Cheap money, what is it good for?

Cheap money, what is it good for

Cheap money should help to stimulate the world economy, but is it working?

Following the leave campaign winning the Brexit referendum, which will see the UK leave the EU two years after the Prime Minister notifies the European Council of its intention to do so, there was much fear about what this would mean for the strength of the UK economy.

Mark Carney, Governor of the Bank of England, issued a statement immediately following the result in which he aimed to calm market sentiment.

He acknowledged that Brexit would result in a period of uncertainty and adjustment, but there would be no initial changes in the way people are able to travel, or in the way that products and services are sold.  In a calm demeanor, he reassured us that the Bank of England would not hesitate to take additional measures, as required.

What kind of additional measures did he have in mind?

Well, Carney went on to say specifically that “… as a backstop, and to support the functioning of the markets, the Bank of England stands ready to provide more than 250 billion pounds of additional funds through its normal market operations.”

What did he mean by this?

Well, traditionally, central banks have aimed to control monetary policy by influencing interest rates. By lowering interest rates a central bank hopes to stimulate the economy by lowering the required rate of return on business investments, which should increase the total amount of investment in the economy.

As recently as ten years ago, it was unthinkable that a responsible central bank would try to stimulate the economy by turning on the printers and pumping new money into the economy. But this is what Carney was suggesting, “the Bank of England stands ready to provide more than 250 billion pounds of additional funds“.

Since the 2008 financial crisis, central banks have increasingly resorted to this new and unconventional policy known as quantitative easing. The US has engaged in three rounds of quantitative easing, purchasing an estimated $4.5 trillion in financial assets. And the UK has also been busily printing money, purchasing more than £375 billion in financial assets.

QE is new and unconventional, but notice how carefully Carney finessed his words.

“The Bank of England stands ready to provide more than 250 billion pounds of additional funds through its normal market operations.”

There is absolutely nothing “normal” about printing money in order to prop up the economy. This behaviour was traditionally the province of banana republics like Zimbabwe and the Weimar Republic, and in both of those cases it led to rampant hyperinflation. The Bank of England’s website even acknowledges this, stating “Quantitative easing (QE) is an unconventional form of monetary policy where a Central Bank creates new money electronically to buy financial assets, like government bonds.” (emphasis added)

However, mid-last week, Carney’s “normal market operations” appear to have finally hit a bump in the road.

The FT reported that the Bank of England’s new programme to buy long-dated UK government bonds had run into trouble as pension funds and insurance companies were refusing to sell. “The Bank of England fell £50m short in its gilt purchase target … , and even then only secured [as much as it did] by paying well above market price,” said Darren Bustin, head of derivatives at Royal London Asset Management.

Is the Bank of England’s money no good?

Why might these institutions be refusing to sell their long-dated bonds?

A few reasons.

Firstly, by printing money and lowering long term interest rates, the Bank of England is, in effect, siphoning money out of the pockets of old people.

Pension funds have long term liabilities which will not fall due for many years. In order to be able to provide for their members during retirement, these institutions need to buy long-dated assets, which will provide revenue over a long period of time. With interest rates continuing to fall, it makes sense that these institutions would prefer to hold onto their long term bonds, which will provide a steady stream of fixed coupon payments.

Already this year, 10-year gilt yields have fallen from 2% to a staggering low of 0.56%, which has led to worsening funding shortfalls for UK pension funds. Lower interest rates mean that pension funds expect to earn less from their bond portfolios in future, and so will be less able to pay their members’ pension entitlements. This means that employees, worried about their standard of living during retirement, are now under pressure to save even more than before (exactly the opposite of what the Bank of England is hoping to achieve).

The second reason that these institutions may be reluctant to part with their bonds in exchange for cash is that, as central banks continue to engage in quantitative easing, money is becoming increasingly worthless.

If we think of interest rates as the “price” of money, then we can see that in many countries money has never been less valuable.

Here is a list of prevailing central bank interest rates in some of the world’s major economies (as of today, August 14th 2016):

  • Bank of Japan: -0.1%
  • European Central Bank: -0.4%
  • Swiss National Bank: -0.75%
  • Sweden’s Riksbank: -0.5%
  • U.S. Federal Reserve: 0.4%
  • Bank of England: 0.25%
  • Reserve Bank of Australia: 1.5%

Cheap money should help to stimulate the world economy, but is it working?

The evidence doesn’t seem too positive.

Low rates are meant to encourage business investment, but in a low growth world where companies and governments are already heavily indebted it is easy to understand why this may not happen.  Moreover, if banks absorb the cost of negative interest rates themselves, then this lowers their profit margins and may make them less likely to lend money.

As we saw in Germany on Friday, one bank has now decided to pass on negative interest rates to its retail clients. In other words, it will now penalise thrifty individuals for having savings in the bank. If enough other banks follow this lead and make more customers pay to hold their money in the bank, then customers may start putting cash under the mattress or stashing it in a safe. This would reduce the total amount of deposits held in banks and could potentially set off a bank run.

Cheap money, what is it good for?

(Image Source: Flickr)

Monopoly Money

If you were playing Monopoly, Quantitative Easing would be the equivalent of helping yourself to a $100 note every time you rolled the dice and never having to pay it back


(Source: Flickr)

CENTRAL banks continue to finance government spending by easing monetary policy in order to help economies get back to “potential output”. (It remains unclear whether Grand High Priest Bernanke slaughters a lamb before proclaiming what the level of “potential output” should be for the US economy. It would be interesting to know.)

