QE or not QE
Gregor Logan has kindly allowed me to reproduce an article of his about QE. When I started out in the City, he was a star fund manager at Fidelity and I never had the privilege of having him as a client. But we met about a year ago, and I have really enjoyed (and benefited from) chatting with him about markets. Today he is an adviser to and non executive director of various investment firms and writes the occasional blog. The article on QE is reproduced below.
Why should we be worried about unwinding QE?
There is a growing list of serious people warning about the possibility of financial market volatility as and when the US raises interest rates and the UK possibly follows later in the year. The IMF was the most recent, warning of the possibility of a ‘super taper tantrum’. Steven Major, head of fixed income research at HSBC was also quoted in the FT last week warning of a possible liquidity trap as the supply of tradable government bonds diminishes.
The world has experienced cycles of economic growth and decline for centuries. Keynes was one of the most articulate economists on how policy-makers should respond to these cycles. He argued for counter-cyclical government spending during downturns and advocated balancing the books or even running budget surpluses during periods of strong economic growth.
With hindsight it appears the great failing of government spending decisions in the US, UK and Europe in the period of strong economic growth of the 2000s was to allow growing budget deficits during a period of rapid economic expansion. Instead of being prudent in the upturn in order to have something in reserve for the downturn, governments were profligate.
Some economists go further and argue that the speculative bubble of 2007/8 was made worse by this public spending. Whether or not this was true, the result was heavily indebted governments with big public sector deficits when the crisis unfolded. This meant Keynesian counter-cyclical government spending was not an available policy option. On the contrary, the-then new UK coalition government controversially deemed it necessary to seek to reduce the deficit in the face of severe recession with their policy of austerity.
Central banks responded to this environment of imploding growth following the 2008 financial crisis by driving interest rates to zero. When zero interest rates appeared to be insufficient to kick-start their respective economies, and in particular the ability of the commercial banks to lend to customers, they introduced a new and novel policy termed quantitative easing, or QE. In brief this involved the central banks buying government debt. This drove down interest rates right along the yield curve but just as importantly it created an environment in which the banks could rebuild their battered balance sheets.
QE has clearly been a force for good in getting economic activity back on track, but there have also been a raft of unfortunate and mostly unintended consequences. The debt burden in the Western economies is higher now than before the crisis. Speculative activity is evident in many asset classes. Savers have lost out to asset owners and speculators. Institutions that rely on yields from government bonds are struggling. The FT reported last week that Swiss pension funds will be bankrupt in 10 years if rates stay at current levels as guaranteed pay-outs can no longer be funded from income.
Robert Schiller, who successfully identified the bubble in equities prior to the 'dot com bust' in 2000 – and the same in US housing in 2007 – has updated his excellent book Irrational Exuberance with a chapter discussing the possibility of a bubble in the bond markets and what this might mean for the real economies if the bubble should burst as it did in the equity and housing markets previously. He concludes: “there is indeed reason to be concerned about the possible widespread economic effects of an end to this decades-long downtrend in real long-term interest rates, and of a corresponding drop in long term bond prices.”
Arguably this new and previously untried policy of quantitative easing would not have been necessary had the fiscal option of increased government borrowing and spending been available as the downturn unfolded.
The legacy after six years of anaemic and patchy recovery is that interest rates remain at zero, government debt is at an all-time high and central bankers still own all of the debt bought through QE. In the case of the UK, some £375bn of it. That’s about half a years’ worth of government spending.
Why might this matter? I think the simple answer is that it leaves policy-makers very short of options in the event of another crisis or downturn. Should some exogenous shock come along and, for example, burst the bubble in financial markets which spills over into the real economy, policy-makers are left with a dilemma. They can’t cut interest rates, they can’t raise government borrowing and yet more QE is going to leave the central banks owning all of the world’s government debt.
Governors Carney and Yellen, of the Bank of England and Federal Reserve respectively, both thought they would shrink their respective balance sheets by allowing the debt to mature, but this caused the taper tantrum in October 2013. Now they talk of only doing so after interest rates have risen a lot and so can be lowered should there be negative consequences. But by putting up short rates, the likelihood is long-rates will rise also, leading to significant losses in bond markets and for central banks.
I am sceptical of the argument that putting QE in place was a major force for good and unwinding it will have no consequences. I also believe policy-makers should be in a position to administer prudent fiscal and monetary policy in the event of a crisis or downturn. I don’t think that is the case today in Western economies, nor will it be until QE has been unwound and interest rates normalised.
Thanks to Gregor Logan for sharing these thoughts.