Satyajit Das: Economic Uppers & Downers

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in Q3 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

Quantitative easing (“QE”) is the currently fashionable form of voodoo economics favoured by policymakers in the US.

QE, loosely “printing money”, entails central banks buying government bonds, which are held on the central bank’s balance sheet to inject money into the banking system thatcan be exchanged by banks for higher return assets, such as loans to clients. The purchases also increase the price of governments bonds, reducing interest rates.

Advocates of QE believe that it will lower interest rates promoting expenditure, growth, reduce unemployment and increase the supply of credit to underpin a strong economic recovery. In reality, QE is primarily directed at boosting asset values, subsidising banks, weakening the currency, helping the government finance its deficits and creating inflation.

Financial Pick-Me-Ups

Lower interest rates can help boost asset values, primarily real estate and financial securities. Fed Chairman Bernanke specifically cited the effect of QE on stock prices. Between the Fed’s announcement of QE2 in August 2010 and January 2011, the S&P 500 rose by around 18%.

Lower rates assist financial asset values by lowering the cost of financing holdings, in effect allowing investors to borrow cheaply to hold assets for potential gain. Lower rates also make financial assets paying higher income, such as dividend paying stocks or corporate debt, attractive.

Boosting asset prices helps financial institutions, reducing losses on investments in securities that fell sharply in value in the crisis. For example, AAA rated asset-backed securities, such as mortgage backed securities, appreciated in value from around 60 cents in the dollar to 90 cents, in part because of QE despite minimal changes in the repayment prospects of the asset itself.

The effect of QE on real economic activity through higher asset prices is based on the wealth effect, whereby people are likely to spend or borrow more when their investments are worth more. It is trickle down economics, where benefits flow down from the top to the bottom. During the Great Depression, Will Rogers, the humorist, defined it as: “money was all appropriated for the top in hopes that it would trickle down to the needy.”

Sales at up-market retailers like Tiffany & Co. and Coach Inc., are up, buoyed by demand for $10,000 diamond pendants and $1,000 leather handbags. One economist termed it “heavy lifting” by upper-income households. At the wrong end of the economic spectrum, Wal-Mart reported that “everyday Americans’ are living paycheck to paycheck as they await an improvement in job prospects”.

The strategy is deeply flawed. Higher income and wealthier individuals, who are likely to be the main beneficiary of such policies, have a lower marginal propensity to consume, that is they spend less of marginal income.

For most individuals, the bulk of their net worth is tied up in their principal residence. QE has had limited effect in arresting the sharp decline in prices. . Since QE2 began, the Case-Schiller Home Price Index, a widely followed indicator, has actually fallen by 3%.

A high percentage of US home owners have negative equity, the house is worth less than the amount owing under their mortgage thus limiting consumption. Higher values of retirement savings are unlikely to have an immediate effect on individual spending behaviour.

Given that low savings levels and increased consumption was one of the factors in the current financial problems, encouraging a return to the same strategy is puzzling.

The Gift of Giving…

QE provides discreet subsidies to banks in the short run. Between August 2010 and January 2011, bank stock prices have increased by around 20%.

Lower rates reduce the cost of deposits, which can then be reinvested in low risk government bonds at a substantial profit. Assuming banks raise 3 month deposits (paying around 0.50% to 0.75%) and invest in 10 year government bonds (yielding say 3.25%), the subsidy to US banks is around $200-300 billion per annum.

However, this only works for a time as Japanese banks discovered. QE ultimately pushes down yield on bonds reducing returns, also decreasing the net interest margin and profits earned by banks.

Regulators argue that this subsidy helps restore bank capital levels, facilitating greater levels of lending. Critics argue that this is nothing more than a secret subsidy to bank, which accrues to staff (as bonuses) and shareholders (as profits and dividends). The strategy does not attract the attention from politicians and the electorate that more overt bank bailouts do.

QE’s mixture of low interest rates and increased supply of dollars also helped weaken the dollar against major currencies such as the Euro and Yen. Since the commencement of QE2, the US dollar has fallen in value by around 5.00% against a basket of currencies.

