An Austrian Wolf In Keynesian Sheep's Clothing
From Guy Haselmann of Scotiabank. As a reminder, exhibiting decidedly non-Keynesian cult attributes as a member of the sellside is generally frowned upon.
"Bubbles Always Pop"
The world has been kept on life support mostly by government spending of trillions of dollars and central bank printing of trillions more. Both have boosted asset prices and given the allure of economic progress. Over-zealous regulators, market rule changes, and aggressive policy stimulus have temporarily stabilized markets. Market vigilantes have been hibernating, because unclear investment rules and uncertainties around the ultimate magnitude of stimulus have prevented them from attacking bad policies or distorting asset price valuations.
It is difficult to know the extent that markets and the global economy have benefited from official policy stimulus; however, five years after the crash, economic growth and the labor recovery remain subpar. Strong growth should have been ignited by now.
Most economists still believe in the ‘official position’ that growth is edging sustainably higher and that interest rates will slowly rise to reflect it. They could be correct, but should it fail to unfold as expected, confidence in the efficacy of official policy will diminish and the social contract will break down further. Since markets require confidence, they will also react accordingly.
Some argue that economic benefits to stimulus have run its course, while the costs from looming unintended consequences have not yet been unleashed. Many believe (and I am one) that the risks and costs of current Fed policy outweigh the benefits.
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The Fed’s asset purchase program (QE) and Zero Interest Rate Policy (ZIRP) are the foremost factors that have widened wealth inequalities. The richest few have benefited the most, simply because the 10% richest Americans own 80% of US stocks. The FOMC believe that its asset-price-inflation-trickle-down-policy leads to spending which ultimately leads to job creation, especially for the poor.
However, several FOMC members themselves have questioned Fed policies, citing that they have not worked as well as had been hoped, and pointing out that aggregate demand has been weak throughout the recovery. To his credit Fed Governor Jeremy Stein broached the subject of unintended consequences of Fed policies when he mentioned in his February paper, “A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risk, or to employ additional financial leverage in an effort to ‘reach for yield’”.
Zero interest rates have incentivized corporations to issue debt in order to capitalize on the historically low interest rates; however, corporations have primarily used the money to pay greater dividends, buyback shares, or modernize plant and equipment. There is a strong case to be made that holding interest rates at zero for a prolonged period is actually counter-productive to the Fed’s efforts to achieve either of its dual mandates. This is because increasing productivity through modernization typically exposes redundancies: it allows firms to lay-off workers, while the improvement in competitiveness allows firms to drop prices.
Furthermore, and as I referenced in my 2013 paper, “Should the marginal propensity to consume of creditors exceed that of debtors, the net effect of redistribution could be to lower household spending rather than raise it. There are some conservative savers who have a predetermined goal in mind for the minimum amount of savings they wish to accumulate over time. Those investors may refuse to move out the risk curve in search of higher yields (likely widening the wealth divide). To them, lower interest rates simply mean a slower rate of accumulation, which likely will jeopardize their minimum goal. The only recourse for this investor is to save more, which is the exact opposite intention of the Fed’s policy. For example, if interest rates fall from 4% to
3%, an investor would have to increase savings by more than 20% each year to reach the same goal over 30 years.”
Another negative result of ZIRP is that banks and other lenders are discouraged from lending due to puny return levels; and, therefore, the Fed’s desire to expand lending is compromised. Are lower (or negative) interest rates supposed to increase the incentive to lend money? To assume such is absurd. Although somewhat counter-intuitive, if interest rates rose, then the supply of money willing to be lent would increase due to wider interest margins.
Policies are so unprecedented and unproven that it is possible that the Fed itself has now become a source of financial instability. This could be the case either through the potential fueling of asset bubbles, through its compromised ability to conduct future monetary policy (due to it unwieldy $4 trillion balance sheet), or due to “unknown unknowns.”
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In a low to zero interest rate policy (ZIRP) environment, investors desperately search for yield. This frequently chases investors into assets to which they are ill-suited and to which they will miscalculate liquidity and downside potential. Under ZIRP paradigms, riskier assets become the best-performing. Credit spreads collapse and equities soar.
Massive monetary ‘printing’ by global central banks has not just emboldened investors, but these actions have collectively changed their behavior and psychology. There is evidence that policies have led to mis-allocation of resources. Investors are emboldened to take what many critics believe is inappropriate or reckless levels of risk. The motto, “Don’t fight the Fed” has taken on added meaning. Moral hazard and a deep-seated bullish psychology have become rampant.
Extended Fed promises of lower rates and a continuation of asset purchases even as the economy heals, are conspiring to propel prices ever-upward. Investing today has become mostly about seeking relative yield, rather than assessing value or determining if the investment’s return is sufficient compensation for the risk.
Simply stated, investors and speculators receive ever-lower returns for ever-higher levels of risks. Over time, the ability of an investor to assess an asset’s fundamental value becomes ever-increasingly impaired. It should a warning sign to portfolio manager’s fiduciary responsibility to maximize return per unit of risk (see market liquidity section).
There have been persistent cycles of asset booms (bubbles) that eventually turned to ‘busts’. Very low or negative real rates (seen recently) always create economic distortions and the mispricing of risk, thereby creating asset bubbles. Each ‘boom’ had some differences, but the common factor has always been easy money which the Fed was too slow to withdraw. Providing liquidity is always easier than taking it away, which is one reason why the Fed has hit the “Zero Lower Bound” in the first place.
Eventually (un-manipulated) asset prices always return to their fundamental value, which is why bubbles always pop. The FOMC has backed itself into a corner. Current changes in policy are being designed around efforts to manage the unwind process seamlessly. Central bank (and government official’s) micro-management appears based on a belief that they can exert an all-encompassing central control over markets and peoples’ lives. Those in power have come to believe that policies have a precise effect that can be defined and managed. This is highly unlikely.
In ‘normal’ times there is a more discernable connection between cause and effect. However, the usual relationships particularly break down during periods of over-indebtedness, unprecedented regulatory changes, and official rates reaching the zero lower bound. Today, the world is far from ‘normal’. It is not difficult to imagine the looming fallout from policies that have promoted asset price inflation, and which have materially compromised market liquidity.
In the long run, policies that punish savers at the expense of helping risk-takers and speculators are bad long-run policies for any country. It would be better to transform the country into net savers, rather than to continue to promote policies where growth is reliant on overly-leveraged consumers or speculators, and is micro-managed by attempts of central-control.
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