lowest of the year.
Contagion
You may be seeing a theme here. The US, China and the European Union are
all taking measures to stimulate their weak economies. Japan
is also expected to expand stimulus, if inflation falls below its 2%
target. The land of the rising sun’s central bank, like the ECB, has gone to
negative interest rates, to try and improve economic growth, which limped
along at 2.1% in the first quarter.
The People’s Bank of China has taken steps to boost lending, as a way
to jumpstart the economy. The central bank said in May it would lower
the reserve-requirement ratio for it small and medium-sized banks, releasing
the dollar equivalent of $40 billion to encourage more lending to small
businesses, Wall
Street Journal reports.
The publication quotes one economist saying “China has the
ability to ease more, as much as needed. If that happens, I don’t think that
Europe is going to go into recession, or the U.S. or Japan.”
Other central banks turning dovish include Turkey, which hacked its
interest rate down to the lowest in 17 years, Australia which cut rates for
the first time in three years, on China growth worries, New Zealand, India,
Malaysia and the Philippines.
Global trade slowed for the seventh straight month in May, and the
International Monetary Fund reduced its global growth outlook - already the
lowest since the financial crisis of 2008-09 - by almost a point to 2.5% this
year.
The United States is doing better than the rest, but growth is weakening
there, too. South
China Morning Post reported that a gauge of US
manufacturing activity fell in May to its lowest since October 2016. Gains in
employment, one of the brightest spots in the US economy, fell sharply, heaping
pressure on the Fed to deliver an “insurance” rate cut to sustain America’s
economic expansion.
QE was a dud
The question, though is, why return to a policy that heaped piles of debt
onto countries to such an extent that, should interest rates rise, their
payments will be so high, they’re screwed? And the spoils of asset purchases
and rock-bottom interest rates really only go to rich corporations
and wealthy investors. Add the tremendous increase in stock buybacks after
the Trump administration’s $1.5 trillion tax cut and overseas profits
repatriation in late 2017, and you begin to see why all is not well in the
land of the brave, home of the free.
I’ve always argued that QE was a dumb idea. Turns out that, with some
retrospection, others agree. Here is what I said
about quantifornication back in 2012, and again in 2016. Remarkable
how so little changed, in particular the inequality that US
monetary easing brought about.
2012:
The initial Fed response to the subprime mortgage crisis was to lower
interest rates, then, having no traditional tools left in its toolbox the Fed
introduced a new policy - quantitative easing (QE).
In September of 2008 the $1.7 trillion QE1 was started. The Fed
purchased mostly mortgage backed securities and established a commercial
paper lending facility. In October of 2010 QE2 started. At $600 billion, QE2
was much smaller then QE1 and its buying was mostly confined to
purchasing long term government bonds.
QE1 & QE2 failed to restart the economy and housing market.
The Federal Reserve has just launched QE3. Key components are:
- The creation of $40 billion a month to buy MBS’s
- The continuation of Operation Twist #2
- An open-ended commitment to keep purchasing
securities at whatever level is judged necessary until the labor market
improves "substantially"
- An extension of the 0.0% to 0.25% target range for
the Fed Funds rate until at least mid 2015
The definition of insanity is “doing the same thing over and over
again and expecting different results.”
“The Committee agreed today to increase policy accommodation by purchasing
additional agency mortgage-backed securities at a pace of $40 billion per
month. These actions should put downward pressure on longer-term interest
rates, support mortgage markets, and help to make broader financial
conditions more accommodative. If the outlook for the labor market does not
improve substantially, the committee will continue its purchases of agency
mortgage-backed securities, undertake additional asset purchases, and employ
its other policy tools as appropriate...” US Federal Reserve
“We will be looking for the sort of broad-based growth in jobs and
economic activity that generally signal sustained improvement in labor market
conditions and declining unemployment.” Federal Reserve Chair
Ben Bernanke
How effective have all these programs, with trillions of dollars
spent, been? Not very…
New orders for manufactured durable goods in August decreased $30.1
billion or 13.2 percent to $198.5 billion. This decrease was the largest
since January 2009.
