Tag

Monetary Policy

Sep 09
0

Why the ECB should raise, not cut rates

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Negative rates are likely one of the reasons behind the lacklustre European growth. Negative rates have worked as a tool to transfer wealth from savers to the indebted governments that have abandoned all structural reforms, while these extremely low rates have also perpetuated overcapacity, incentivised the refinancing of zombie companies and effectively worked as a disguised subsidy on low productivity. Not only those measures have damaged banks, but they have also created very dangerous collateral impacts (read “Negative Rates Have Damaged Banks But This Is Not The Worst Effect”).

In recent weeks we have heard of a likely new stimulus plan that would include a new repurchase program and further rate cuts. A new asset purchase program is completely unnecessary and unlikely to spur growth when all Eurozone countries already have sovereign debt with negative yields in 2-year maturities and the vast majority have negative real or nominal yields in the 10-year bonds.  Why would the ECB repurchase corporate and sovereign bonds when the issuers are already financing themselves at the lowest rates in history?  Furthermore, by reading some statements one would believe that the ECB has stopped supporting the economy. Far from it, when it repurchases all debt maturities in its balance sheet and has implemented another liquidity injection TLTRO in March 2019.

The main problem of those who defend further purchases and more negative rates is one of diagnosis. The central planners believe the Eurozone problems come from lack of demand, and that investment and credit growth are not what they would want them to be only because investors and corporates believe that rates will ultimately rise, leading to defensive positioning.

The eurozone has seen nothing but demand-side stimuli, and after trillions of euros the economy is weakening because of them, not despite them. Because the problem is a supply-side problem that the ECB cannot solve. Rising interventionism and tax wedge that choke the private initiative despite alleged attractive conditions.

The other problem of diagnosis is to believe that credit growth and investment today are insufficient.  There is no evidence that companies are investing less than what they need or that citizens are not taking the credit they desire and are able to repay, rather the opposite. In fact, the rise of zombie companies that the BIS mentions in various papers is precisely a sign of malinvestment and excess capacity. Ultimately, the central planners who believe that credit and investment growth are insufficient think so because they ignore technology and aging of the population. When governments and central banks ignore the diminishing requirement of capital investment that technology creates and the changes in consumption and investment patterns from demographics, their diagnosis of what is adequate investment and consumption is simply wrong. Even worse, when the rationale to support the idea of “lack of investment” and therefore a need for lower rates is based on looking at 2001-2007 as “normal” years, they are always going to make a mistake. Those were years that no one should consider as average, but years of a bubble that burst badly.

A recent analysis made by Scope Ratings showed that “a tiered system of remunerating reserves to mitigate the impact of lower rates on bank profits will have a limited effect. Euro Area banks have already incurred EUR 23.2bn in charges since the negative-rate began policy in 2014, EUR 7.5bn in 2018 alone”. Scope calculates the annualized current running cost of excess liquidity is EUR 6.8bn. Any further cut to the deposit rate would cost EA banks EUR 1.7bn. “In other words, EA bank ROE is c.40bp lower than it would be in the absence of negative rates.

Why should the ECB raise rates by a small 25bps then?

  1. It would show a sign of normalization without any real impact on mortgage, credit or investment growth. It would be a signal of health.
  2. It would stop the bleeding in banks, ultimately supporting the credit transmission mechanism, especially relevant in the eurozone, where banks finance 80% of the real economy.  Read this paper by Urbschat et al “The Good, the Bad, and the Ugly: Impact of Negative Interest Rates and QE on the Profitability and Risk-Taking of 1600 German Banks“. as well as Christensen et al “Negative Rates and Inflation Expectations In Japan“.
  3. Negative interest rates are generating dangerous collateral incentives to take more risk in speculative areas, refinance zombie entities and drive investors to levels of excess risk that many find difficult to understand.Worth reading Palley’s  “The fallacy of the natural rate of interest and zero lower bound economics: why negative interest rates may not remedy Keynesian unemployment“, even if you disagree (as I do) with the idea of “demand shortage”. We have excess supply from demand-side policies, as well as “Global Real Rates, A Secular Approach” by the BIS.
  4. Persisting with Japan-style measures, ignoring technology and demographics, as well as ignoring the side effects of negative rates will only lead the eurozone deeper into stagnation. The paper “Raise Rates to Raise Inflation? Neo-Fisherianism in the New Keynesian Model” by  Garin et al also show that even if you follow the Keynesian principles of central planners, the best way to improve inflation expectations is to mildly raise rates.

The evidence of the last years shows that the eurozone is slowing down in the middle of an unprecedented chain of fiscal and monetary stimuli. The failure to improve growth cannot be detached from the persistence on repeating failed measures. Implementing a larger quantitative easing and deeper rate cut program will not solve it,  because the diagnosis is incorrect.

A small rate hike added to support to those governments that implement structural reforms may help the eurozone. Monetary policy now is dangerously whitewashing populists who feel they can increase imbalances and put further fiscal strains on their countries’ budgets with no real risk, as yields continue to fall, albeit artificially.

A small rate hike would be a healthy signal that may help the ECB understand the real secondary demand for sovereigns, stop the zombification of the economy and improve liquidity transmissions to the real economy. Instead of being an incentive for reckless behavior from deficit-spending governments, it can be the beginning of an incentive to strengthen the private sector and the real economy.

Oct 26
0

Are Central Banks Nationalising the Economy?

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The FT recently run an article that states that “leading central banks now own a fifth of their governments’ total debt”.