The weaker dollar helped improve America’s export competitiveness, enabling US companies to compete better in a world of lower demand. A weaker currency also effectively reduces the value of US debt that can now be paid back in cheaper dollars.

The currency effects of QE brought forth a sharp riposte from China and emerging market countries, themselves well skilled in currency manipulation, about the declining value of their dollar investments. Chinese leaders preached about the unique responsibility of the US as the issuer of the world’s reserve currency.

Even the ability to influence currency values through QE proved illusory. The European debt crisis led to the dollar appreciating, driven by its safe haven status, reducing the benefits of a weaker dollar.

QE assists governments in financing public debt and the budget deficit. Purchases by the central banks keep interest rates low, allowing governments to increase borrowing at cheaper cost. QE creates a ready market for government debt. The central bank buys government. Reserves created by the central bank in payment for the purchase are recycled by banks, reluctant to lend to customers, into further purchases of government securities. As government bonds regarded as risk free do not attract significant capital requirements, banks can leverage their purchases substantially, further enlarging the demand for the securities.

At best, QE artificially boosts asset prices in financial markets and assists financial institutions. It does not directly improve the real level of demand, economic activity, employment, business investment and the supply of credit to small and medium enterprises and households, where serious problems remain.

Emerging Problems…

QE also creates significant problems, especially for emerging markets and commodity prices. Low interest rates and falling currency values have encouraged investors to increase investments in emerging markets, offering better returns and more encouraging growth prospects.

Given the small size of many emerging markets, these flows have pushed up asset prices, often sharply. They have distorted these economies, disguising deep-seated problems. Large short-term capital flows into India have helped finance the country’s large trade and budget deficit, masking structural problems and alleviating pressure to deal with them. In China, limitations on foreign investment encouraged purchases of non-productive assets, including vacant property, as a bet on the revaluation of the Renminbi.

Much of the capital flows into emerging markets are short term and potentially volatile. A rapid withdrawal of this money could be highly destabilising, as evidenced by the Asian crisis of 1997/ 1998.

QE effects on commodity markets have been significant. Between August 2011 and January 2011, commodity prices (as measured by CRB Index) rose by 14%. Oil prices have increased by around 20% and average gasoline prices have increased around 15%. Food prices (as measured by the CRB Food Index) have increased 12%, with some individual foodstuffs rising more sharply.

As most commodities are priced and traded in US dollars, the lower value of the currency causes price rises. In addition, low interest rates have encouraged speculation in and stockpiling of commodities.

The conjunction of low interest rates, cheap warehousing charges, strong commodity demand from emerging markets and contango (commodity forward prices above the current market price) have encouraged stockpiling. Traders have purchased commodities, financed and stored the holdings, simultaneously selling forward to minimise price risk (known as “cash and carry”).

An estimated 10-15 million tons of aluminium are stockpiled in this way. Similar situations exist in many other industrial commodities markets. If there is a slowdown in commodity demand or financing conditions tighten, then these stocks could be released into the market affecting prices.

The political instability in North Africa and the increasing problems in a string of African and Middle-Eastern countries have also boosted oil prices. In the short run, the price rises reflect uncertainty about immediate supply. Longer term political and economic changes in major oil producing countries are difficult to predict and likely to be complex, adding further volatility to the outlook for energy prices generally. In many ways, these geo-political factors may, in fact, also undermine the QE initiatives, forcing up interest rates and reducing the flexibility of central banks to continue a policy of loose money.

Higher commodity prices and strong capital flows are fuelling inflation in emerging markets. Central banks in these emerging countries have been forced increase interest rates and restrict bank lending to reduce price pressures. Given that emerging markets have been a key driver of the tepid recovery of economic activity globally, this risks truncating the recovery.

The side effects of QE may prove highly toxic, in part because of the risk of retaliation from affected parties. Other countries may institute competitive QE programs, to offset the Fed’s actions. Emerging market countries are openly talking about “currency wars”. Some countries have already introduced controls against short-term capital flows. Such measures, triggered by QE, could also affect the prospects of global economy recovery.