Central Banks Digging a Deeper Hole
Dear readers, first of all, apologies seem in order. An unusual gap between blog posts has appeared on the Schlichter Files this summer. The reason is that I was travelling with my family in East Africa through most of August, enjoying the spectacular landscapes and the fascinating wildlife there, and meeting some very interesting people. Although, admittedly, I travelled in considerable comfort, and East Africa offers today reasonably good internet connections, often even in fairly remote areas, I decided not to read any newspapers, websites or even my emails for a few weeks, and instead tried to take my mind off the depressing subject of monetary meltdown and the destruction of capitalism and the free society at the hands of politicians and central bankers. So here I am, back in London after almost a month in the relative wilderness, slowly and reluctantly catching up with events in the strange world of 21st century finance. My first impression is that I have not missed much in terms of the unfolding crisis. None of the dynamics have changed. If anything, I feel my dire predictions and gloomy outlook again confirmed by recent events.
Where we are
Last month we entered the sixth year of this crisis, although parts of the media seem determined to continue calling it a ‘recovery’. Wishful thinking. We have been in continuous crisis for half a decade. Doses of Valium and Prozac – called QE among central bankers – have calmed nerves occasionally and given the false impression of healing.
QE, or ‘quantitative easing’, is, of course, the creation of massive new quantities of monetary units and their targeted injection into financial markets for the purpose of manipulating asset prices and interest rates, and of flooding the banks with extra free reserves. QE is a dangerous drug. It is a hallucinogen. It can make you feel better for a while but it won’t cure the disease. In fact, it makes you sick. The global economy suffers from grave distortions that are the result of years and decades of artificially cheapened credit: Overstretched banks, too much debt, inflated asset prices, misallocated capital. Cheapening credit further – and manipulating asset prices further – is, however, the MO of QE. QE encourages additional borrowing and further balance sheet expansion.
QE – and zero interest rates – is the policy equivalent of crack cocaine. It makes addictive. There is no end to it.
I was reminded of this when I opened the newspapers last Thursday for the first time in almost a month, and learned that the Fed might be on the cusp of another round of QE.
“Fed Minutes Signal Action Likely”, headlined the Wall Street Journal, “Fed shows a strong consensus for action”, the Financial Times.
Whenever the policy elite is promising more action you should get very concerned.
QE – to the bitter end
When compared to their peers among the global oligopoly of state money printers, the Fed bureaucracy has had a rather quiet spell over the past 12 months. The Fed only conducted some balance-sheet neutral bond price manipulations (‘Operation Twist’) but refrained from any money-printing worth mentioning. Since the crisis started in July of 2007, when the bottom fell out from under the US subprime market, the Fed has, of course, created a cool $1,900 billion in new money in the form of bank reserves. Its balance sheet has more than tripled. But most of this money was created during QE1 – after the collapse of Lehman in 2008, when the Fed bailed out the US banking system by taking over more than $1,000 billion of its mortgage exposure – and then during QE2 – when the Fed created another $600 billion to manipulate the prices of US Treasury securities. But in year 5 of the crisis – July 2011 to July 2012 – the monetary base has remained unchanged, for the first time in any one-year spell since July 2007.
Such impassivity is not becoming for the most powerful central bank in the world, in particular when the Bank of England is already on QE3, and the ECB has just expanded its balance sheet by more than 50 percent. (Incidentally, the ECB, the pantomime villain among international QE-enthusiasts because of its supposedly Bundesbank-inspired hard-money line, created more money, at least exchange-rate adjusted, since 2007 than the Fed: €1,800 billion. As I keep saying, when I look at the world’s major central banks, I see sameness, not divergence.)
Bureaucrats can, of course, not sit still for long. People might get the idea that they are useless and that we don’t need them, or, heaven forbid, that their work is even positively harmful. The bureaucrat cannot allow these concerns to emerge. Through ‘action’ he has to remind the public of his vital importance to society. By contrast, private companies are ventures that are ultimately controlled by consumer demand, and that are therefore usually limited in time. They emerge, grow and prosper, decline and die when consumer tastes change or better competitors come onto the scene. Not so the monopolistic state bureaucracy. It is built for eternity. Regardless of how disruptive, harmful and distortive the central banks’ ongoing money injections and cheap credit policies have been over the years and decades, and how culpable the Fed (among others) has been in creating and maintaining vast imbalances, the central bank bureaucrat has to go on with his work. He can’t question his mission without questioning his own existence.
Part of the Fed’s official mission is, famously, to boost employment. The notion behind this task – namely that lasting private sector employment can be enhanced through constant money injections and manipulations of interest rates – is utter economic nonsense. However, it is the very raison d’etre of the Fed. That is their line and they are sticking to it.
