21st November 2010
By Sam Kirtley
It is generally accepted that the recent financial crisis was brought about by excessive borrowing due to cheap and easy credit, and this excessive borrowing increased the risk in the financial system as market participants leveraged up to the hilt. Therefore it appears to be somewhat hypocritical to claim that the best action to take after such a crisis is to lower borrowing costs and make credit more accessible. This essay will explore the recent quantitative easing actions by the Federal Reserve, the repercussions of these actions and what implications similar policies may have on the financial markets and the global economy going forward.
The first effect of this quantitative easing by the Fed that we will consider is higher equity prices, which Chairman Ben Bernanke believes will lead to lower unemployment. Although such a leap may appear a tad far-fetched to some, Bernanke’s reasoning for this is based on an economic theory called the wealth effect, which states that an increase in spending accompanies an increase in perceived wealth. Therefore if the stock market is rising, consumers will feel wealthier and increase their spending. This will boost the economy and lead to more jobs, thereby decreasing unemployment.
The question that therefore must be raised is this: how many people actually feel richer and therefore spend more due to a rise in the stock market? One would have to have investments in the stock markets to be a beneficiary of such a rise, and with US domestic funds being hit with their 27th consecutive week of outflows, it is clear that the majority of ordinary retail investors do not have significant holdings in the stock market and those that do are reducing those holdings. Furthermore, retail outflows for 2010 stand at $85 billion, so the very consumers that Ben Bernanke is trying to stimulate by raising stock prices are pulling their money out of the market. Even if a consumer did have significant stock holdings, if they are to spend that money in the economy, then they will have to sell their holdings to create the cash to spend. In turn, this would exert a downward pressure on stock prices which the Fed is trying to keep high. Perhaps the Fed believes it can create more money to counteract this, or that consumers will borrow money against their stock market profits to spend, or they will start spending their cash savings instead of selling stocks. Whichever way one looks at it, the logic is built on shaky foundations. It makes one wonder why the Fed does not simply cut the stock market, (the middle section of the equation) out, and simply write all consumers a cheque. The recent measure quantitative easing announcement of US$600 billion split amongst the US population would give everyone $1954.35 each, which would undoubtedly lead to a fair increase in spending.
However there could be something to be said for the psychological effect of rising stock prices even for those who do not have any holdings in the stock market. This is the preposition that a rising stock market generally increases confidence amongst consumers leading them to spend more. Businesses may also be more confident in the state of the economy and therefore be more inclined to hire more workers. Such a boost in confidence, however, is more likely to be generated via a sustained rise in the stock market over a longer period of time. The fact that the S&P 500 has just about rallied to a level (1200) it first reached in nominal terms in 1998, some 12 years ago, isn’t exactly confidence building material.
Therefore, if the stock market is to truly have a psychological impact on the mindset of consumers and businesses, it would really need to make a new all time high. This would be a clear psychological sign that the business cycle is in an upswing and consumers can get back to spending, and businesses back to hiring. However the market would need to rally by a good 25% to reach these highs, something which may require a great deal more quantitative easing by the Fed to be achieved in the short term.
The image of the Federal Reserve pumping money into the system to keep stock prices rising may actually be counterproductive to confidence building. Ben Bernanke saying that it is necessary to print another $600 billion, on top of previous quantitative easing programs that injected over $1 trillion, in order to keep the stock market rising, implies that without such action by the Fed share prices would not be moving upwards. Therefore one can infer that all is not well in the economy and using the stock market as a barometer of the economic health is flawed since the market is being moved higher by the Fed’s actions, as opposed to good fundamentals. So while the wealth effect theory may have its merits, its application by the Federal Reserve to restore confidence and achieve their mandate of full employment is not going to work. After all, Zimbabwe’s stock market gained 30,000% in 2008, but nobody would say that it is an effective measure of economic health in that country, nor restoring confidence in the state of the economy.
A primary goal of the current Federal Reserve policy is lower interest rates, which it believes will stimulate growth after the global financial crisis. Despite the apparent hypocrisy of combating a financial crisis spawned by an excess supply of cheap and easy credit, by making credit cheaper and easier to access, there is another negative aspect to the Fed’s actions. During the recent global credit crisis, financial markets underwent a massive dose of deleveraging, in which there was a drastic selling of almost all assets in an attempt to increase core capital ratios. This reduced the risk in the system, which had grown to unstable levels as evidenced by the leverage in some financial institutions, which was running at around 30-1. However current Fed policies are creating strong incentives for institutions to increase their risk, and therefore the risk in the financial system.
As the Fed lowers interest rates by purchasing US Treasury bonds, which would be the common benchmark of a risk free asset, or at least the lowest risk possible for a US dollar investment, it lowers the incentive for investors to invest in these bonds. With one month Treasuries yielding just 0.13% and the real rates on even 5 year bonds being negative, there is not much return to be had in holding these bonds. This is of great concern to the management of highly competitive investment firms, all anxious for their performance to be substantially positive to secure bonuses not and to lag behind others. Therefore there is now a higher incentive to place funds in riskier investments, with money flowing not only into US equities, but gold, commodities and emerging markets as well, as shown by surges in their respective prices recently.
This shift in trading incentives has been dubbed “risk on/risk on” by many in the investment community, summarising the pattern of looser monetary policy leading to rises in the prices of riskier assets, risk on, and if monetary policy appears to be tightening or even becoming slightly less accommodating, risk is off and risky assets will be falling in price. The fact that the Fed actions are fuelling the “risk on” trade should be of grave concern to all market stakeholders, as it is increasing the risk in the financial markets and therefore increasing the probability of a crisis caused by deleveraging as we saw in 2008, since the same policies that brought about that crisis are in full swing yet again.
