Why QE, fiscal stimulus and Modern Monetary Theory (MMT) won't prevent an economic downturn.
Those of us of a certain age can remember watching Saturday afternoon black and white reruns of Laurel and Hardy films. Invariably, after a series of laughable misunderstandings and comic mistakes Hardy would lament to sidekick Laurel, “Well, here's another nice mess you've gotten me into!” Well, today's Federal Reserve (Fed) reminds me of the well-meaning but often bumbling Laurel, while pompous and stubborn Hardy is today's bond market. Unfortunately, the mistakes are no longer playing out in grainy black and white, but in vivid color for all to see.
A fine mess indeed…
In late September, we saw the Fed—which had made historic purchases of U.S. Treasury and mortgage obligations across the term structure in an effort to influence yields and engender a more robust economic recovery—step back into capital markets to provide overnight and term financing for leveraged financial institutions and funds.
So much for free and unfettered markets…
Quantitative easing (QE), the novel “wet index finger in air” attempt of Takahashi Korekiyo to reflate Japan in the 1920s, was refined, appropriately quantified and ultimately academically anaesthetized by economist Ben Bernanke to become accepted monetary policy doctrine—just in case of an emergency. Well, the economic emergency came, and the expected growth and strong recovery have not followed– just ask the average American—or better yet, the Japanese and Europeans who've had it much worse, and taken the monetary policy experiment even further.
The attempt to exit QE has been anything but watching paint dry. As far as I know, there aren't any historical examples where QE was exited “smoothly.” Korekiyo was assassinated by a military aligned with imperial ambitions, so he never saw the tragic results of his desperate and unorthodox policies; remember, he had limited formal schooling.
Coming soon: negative or near-zero yields on Treasury notes
The discussion around QE and its very weak, flimsy logical underpinnings matter, because I believe that 10-year U.S. Treasury yields may approach zero in the next period of weak economic growth—the Japanese and some European economies have already beaten us there. How different is the U.S. really than those economic zones? The U.S. also has low birth rates, aging demographics, weakening productivity, and broadly increasing aggregate debt burdens.
The policy of QE has become a proverbial “Hotel California”: you can check out any time you'd like, but you can never leave. The disruptions in overnight financing have been brought on by a host of factors including a preference for liquid reserves by the major money center banks due to a panoply of regulatory terms only a bank treasurer can appreciate and understand: HQLA1, SLR2, LCR3, etc.
But the undeniable issue is that the Fed has once again been forced to expand its balance sheet, but this time during relatively strong economic times, with wages rising and unemployment plumbing new generational lows. Against this backdrop, to expect 10-year Treasury yields to fall 200 basis points as the U.S. economy approaches the depths of a normal economic recession does not seem unthinkable to me.
So, prepare now for even lower Treasury yields over the next few years...just in case. A fine mess, indeed!
Financial follies II: Draghi’s last stand
Conventional economic wisdom is that monetary policy has done the heavy lifting in terms of reviving economic growth. Now that policy rates are low or negative and balance sheets have expanded, all we need is some fiscal stimulus to keep an economy from turning down into recession. Outgoing European Central Bank President Mario Draghi reinforced this dogma in what may have been his last interview as the incumbent with the Financial Times. Draghi left with a parting shot, chastising Germany and its northern European neighbors, the region's de facto economic growth engine, for not spending enough. Draghi's dogmatic protestations are nothing new. Except, his dogma is flawed.
Let’s look to the U.S. to test his hypothesis
We've already established the challenges around managing expanding central bank balance sheets when policy rates are negative or near zero. Add deficit spending and the problems are compounded. The U.S. now has fiscal deficits approaching $1 trillion annually, brought on by tax cuts to corporations and well-off individuals. The ability for the market to absorb the additional government debt has reached its limit, at least when the Fed's balance sheet is shrinking. We saw this in the recent ructions in the overnight financing markets. If the Fed did not step in with overnight and term facilities, these new liabilities would be challenging to finance.
So, deficit-financed fiscal stimulus and expanding central bank balance sheets need to go hand in hand. The central bank can then limit yields rising by buying the government debt. However, the longer-term problem—improving economic growth that stimulus is meant to solve—actually becomes worse.
Additional government debt and the need for central bank intervention slows spending and investment by the private sector—which is where real growth and productivity occur. So fiscal stimulus may not be the panacea central bankers hope it will be; in fact, deficit-financed stimulus would just drive government yields lower as structural growth and productivity decline.
What's next if fiscal stimulus won’t help?
But what if the central bank balance sheets keep expanding to fund the fiscal deficits? Or better yet, why not have the central bank just buy newly issued government liabilities directly and disperse the proceeds directly to the taxpayers or finance the pet projects of the political establishment? Now, we're entering the world of MMT. I candidly admit that the “real world” MMT would move Treasury yields off zero as inflation expectations rise rapidly, but the relevant currency—the domestic economy's store of value—would markedly depreciate. As we mentioned before, there would be consequences for inflation and the currency by printing more money to pay off local- and hard-currency debt. Just ask Argentineans.
Central bankers and politicians would be wise to consider the recent warning from Oliver Bäte, the chief executive of Allianz, “The politicians and the regulators have told us they fixed the banking system and insurance system in terms of this negative spiral of financial sector risk morphing into sovereign risk and [looping] back. It is the biggest non-truth that exists.”
Aren't negative and near-zero rates and expanding balance sheets just a manifestation of this truth?
1 High-quality liquid assets include only those with a high potential to be converted easily and quickly into cash.
2 Statutory liquidity ratio refers to the proportion of deposits a commercial bank is required to maintain with them in the form of liquid assets in addition to the cash reserve ratio. The statutory liquidity ratio is determined and maintained by the central bank to control bank credit, ensure the solvency of commercial banks and compel banks to invest in the government securities.
3 Liquidity coverage ratio refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations. The LCR is calculated by dividing a bank's high-quality liquid assets by its total net cash flows, over a 30-day stress period.
Modern Monetary Theory (MMT), not widely accepted, has the following basic attributes: A government that prints and borrows in its own currency cannot be forced to default, since it can always create money to pay creditors. New money can also pay for government spending; tax revenues are unnecessary. Governments, furthermore, should use their budgets to manage demand and maintain full employment (tasks now assigned to monetary policy, set by central banks). The main constraint on government spending is not the mood of the bond market, but the availability of underused resources, like jobless workers.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
One basis point (bps) equals one one-hundredth of one percentage point.
Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.