This article was written by Fred Piechoczek. All views and opinions expressed are strictly his own.
Imagine that you are skiing in the French Alpine resort of Courchevel at over 2000 metres altitude. You decide to teach the kids to ride a bicycle and set off for Moûtiers at the bottom of the mountain. Half way down the kids have learned balance and steering and are thrilled at the speed of descent. What they do not yet know is that they will have to pedal back up the mountain.
Cruising down the mountain is what it may be like for some of our young finance executives and market traders who were still at school when the Great Recession hit and quantitative easing (QE) was launched by the world’s central banks. QE is when the central bank (or Federal Reserve in the US, which is what we will deal with in this article) buys long maturity treasury bills for newly created cash that is deposited in the banking system. This increases the supply of money in the economy providing a stimulus to avoid recession and unemployment. We have lived in this QE economic environment for over a decade, comfortably cruising down the hill to Moûtiers.
When QE was introduced, I thought that the ensuing consumer price inflation by reason of excess cash would cause my savings to wither away. Had I been an economist, I might have realised at the time (as I did later) that something else could happen and did, but then again maybe as an economist I would not have worked it out. After all, Ben Bernanke, then Chairman of the Federal Reserve, has a doctor’s degree in economics, and it is not clear that he worked it out.
There are two immediate risks with QE. The first risk is consumer price inflation, and it transpires that the economy was not ready for this in 2010. But the money has to go somewhere, and this is what some economists call an ‘allocation’ issue, the second risk. In layman’s speak, this second risk is asset price inflation when stock markets and real estate rise fast in value as the new money supply piles into purchases at ever higher prices. This is exactly what happened in the US (until now). The thing about asset price inflation is that everyone loves a ‘boom’, as opposed to the ‘curse’ of consumer price inflation. Donald Trump could proudly proclaim the success of the stock markets. But is the boom based on economic growth and healthy commercial earnings or on excess liquidity pumped into the economy by the central bank?
QE may be a bit like going to Mars: you might have worked out how to get there without knowing how to get back. In the meantime, the sheer weight of QE has destroyed traditional methods of controlling markets, such as open market operations where the central bank tweaks markets by buying short government debt. There were some modest attempts in the US to reverse QE, but to my knowledge, no one has worked out a benign route to exit the QE hangover or how to get back from Mars.
While this hangover was in full force, along came the Covid 19 pandemic, demanding in the US a scale of QE way beyond what came before, no other tools apparently being left in the Federal Reserve’s arsenal of economic weapons.
It is possible to gauge the extent that QE has increased the money supply by simply looking at the size of the balance sheet of the Federal Reserve, as this is where the stock of purchased treasury bills is held. This reveals that the pandemic QE was many times the size in a far shorter period of time than the original QE to combat the Great Recession.
To confront the pandemic, the Federal Reserve had to bail out not just the banking system but also the (unregulated and no one knows what is really going on) shadow banking system, which has been a problem in the US for decades. And of course, some of this problem was caused by nothing other than QE. When there is an inflated money supply in a time of low interest rates the excess money has to seek yield, hence self-sustaining asset price inflation in stock markets, real estate and other forms of ‘investment’.
There is a good ‘investment’ example in the hedge fund world, which results from QE itself. If you have, say, a spare billion dollars, you can use it to arbitrage a tiny wrinkle in the treasury forward market for a trivial profit, so you buy treasury bills. But then very cheap funding caused by QE allows you to refinance your treasury bills on a sale and repurchase basis, and repeat this until you achieve leverage of fifty times to hold fifty billion dollars of bills.
Your original billion dollars is just to cover the costs and financing of your position, while your leverage, using QE excess liquidity, gives you an adequate absolute return on that money. Many hedge funds deemed this to be ‘risk free’ investment, and I suspect Nick Leeson would agree with this, as would have Bernie Madoff for that matter; and let’s not forget the Nobel laureate geniuses at LTCM……
However, dire risk raises its head when repo funding costs rise from a fraction of a percentage point to several percent, sucking out the arbitrage profit and creating a funding deficit. Just when the Federal Reserve needed to save the economy by exercising QE and buying treasury bills, there existed the potential of massive treasury bill sales to liquidate bust hedge funds. This is one reason why the Federal Reserve was forced to bail out the shadow banking system including bust hedge funds and save the day, and why QE became so massive.
I think at this point Moûtiers may be in sight. Any future enhancement of QE is likely to lead to a bail out of the entire economy. Given that the US is the leading economy, the scale of this may require some kind of alien invasion, aliens who can bring sufficient resources with them.
If you know how to ride back up the mountain with the kids to Courchevel, then you may wish to apply to the Federal Reserve for the post of Chairman, when the current one vacates it. I think he may have done an excellent job of what he had to do, given how far down the mountain his economy had already pedalled. The big question is: what now?
The spectre that has always hovered over QE is an impending uncontrollable market crash or series of crashes that unsettle the economy for years/decades, because there is no central bank tool left powerful enough to counter the expanded problem when it comes.
Some believe that asset price inflation coupled with tax cuts has transferred too much wealth to the wealthy. It is certainly the case that there has been a massive transfer of wealth in the developed world to the asset holding minority. Some argue for progressive taxation to counteract this, including wealth tax. This funding could enable QE reversal. Others proclaim that Modern Monetary Theory (MMT) is a way forward that decouples government spending from its revenues, I believe, allowing the state extra choices by reason of its fiat currency. Whatever the case may be, there is a huge money supply overhang, or hangover if you prefer, that seeks a viable long-term solution, much strenuous and energetic pedalling back up the mountain.