Quantitative easing (referred to as “QE”) is an unorthodox monetary policy tool that involves creating new money to buy assets, usually in the form of government bonds. The policy was introduced during the financial crisis to enable central banks to continue stimulating the economy even as interest rates approached zero (see, liquidity trap). During the crisis the policy was viewed by many people as helpful in providing liquidity to the banking system and in preventing long term interest rates from rising.

In America, the Federal Reserve pursues QE by buying US government bonds in the secondary market, which basically gives the government a blank cheque to sell as many bonds as they want to private investors in the primary market (who then turn around and on-sell these bonds to the Fed in the secondary market).

QE makes things easier for a cash strapped government in times of crisis by providing a willing buyer for their bonds.

But by allowing governments to continue running deficits, QE removes the need for fiscal discipline.

Where will it end?

The Fed already owns around $2.3 trillion of Treasury bonds, and the Bank of England owns around £375 billion of gilts. Any attempt to sell these bond could result in an unwanted rise in interest rates. And, The Economist reports that Mark Carney, Governor of the Bank of England, recently signaled that the Bank is not expecting to sell all of its holdings.

What does this mean exactly?

In effect, central banks are providing their governments with interest free loans financed by printed money. If you were playing Monopoly, this would be the equivalent of helping yourself to a $100 note every time you rolled the dice and never having to pay it back.

Or, to speak more plainly, our governments are cheating us.

World Collapse Explained in 3 Minutes

Bailouts: a band-aid solution for continuing sovereign debt crises

BAILOUTS were the band-aid solution prescribed for the Greek sovereign debt crisis. And every indication suggests that Greece will require another band-aid early next year.

In this context, Clarke and Dawe raise an interesting and often carefully overlooked question. Where does the money come from to bail out basket case economies? Countries whose finances are in such a state of disarray that they were not only unable be repay their original debts but will almost certainly be unable to repay the subsequent bail out money.

In the case of Greece, the money has come from the EU, the European Central Bank and the IMF, which is all well and good. Saving Greece is possible since it is only the 13th largest economy in the European Union.

Compare this with Italy which is the 3rd largest economy in the Eurozone, and has public debts of around 125% of GDP (second only to Greece). Standing at around $2.5 trillion, Italy’s gross external debt is simply too big to bail out. If Italy should default on its debts, as well it might, then this could spell the end of the Eurozone.

Looking slightly further afield, we see the USA (~$17 trillion of public debt) and Japan (~$14 trillion of public debt). These two countries continue to run large fiscal deficits, to rely on foreign creditors (who for the moment seem happy to continue fueling government excess), and are also the largest donors to the IMF. For these two countries, there are no lenders of last resort.

Both countries appear to be aware of their precarious position, and have engaged in a number of rounds of Quantitative Easing (read: printing money). QE is a remedy of last resort which aims to create price inflation and thereby reduce the real value of government debt. Printing money is often associated with hyper-inflation and is the kind of solution you would expect from leaders like Robert Mugabe (hyperinflation in Zimbabwe was estimated at 6.5 sextillion percent in November 2008).

Bailouts are only a band-aid solution for government excess. They don’t work in the long run, and they don’t work if the country is too big to bail out. We can only hope that Greece, the USA, Japan, and other countries decide to get their fiscal houses in order. Failure to do so may result in more loss of blood than can be remedied by a few band-aids.

Quantitative Easing

Printing money is the last refuge of failed economic empires and banana republics

QUANTITATIVE EASING is a monetary policy tool sometimes employed by central banks to stimulate the economy when conventional monetary policy becomes ineffective.

To stimulate the economy, the central bank normally carries out expansionary monetary policy by lowering short-term interest rates through the purchase of short-term government securities. However, when the short-term interest rate gets close to zero it becomes impossible to lower the short-term interest rate further and so this policy tool can no longer be used to stimulate the economy (the liquidity trap).

When faced with the liquidity trap, the central bank can shift the focus of monetary policy away from interest rates and towards increasing the supply of money (quantitative easing). To increase the money supply, the central bank buys government bonds and other financial assets with newly printed (or more correctly, electronically generated) money which will increase excess reserves in the banking system. The central bank hopes that banks will use these excess reserves to increase lending which will help to stimulate the economy.

When a government increases the money supply, this will lead to higher prices because there will be more money chasing the same amount of goods and services.  In other words, printing money (quantitative easing) causes inflation.

More spending: our economic poison and panacea

Subtitle: The battle between John Maynard Keynes and F.A. Hayek

DURING THE global financial crisis, we were told by governments that the best way to fix the world economy was to increase spending. This sounds simple enough given that increased government spending and lower interest rates can be used to boost output, but it is only a partial truth.

John Maynard Keynes is the poster boy for governments everywhere because he prescribes a simple medicine for broken economies, more spending. The story runs like this: in uncertain economic times people save more money which makes sense for each person individually but leads to reduced spending overall and therefore lower firm revenues and lower economic growth. The only way out of this unhealthy spiral of saving is for the government to step up to the plate and increase the circular flow of money by spending on public works, digging ditches, war, fixing broken windows, or pretty much anything.

F.A. Hayek is the voice of reason who provides us with the other side of the story. Increased government spending (and quantitative easing) is not the solution to the problem and may actually make things worse because it continues to reward the malinvestments made during the boom years. The argument is that governments should play a limited role because propping up poor businesses and investments is not the best way to encourage strong and sustainable economic growth.

As you can guess, Hayek is not popular among the fat cats in public office because allowing businesses to fail during hard economic times will most likely lead to a sharp increase in unemployment (albeit temporary) and this will be very politically unpopular.

We should ask ourselves though, do we actually believe in the capitalist system? And if we do, what is the legitimate role of government in that system?