The figures are staggering. Without any recession or crisis, major central banks are purchasing more than $200bn a month in government and private debt, led by the ECB and the Bank of Japan.

  • The Federal Reserve owns more than 14% of the US total public debt.
  • The ECB and BOJ balance sheets exceed 35% and 70% of their GDP.
  • The Bank of Japan is now a top 10 shareholder in 90% of the Nikkei.
  • The ECB owns 9.2% of the European corporate bond market and more than 10% of the main European countries’ total sovereign debt.
  • The Bank of England owns between 25 and 30% of the UK’s sovereign debt.

A recent report by Nick Smith, an analyst at CLSA, warns of what he calls ” the nationalization of the secondary market .”

The Bank of Japan, with its ultra-expansionary policy, which only expands its balance sheet, is on course to become the largest shareholder of the Nikkei 225’s largest companies. In fact, the Japanese central bank already accounts for 60% of the ETFs market (Exchange traded funds) in Japan.

What can go wrong? Overall, the central bank not only generates greater imbalances and a poor result in a ‘zombified’ economy as the extreme loose policies perpetuate imbalances, weaken money velocity and incentivize debt and malinvestment.

Believing that this policy is harmless because “there is no inflation” and unemployment is low is dangerous. The government issues massive amounts of debt and cheap money promotes overcapacity and poor capital allocation. As such, productivity growth collapses, real wages fall and purchasing power of currencies fall, driving the real cost of living up and debt to grow more than real GDP.  That is why, as we have shown in previous articles, total debt has soared to 325% of GDP while zombie companies reach crisis-high levels, according to the Bank of International Settlements.

Government-issued liabilities monetized by the central bank are not high-quality assets, they are an IOU that is transferred to the next generations, and it will be repaid in three ways: with massive inflation, with a series of financial crises or with large unemployment. Currency purchasing power destruction is not a growth policy, it is stealing from future generations. The “placebo” effect of spending today the Net Present Value of those IOUs means that, as GDP, productivity and real disposable income do not improve, at least as much as the debt issued, we are creating a time bomb of economic imbalances that only grows and will explode sometime in the future. The fact that the evident ball of risk is delayed another year does not mean that it does not exist.

The government is not issuing “productive money” just a promise of higher revenues from higher taxes, higher prices or confiscation of wealth in the future. Money supply growth is a loan that government borrows but we, citizens, pay. The payment comes with the destruction of purchasing power and confiscation of wealth via devaluation and inflation. The “wealth effect” of stocks and bonds rising is inexistent for the vast majority of citizens, as more than 90% of average household wealth is in deposits.

In fact, massive monetization of debt is just a way of perpetuating and strengthening the crowding-out effect of the public sector over the private sector. It is a de facto nationalization. Because the central bank does not go “bankrupt”, it just transfers its financial imbalances to private banks, businesses, and families.

The central bank can “print” all the money it wants and the government benefits from it, but the ones that suffer financial repression are the rest. By generating subsequent financial crises through loose monetary policies and always being the main beneficiary of the boom, and the bust, the public sector comes from these crises more powerful and more indebted, while the private sector suffers the crowding-out effect in crisis times, and the taxation and wealth confiscation effect in expansion times.

No wonder that government spending to GDP is now almost 40% in the OECD and rising, the tax burden is at all-time highs and public debt soars.

Monetization is a perfect system to nationalize the economy passing all the risks of excess spending and imbalances to taxpayers. And it always ends badly. Because two plus two does not equal twenty-two. As we tax the productive to perpetuate and subsidize the unproductive, the impact on purchasing power and wealth destruction is exponential.

To believe that this time will be different and governments will spend all that massive “very expensive free money” wisely is simply delusional. The government has all the incentives to overspend as its goal is to maximize budget and increase bureaucracy as means of power. It also has all the incentives to blame its mistakes on an external enemy. Governments always blame someone else for their mistakes. Who lowers rates from 10% to 1%? Governments and central banks. Who is blamed for taking “excessive risk” when it explodes? You and me. Who increases money supply, demands “credit flow” and imposes financial repression because “savings are too high”? Governments and central banks. Who is blamed when it explodes? Banks for “reckless lending” and “de-regulation”.

Of course, governments can print all the money they want, what they cannot do is convince you and me that it has a value, tat the price and amount of money they impose is real just because the government says so. Hence lower real investment, and lower productivity. Citizens and companies are not crazy for not falling into the trap of low rates and high asset inflation. They are not amnesiac.

It is called financial repression for a reason, and citizens will always try to escape from theft.

What is the “hook” to let us buy into it? Stock markets rise, bonds fall, and we are led to believe that asset inflation is a reflection of economic strength.

Then, when the central bank policy stops working -either from lack of confidence or because it is simply part of the liquidity-, and markets fall to their deserved valuations, many will say that it is the fault of “speculators”, not the central speculator.

When it erupts, you can bet your bottom dollar that the consensus will blame markets, hedge funds, lack of regulation and not enough intervention. Perennial intervention mistakes are “solved” with more intervention. Government won on the way up, and wins on the way down. Like a casino, the house always wins.

Meanwhile, the famous structural reforms that had been promised disappear like bad memories.

It is a clever Machiavelian system to end free markets and disproportionately benefit governments through the most unfair of competitions: having unlimited access to money and credit and none of the risks. And passing the bill to everyone else.

If you think it does not work because the government does not do a lot more, you are simply dreaming.