You see there have already been several programs written that help you to arrive at decisions by properly ordering and analysing all the relevant facts so that they then point naturally towards the right decision. The drawback with these is that the decision which all the properly ordered and analysed facts point to is not necessarily the one you want.”
“Well, Gordon’s great insight was to design a program which allowed you to specify in advance what decision you wished it to reach, and only then to give it all the facts. The program’s task, which it was able to accomplish with consummate ease, was simply to construct a plausible series of logical-sounding steps to connect the premises with the conclusion. “And I have to say that it worked brilliantly. Gordon was able to buy himself a Porsche almost immediately despite being completely broke and a hopeless driver. Even his bank manager was unable to find fault with his reasoning. Even when Gordon wrote it off three weeks later.”
Adams, Douglas (2009-08-21). Dirk Gently’s Holistic Detective Agency (p. 69). Macmillan Publishers UK. Kindle Edition.
The answer is austerity and tight money. Now, what was the question? Inflation is clearly in the toilet and not set to resurface any time soon (so to speak), and looking really extraordinarily low once you look at core measures. The hyperinflationistas have lost the argument so comprehensively that you have a certain grudging admiration that they’re still sharing their wisdom. The grounds for opposing loose monetary policy is now Financial Stability.
The argument runs that the various bubbles around the world in the 00s were a result of loose money to offset the aftermath of the tech crash policymakers inflated unhealthy debt bubbles all over the world – so low rates to offset this crash will just result in more toxic imbalances, making the final crash all the more destructive. This is actually a pretty formidable argument, given that the success of loose money appears to depend on the financial sector* not being cretinous, selfish and shortsighted. Even Mike Konczal in the go-to takedown of the Financial Stability argument is forced to concede that:
It’s hard not to read the financial stability arguments as saying “look, we can’t trust the financial sector to accomplish its most basic goals.
What follows is basically my outline of why I think so far the industry has avoided the pitfalls that it’s being accused of falling into again, and what I’d suggest looking out for as a sign of “Honey I Shrunk the Economy”
The problem the world faces as we emerge from recession is that banks are reluctant to lend. Monetary policymakers are confronted with “You can lead a horse to water, but you can’t make it drink”. The response around the world has been instructive: Ben Bernanke has rolled up his sleeves, gone Zero Dark Thirty on the poor nag and started pouring water down its throat; Mervyn King has shrugged and put on his best “What Can You Do?” face; while the ECB has decided that the horse was actually looking a little overhydrated anyway. And what have the results been?
The strategy has been quite ruthless. Interest rates and government bond yields have been forced down to historically unprecedented levels. (this is unlike Japan, where in real terms, rates were consistently positive during the “lost decades”). As Ray Dalio – the most successful money manager of the last several years has noted, this is a deliberate strategy to force investors out of cash, and into “live” investments. Well in the US, surely grounds for optimism: lending to non-financial corporates is coughing into life:
Source: H-8, Flow of Funds
Now let’s be clear – this is not costless. By cutting rates, the Fed is favouring borrowers over savers. This is tough on retirees for example. But is it just inflating the next bubble?
The mysterious majesty of the capital allocation process:
Billy Ray Valentine: Okay, pork belly prices have been dropping all morning, which means that everybody is waiting for it to hit rock bottom, so they can buy low. Which means that the people who own the pork belly contracts are saying, “Hey, we’re losing all our damn money, and Christmas is around the corner, and I ain’t gonna have no money to buy my son the G.I. Joe with the kung-fu grip! And my wife ain’t gonna f… my wife ain’t gonna make love to me if I got no money!” So they’re panicking right now, they’re screaming “SELL! SELL!” to get out before the price keeps dropping. They’re panicking out there right now, I can feel it. (Trading Places, 1983)
Now the financial sector has been reformed. A bit. A lot of people got the fright of their lives, some legislation has been introduced. But is it enough? surely – for example – “High Yield” debt trading at sub-5% yields has to signify a bubble?
Not proven. Look not just at average yields, but dispersion within the asset class. The two graphs below aim to capture this. The first shows that although yields on BB-rated bonds are back through the bubble lows, investors are noticeably more reluctant to pile into the crappier end of the spectrum than they were then. Similarly, in Emerging market debt, the spread between the strongest and weakest credits is far
lower wider than it was back then.
Source: Citi, JP Morgan data
It’s worth bearing in mind what blew us up last time. The mechanism of Return on Equity = Return on Assets x Leverage dictated a model of piling into “safe assets” leveraged up to an insane degree. Not only were the assets crap, but leverage multiplied the losses. The damage was done in AAA-rated securities leveraged hugely, not in overbid EM debt and high yield markets. This model is – pretty much – absence so far. Even as “proper” commercial lending returns to pre-crisis highs, financial leverage remains well off the highs. Crucially, “Shadow banking” seems to have returned to the shadows. This is the key thing I’d suggest watching to see if it’s all going wrong again.
If this sounds pretty lukewarm, well it should. The financial sector’s incentives haven’t really been fixed, even if there’ a lot more change than widely appreciated outside and the political climate has clearly changed. But there’s damn all evidence of a bubble so far, and beware those who claim it’s already formed. In particular, part of the more impressive performance of the US economy is likely down to the determined efforts of the Fed in forcing liquidity into the system.
* I work in finance. Been on social media long enough to know it’s All My Fault.