That QE3 would ultimately come was clear from the moment that QE2 had been concluded. It was only a matter of time. Yet, from the point of view of the central banker, it would be a mistake to simply resume QE without orchestrating first a protracted and well-publicised internal debate. Otherwise, the public could get the idea that modern central banking was simply ‘money printing’ rather than a difficult, complicated, and intricate affair that requires countless economic analysis and careful fine-tuning.
The Fed’s present deliberations seem to go something like this: There is a ‘recovery’ out there, but it does not look ‘substantial and sustainable’ enough. Some higher asset prices, lower interest rates, tighter risk premiums, or more generous bank reserves – preferably, all of the above – could help the economy and make sure that the ‘strengthening’ is ‘substantial and sustainable’. Let’s print more money!
What to expect
I have no insights in what precisely the Fed is up to, and frankly, I find the expert-discussions among analysts on CNBC or elsewhere on the topic slightly degrading and cringe-inducing, akin to watching an episode of ‘I am a celebrity, get me out of here’. Do these experts realize how much we have moved away from capitalism? These financial analysts often call themselves ‘economists’ when what they are doing resembles much more the work of the Soviet-era Kremlin watchers who tried to read between the lines of policy pronouncements and the tea leaves of the Politburo.
For what it is worth, my guess is the Fed will have to do more than the lame $600 billion they did last time. And at some point they will have to also stop paying interest on the massive excess reserves at the Fed to push more money into the economy.
What will the consequences be? Will this be the straw that breaks the camel’s back? Will it push the financial system over the edge? Will it finally undermine confidence in the system? Will this trigger sell-offs in bonds and trigger currency meltdown? – I doubt it. Not yet. We may have to wait a tad longer for this. But it will undoubtedly add to the grave distortions in our financial system. The Fed’s chosen assets will get a temporary boost, some well-connected financial firms will make handsome windfall profits, and some of the economic data might improve for a while. I also think that the deflationists out there, who expect balance sheet shrinkage and drops in asset prices, will again be disappointed. Another dose of Valium will probably keep asset prices supported and also consumer and producer prices on an upward trend. All this new cash has to go somewhere. The debasement of paper money will continue. Gold could do well.
Naturally, none of this will end the crisis. It will certainly not kick off a ‘virtuous cycle’ of growth and prosperity such as Bernanke foolishly promised back in 2010 when he last engaged in QE. That this is the one ‘stimulus’ that will finally put the economy on self-sustaining growth, on the ‘substantial and sustainable strengthening’ the Fed demands, is grotesque and simply laughable. This policy will simply cement the dislocations and add more debt to our economies. It could inflate the government bond bubble – the most dangerous of all bubbles – further, and allow the US government to run even larger deficits for even longer (although, admittedly, the bond bubble continued to inflate even in the absence of QE, due to private sector ‘safe haven’ flows, although the bubble has also been supported continuously through zero interest rates and ample bank reserves, both provided by the Fed). The financial system will, on the margin, become even more dependent on ongoing Fed support and ultra-low policy rates. This will make it impossible for the Fed to ever reverse course.
The idea that all this monetary madness is only temporary, only to help us get out of the crisis, and that the central banks have an ‘exit strategy’ –a term that I have not heard or seen in any discussion of central bank policy since spring of 2011! – is getting less tenable by the day. There is no exit strategy. Not in the US, not in the UK, not in the Euro Zone.
In Britain, the ex-central bankers Blanchflower and Posen are demanding that the Bank of England, the global QE champion, drops its ‘anguished religious ethics’ over QE and finally buys a wider range of financial assets, and not just government bonds. Germany’s Spiegel-magazine this month reported that the ECB might establish upper yield spreads for non-German government bonds and then defend them through its own open-market bond-buying. Wherever you look, the same story: More money has to be printed in order for the central bank bureaucracy to influence, distort and manipulate an ever wider range of asset prices.
One day a sufficiently large section of the public will realize that the central bank and the government have no alternative to printing ever more money and taking on ever more debt. The only way they know of how to ‘stimulate’ the economy is via cheapening credit and encouraging more lending and borrowing. At some point, confidence will evaporate, people will disengage from bonds and paper money, inflation will rise (as money becomes a hot potato) and real interest rates rise even faster (as bonds become hot potatoes, too). Nobody knows when that will be. But we know one thing: the policy bureaucracy remains relentless in its efforts to make the widespread price distortions, capital misallocations and the gargantuan debt pile bigger. More interventions and market manipulations are on the way. All of them are designed to discourage the liquidation of imbalances and instead encourage more debt accumulation. The goal seems to be to make the endgame as catastrophic as possible.
That is the one thing the central bank bureaucrats and politicians will succeed in.
Source: Paper Money Collapse
About Detlev S Schlichter
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