QE: an Addiction that is Proving Impossible to Break?
Updated: May 20, 2022
Austrian-born restaurateur Wolfgang Puck was an unusual but highly entertaining speaker at an investment conference I attended recently. He was a strong advocate of the keep-it-simple principle – “When I was young, I put twenty four ingredients in a dish and I thought I was a good chef. Now, the opposite is the case. Six is enough” – which got me wondering how I could apply it to a difficult subject I had been thinking about recently, namely the massive build-up of credit in the global economy.
"Nowadays, most money takes the form of electrons stored in silicon wafers"
Credit and the credit cycle, which incidentally sit at the heart of the school of economic thought founded in the country of Puck’s birth, are often explained in terms that are over-complicated and thus misunderstood. I get slightly irked when I hear talk about banks lending out deposits, as if the deposits existed before the loans did and the banks could choose what to do with them. Wrong. Banks create deposits when they create (extend) loans. If I get a $10,000 loan from my bank, the bank creates a $10,000 deposit in my name which I then go and spend (unless it’s a mortgage or car loan, in which case my bank transfers the newly created deposit to the seller’s account, even if it’s at another bank). So here is my attempt to provide some clarity on what is a complex issue as well as, more importantly, a big problem.
First, a history lesson. Before the advent of money, economic activity required paying for goods or services with other goods or services, known as barter trade. This was naturally an inefficient system, as not only did you need to have a good or service to trade but it needed to be what the sellers (or buyers) were looking for. Soon enough, money was invented, which solved the problem of needing to have a good or service to trade if you wanted to buy something (though you would still have needed to have sold a good or service to get money in the first place). Early on, money took the form of rocks (sometimes huge, immovable ones), cowry shells or the like. Later, metal coins were used, though it was a necessary condition that the value of the metal with which coins were made was less than the denomination of the coins (otherwise they’d always be melted down.) Nowadays, most money takes the form – perhaps disconcertingly – of electrons stored in silicon wafers in banks’ computers.
Bank credit is newly created money, only money that’s easier to create and store (perhaps easier, particularly for computer hackers, to destroy too). Instead of me writing an IOU in exchange for a good or service, the bank steps in, writes the IOU itself, and passes it to the seller i.e. lends me money with which to make the purchase. Furthermore, these bank-originated ‘IOUs’ (bank deposits) don’t say anything about who owes what to whom and when so they can be used by anyone (what is known as fungibility). Put like this, it is much clearer how much more economic activity is possible under such a system.
The problem is, in a free market economy, credit creation inevitably gets out of control. If you pick two individuals at random, one of them is likely to be more productive than the other, let’s call them Lucky and Hapless. Put them in a free market system and allow them to trade with each other, and Lucky is going to be the one selling goods and accumulating IOUs (written by Hapless). At some point Lucky realises that he’s accumulated more IOUs than he will ever be able to ‘spend’ in his lifetime (particularly since he can only buy from the less productive Hapless). If we introduce other agents to our simple system such as politicians and banks (let’s call them Pol and Banker), we can see that Lucky might have a use for his piles of IOUs. He can use them to persuade Pol to tweak tax rates in his favour or persuade Banker to write even more IOUs with which he can speculate in the financial markets, having also persuaded Pol to repeal Glass Steagall thus allowing Banker to go off the reservation. OK, that’s a few big leaps, but you get the idea.
Where are we now? Governments in much of the developed world have issued lots of debt in recent years which has either indirectly via government deficit spending, or directly via bailouts, been exchanged for poor quality private debt. Furthermore, central banks have been buying a lot of the newly issued government debt as well as the poor quality private debt. In our simple, four-agent system, Lucky has been bailed out. Or has he? The poor quality private debt has not disappeared, it’s just been exchanged for government debt. Lucky’s tax rates are still low and on the face of it the wealth gap between himself and Hapless has only widened. Problems have been swept under the carpet rather than solved, the realisation of which might at some point come as a bit of a shock to financial markets.
In the real world there is a big question mark over how the US Federal Reserve (Fed) at some point shrinks its bloated balance sheet, particularly in view of the recent surprise decision to keep expanding it at the current pace rather than a slightly lower pace. Many think that rather than sell the roughly $3 trillion of bonds, the Fed can simply let them mature, in the process reducing banks’ reserves held with the Fed.
My own view on the issue is heavily influenced by US fund manager John Hussman’s work, summed up in his chart below. As Hussman notes, we are at the far right side of the chart where he suggests that monetary policy is like “pushing on a string”; people cannot be forced into spending to kick-start the economy, even if the cash rate is near zero. It seems to me, given the clear inverse relationship below between short term interest rates and the monetary base, that when the Fed wants to start increasing short term rates it will have to have already shrunk its balance sheet (remember that QE was needed only because short term interest rates had hit their zero bound, so the same must happen in reverse).
Assuming that a short term rate rise will be needed in the next two to three years and thus well before the bonds mature (average duration is around seven years) active selling down of bond holdings will be required. Given the Fed’s recent reluctance simply to slow the monthly purchases given the possible economic impact one can only imagine how much consternation such active selling might cause. The only way the Fed can maintain its balance sheet in nominal terms while keeping the relationship below intact is for its value to be shrunk significantly in real terms. In other words, for inflation to take off. The Fed really does seem to be stuck between a rock and a hard place.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.