Loose Money: Stop Us* Before We Kill Again

9 May

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:

US borrowing

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.

dispersion

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.

shadow

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.

15 Responses to “Loose Money: Stop Us* Before We Kill Again”

  1. Charlie May 10, 2013 at 6:24 am #

    Perhaps bubble is not quite the right term.. But do you think 4% in dollars compensates you for all the risks in Nigeria over 8 years, or 2.x% in Brazil for risks on a 10 year horizon. And EM debt is the good story.

  2. Paul Andrews May 10, 2013 at 8:12 am #

    Your tweet said: “Beware the austerians’ new scam.” – but there’s no mention of a scam here. The article seems more moderate – why the provocative tweet?

    • pawelmorski May 10, 2013 at 8:54 am #

      Clickbait tbh

      • Paul Andrews May 11, 2013 at 8:14 am #

        AKA unfollowbait

  3. SK May 10, 2013 at 8:42 am #

    Inflation is not in the toilet. In UK in 2011 essential inflation was above 8% and even now RPI is still above 3%.
    Anyone claiming the opposite does not probably live in the real world or probably consumes electronics for lunch/dinner.

    As for bubbles, you only have to look for UK property in order to see a big bubble which is suffocating the economy.

    And it is not only savers who are damaged. You can add pensioners, tenants, FTB and youth. The longer the low yields stay the more youth/savers/tenants/FTB will have no compound effect on their savings/pensions and they will not have the assets to support them when they grow older compared to the current baby boomers generation.
    But nobody from CBs is thinking about the future.

  4. William Herschel May 11, 2013 at 10:34 pm #

    Is there a current bubble in stocks and bonds? Haven’t people made a bundle in stocks and bonds since Lehman? The “problem” being that no one will sell.

    Buy and hold versus buy and buy. Both result in a bubble.

    Does anything there make sense?

  5. karroryfer May 12, 2013 at 6:57 pm #

    Reblogged this on Karroryfer's Blog.

Trackbacks/Pingbacks

  1. Stability through instability | She's a Savvy Investor - May 10, 2013

    […] can read some very nice recent responses to these points here and here. I have commented on this line of thinking in the past (see the first link above and this). But […]

  2. Counterparties: Bernanke haters | Felix Salmon - May 10, 2013

    […] Pawel Morski looks at lending, the shadow banking sector and the bond market and sees little evidence that the Fed is pushing the financial sector into anything resembling pre-crisis behavior. Still, the anti-Bernanke crowd may have some new ammunition: junk bond yields fell below 5% this week for the first time ever, IFR notes. As the Fed has kept interest rates at historic lows, investors looking for higher returns have piled into the junk-rated corporate debt. Even if that 5% record is effectively meaningless, these milestones can have an effect. “Asset bubbles now rank as the number one concern on credit investors’ minds,” Bank of America Merrill Lynch analysts said. – Ryan McCarthy […]

  3. Yes, Central Banks Should Care About Financial Stability | Matthew C. Klein - May 13, 2013

    […] necessarily think that central banks should start tightening up right now. Pawel Morski points us to the ongoing shrinkage of the shadow banking sector. That makes it hard to argue that […]

  4. It Is That Simple: Europe’s Problem is the Banks. | It's Not That Simple - May 16, 2013

    […] The numbers for the Eurozone are an average. Clearly Greece’s depression is linked to massive fiscal cuts (even if I’m the sort of person who distinguishes between austerity and not having any money). But on the other hand, on average Eurozone citizens haven’t faced much tighter fiscal policy than the Americans. (Brits on the other hand, clearly have). It’s an awful lot easier to say “the ECB should do something” than suggest exactly what it should do. In terms of cutting rates, it’s all but impossible to argue that they’ve done much less than the Fed. US banks are much smaller (relative to GDP) and the US has deeper and healthier non-bank capital markets to help when the banks are in trouble (see I warned you there was neoliberal apologia here). The US has a unified banking system – the fragmentation within Europe (German banks flooded in liquidity, peripheral ones treading carefully) is extremely difficult to address when sovereigns can’t recapitalise banks to the point where they’re happy to lend again. Fixing the banks is a job beyond pure monetary policy. Still, even bearing this in mind, it’s hard to argue that the ECB has done everything it can. Advantage Bernanke and the horse-waterboarders. […]

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