The rise in commodity prices spurred by the Fed’s actions has further negative repercussions, which are both economic and social in nature. Firstly, rising commodity prices risks stifling already fragile global economic growth. For example, soaring cotton prices have caused issues for many clothing business, and all are aware of the negative effect rising oil prices can have on economic growth. At best this could lead to some cost push inflation, but more serious consequences could include business shutting down their operations due to the rising cost of their raw materials. It may not be possible for businesses to increase their prices in accordance with the increase in costs to maintain profit margins, especially when most consumers are already reluctant to spend. Secondly there is the social impact of rising food and energy costs, which hit the poorest in society the hardest, since these items make up a larger proportion of their expenditure. The poorest 20% of Americans spend over 50% of their income on food and energy, whereas the richest 20% only spend 10%. One may think that the wealth effect of rising stock prices would then be counterbalanced by the rise in food and energy costs for Americans, but the reality is that the poorest 20% are being hit the hardest by rising commodity prices and likely do not have any meaningful investments in the stock market, if any at all. In comparison, the richest 20% are being affected the least by the rise in commodities and benefiting the most from rising stock prices since they are more likely to have meaningful investments in the market.
Another major goal of current Federal Reserve policy is apparently to devalue the US dollar, and the decline in the US dollar has also contributed significantly to the rise in commodity prices recently. The Fed believes that devaluing the dollar will lead to an increase in net exports, as American goods become cheaper in foreign currency terms, and this will lead to an increase in GDP and therefore a decrease in unemployment. Whilst this sounds like a reasonable argument at first glance, the argument loses credibility when one acknowledges that Bernanke is not the only central banker to have recognised this relationship, and the Federal Reserve isn’t the only central bank trying to devalue its currency in order to boost growth.
Since all currencies trade relative to one another, devaluation of the greenback can be cancelled out by the weakening of currencies that it trades against. Countries including Japan, Brazil, Peru, Taiwan and Korea have all intervened in an attempt to weaken their currencies against the US dollar. Brazil has gone even further and increased its tax on foreign inflows into fixed income and investment funds from 2% to 4%, in an attempt to reduce demand for the Brazilian Real. China has the most effective means of ensuring that their currency does not strengthen against the US dollar, simply by pegging the Yuan to the greenback and refusing to allow the Yuan to appreciate to a level which Bernanke and many others believe it should be trading at. The calls for China to allow their currency to appreciate, and Bernanke saying that their refusal to do so is hampering global growth, are falling on deaf ears. The Chinese are ultimately only interested in Chinese growth and the health of the Chinese economy, exhibiting the self interest quality that is indeed present in all countries. Therefore the theory that devaluing the dollar boosts exports and growth is not valid in this case, since there are too many players trying the same move.
A more serious threat is presented by these common policies of currency devaluation, being that a currency devaluation war will ensue as countries attempt to beat one another’s devaluation efforts and fight to have the weakest currency. This bares uncomfortable similarities to the infamous tariff war of the 1930s. Currency devaluation aims to make exports cheaper to foreign consumers and imports more expensive to domestic consumers, thereby increasing net exports. This has the same effect that trade tariffs had in the 1930s, as countries are still exhibiting protectionism, albeit using a different method. Therefore a currency devaluation war risks damaging global trade in a similar fashion to the way it was damaged by tariffs in the 1930s, something which is a serious threat given the consequences of such polices during the Great Depression.
One major currency that has yet to seriously enter this devaluation battle is the Euro, with the EU currently far too preoccupied with sovereign debt issues and trying to maintain the credibility of this relatively new currency in the global financial marketplace. In reality, the sovereign debt issues have caused plenty of downwards pressure on the Euro, so the ECB has not yet been forced to deal with the issue of a weakening US dollar causing the Euro to appreciate and harm European exporters. Whether or not the ECB will follow the Fed and embark on quantitative easing in the future is a topic best left to another essay, but the Fed actions are perhaps increasing the incentive for the ECB to do so since they are devaluing the US dollar and therefore strengthening the Euro relative to the greenback.
Regardless of how detrimental one thinks current Federal Reserve actions are, the reality is that Bernanke and his colleagues cannot do much else. The true problem does not lie in the actions of the Federal Reserve, it lies in the motive for these actions. The Federal Reserve has a mandate of using monetary policy to promote the objectives of full employment, price stability, and moderate long-term interest rates. Therefore their job is not to decide whether these goals are in the best interest of the economy, their function is simply to use monetary policy to achieve these goals. The goal of full employment is the problem here, since we are going through a slump in the business cycle, so the reality is that the unemployment rate should be fairly high. Attempting to bring this unemployment rate down, when market forces are dictating that it should remain high for some time, is not possible, at least not without causing additional problems that will most probably be more severe.
Therefore the solution for current challenges facing the American and indeed global economy is not quantitative easing, lower interest rates, higher stock prices or currency devaluation. The solution is to change the mandate of the Federal Reserve so that the only goal is price stability, allowing the Federal Reserve to step back from the current environment where inflation is low and under control, and thereby letting natural market forces to begin working to bring about a sustainable economic recovery built on solid fundamentals. Businesses should be focusing on to how to make their operations more efficient and competitive, rather than hoping a depreciation in the exchange rate will do this for them. A high unemployment rate is not the end of the world, recessions and slumps in the economic cycle are to be expected and taken in ones stride. It is the fear of these declines that is the more dangerous, since it leads to reckless and ineffective policy making in an effort to avoid them. This produces more significant negative consequences than if the economic cycle was simply left to run its course, with the free market dictating its movements.
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