Our overall workforce participation rate looks pretty dismal.
Shocking stats:
- Nearly half of Americans die broke
- One out of three Americans has no savings
- Our labor force participation rate is at a 30
year low
- Household income has fallen to 1995 levels
- There are over 46 million Americans currently
receiving food assistance – that’s one out of every seven people
- From 2007 to 2010, a typical US family lost 39% of
its wealth
- The Gini index, a measure of household income
inequality, increased 1.6 percent in 2011, its first annual increase
since 1993
2016:
The middle class has shrunk to just under half the US population for
the first time in decades, with more of the population shifting to the
extremes both above and below the middle.
Allianz’s Global Wealth Report 2015 dubs the U.S. the ‘Unequal States
of America’ because the U.S.’s wealth inequality is even more gaping its
income inequality.
Allianz calculated each country’s wealth Gini coefficient — a measure
of inequality in which 0 is perfect equality and 100 would mean perfect
inequality, or one person owning all the wealth. It found that the U.S. had
the most wealth inequality, with a score of 80.56, showing the most
concentration of overall wealth in the hands of the proportionately fewest
people.
When the Organization for Economic Cooperation and Development (OECD)
examined income inequality, it found that the U.S. has the fourth highest
income Gini coefficient — 0.40 — after Turkey, Mexico, and Chile.
The U.S. Federal Reserve ended
their quantifornication program in 2014.
The S&P has more than doubled since 2009, while the Dow Jones
has actually tripled.
Stock buyback programs, fueled by CEOs borrowing hugely from the
bond market, have supported the market since the Federal Reserve stopped
pumping money into the system.
A recent
editorial in the South China Morning Post looking back at QE, backs
my assertions, in presenting four reasons why quantitative easing isn’t the
solution to the global economy’s problems, right now:
Most worryingly, quantitative easing has exacerbated social
divides. The wealthy have benefited from higher asset prices
while those with no financial assets have seen the returns on their savings
shrivel. The reality is that quantitative easing has contributed to rising
populism in Europe and America.
Forbes
is more sanguine in its impression of easing programs. QE makes it easier
(and cheaper) for businesses to borrow money, it keeps consumer debt
reasonable due to such low borrowing rates, and by increasing the money
supply, keeps the currency low, making exports cheaper and US stocks more
competitive to foreign investors.
However the column by Tyler Gallagher, a member of Forbes Finance
Council, also comments on the inequalities QE engenders. Number one is the
fact that it benefits wealthy borrowers and corporations but not the average
Joe and Jane:
QE can, therefore, possibly lead to social unrest if the rich and
large corporations can borrow at the lower rates, leaving average citizens in
their wake. QE also increases the deficit, which impacts all taxpayers, but
has less effect on the wealthy.
Currency war?
One of the risks of concurrent rounds of quantitative easing among the
world’s largest economies, is a currency war. As we’ve previously written,
the US government now, under President Trump, is preparing for what could be
a full-blown currency war, between the United States, the European Union and
China – plus whoever else the US president happens to be targeting.
For more on this read US
prepares for currency war
Recently the Treasury Department came out with a report that
recommended nine trading partners should face scrutiny over their
currencies - China, Germany, Japan, South Korea, Ireland, Italy, Malaysia,
Vietnam and Singapore - showing that the US is paying close attention to who
is devaluing and by how much.
Andrew Moran, writing for Liberty
Nation, argues nothing good can come of a race-to-the-bottom round of
currency devaluations. Even though cheaper imports would help middle class
Americans’ purchasing power, it’s not worth it considering the damage it
would due to the international monetary system, Moran writes:
Like a military conflict and a trade war, there aren’t any
victors. It can be difficult to determine when central banks fire the first
shots, but these bullets are usually pointed at their own heads because a
currency war is more like currency suicide. The act of destroying any
semblance of value will inevitably harm a nation and its economy in myriad
ways, from slashing rates to creating price inflation.
Once competitive devaluation begins though, the US as the largest economy
has no choice but to participate. But it would be tough to win. Being the
world’s reserve currency means there is constant demand for dollars. The US
can’t devalue its currency so low as to squelch demand for Treasuries, which
it needs to sell to foreign investors in order to finance its $22 trillion
debt. Many people also don’t realize that as the reserve currency, the United
States must run a trade deficit - it’s only a question of
how large that deficit will be.
There are two other possibilities, according
to Joachim Fels of Pimco, a global investment firm, interviewed on CNBC recently.
One possibility is if everyone eases at once, and currencies don’t move very
much, a currency war would be averted. As for who could win a currency war,
Fels picks the United States, because the Federal Reserve has more room to
cut interest rates than the ECB or the Bank of Japan, so the US would win in
the sense that the dollar is more likely to weaken than strengthen, he
said.
Limited options
Taking that idea further, Wall
Street Journal presents a couple of scenarios, should global growth stall
and key economies enter recessions. If the downturn is fairly
minor and cyclical, then most central banks would have the easing tools
needed to deal with it.
However, if the world economy is hit with a big shock like in
2008, central bankers might find their options are limited, especially
because interest rates in the US are a lot lower than previous recessions. In
Europe and Japan they’re negative. The Wall Street
Journal states:
But were a recession to loom that raises unemployment and brings
inflation toward zero, even the Fed could run out of conventional ammunition
quickly. It shaved rates by more than 5 percentage points in a little over a
year from 2007 to late 2008. It cut rates by a similar amount from 2001 to
2003 after the tech bubble burst, even though that recession was milder than
the one during the financial crisis. It now has less than half that much room
in which to start lowering rates before it hits negative-rate territory.
Central banks in Europe are in the trickiest spot, with policy rates
below zero in the vast majority of the region, including the
eurozone, Sweden, Switzerland and Denmark. Cutting rates more in those
regions wouldn’t do much to stimulate their economies and could further
weaken the commercial banks that must pay those negative rates to their
central banks.
Tempting a crash
The elephant in the room nobody wants to talk about is the debt crisis. Seeking
Alpha contributor Ronald Surz wrote a piece where he points out that
global debt has reached a record high. The official numbers are $184 trillion
but Surz thinks that’s underestimated by a factor of 2.5X. The
more likely figure he writes is $460 trillion, which is 560% of global GDP,
and $215,000 per capita. The three most indebted countries are the US, China
and Japan, which together represent about half of global debt.
But why worry about it? The Fed certainly isn’t. It still has about $4.5
trillion in government debt and mortgage-backed securities on its balance
sheet after earlier rounds of monetary easing. Surz writes:
Debt brought the world to its knees in 2008. Paradoxically,
disaster was circumvented by doubling down with even more debt, deferring the
consequences to sometime in the future. That future is rapidly approaching. In The
Coming Global Financial Crisis: Debt Exhaustion, Charles Hugh
Smith observes:
The global economy is way past the point of maximum debt saturation,
and so the next stop is debt exhaustion: a sharp increase in defaults, a
rapid decline in demand for more debt, a collapse in asset bubbles that
depend on debt and a resulting drop in economic activity, a.k.a. a deep and
profound recession that cannot be "fixed" by lowering interest
rates or juicing the creation of more debt.
Conclusion
We are currently experiencing deja vu where it comes to the
global economy. In 2008-09 the financial crisis hastened some creative
thinking among central bankers. The quantitative easing solution that
followed proved popular, so popular that any suggestion of raising interest
rates beyond rock-bottom levels sends stock markets into a spin.
When times get tough, the first line of attack is monetary easing. The
guests at this party are used to the punch bowl and they see no reason to
take it away. It’s highly addictive. But this punch comes with an
after-taste, in the form of inequality. How far are central banks willing to
go to please their corporate paymasters while continuing to impoverish their
middle classes?
QE4 carries with it the risk of a currency war that could lead to
hyper-inflation and even stagflation if interest rate cuts and asset
purchases fail to stimulate growth. Quantitative easing also kicks the debt
can down the road, heightening the risk of another Great Recession. Do we
really want to go there?
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