The dwindling impact of QE and burgeoning global debt burden

On the 7th of November 1930, Caldwell and Company (banking/brokerage/insurance firm), still reeling from losses sustained in the 1929 stock market crash, announced that its subsidiary the Bank of Tennessee (Nashville) would have to close its doors as reserves were insufficient to cover withdrawals. A string of other regional banks in the south soon followed suit before the contagion swept north forcing the fourth biggest bank in New York City, the Bank of the United States, to cease operations. The Great Depression was in full swing, as a fragmented and undercapitalized banking system collapsed under the weight of falling consumption and an agricultural sector suffering from overcapacity and far too much leverage (those fancy new tractors were simply too cool to resist!).

Meanwhile, across the pond, Germany was encumbered with a punitive debt burden resulting from the Treaty of Versailles. She owed billions to Britain and France which was largely funded by American banks (via the Dawes plan), so when US credit froze up the European economies also fell off a cliff. Hoover had failed to veto the Smoot-Hawley Tariff Act and trading partners had retaliated with tariffs of their own, hindering international trade and exacerbating the global economic decline.

It wasn’t until in 1932 — Hoover’s final year before losing in a landslide to FDR — that the Fed, armed with congressional approval, opened the liquidity floodgates by initiating an unannounced round of quantitative easing to the tune of 1 billion USD (although half was sterilized by shorter-term securities). In today’s dollars, that’s only about 18.7 billion USD, but the size of the economy back then was also much smaller so commentators note the size was comparable to the 600 billion round of MBS purchases of QE1. When you run the numbers the 1 billion in 1932 equates to a little under half of the QE1 monetary impulse measured in GDP terms.

Within months short term market rates dropped to 50bps. As excess reserves hit $500 million the Fed’s reluctance increased and they halted UST purchases in November 1933. Cleverly, Roosevelt then effectively shifted the monetary expansion over to the Treasury via gold purchases, which were naturally followed by a revaluation (Gold Reserve Act 1934) which netted the US Treasury a windfall of more than $2 billion. Coupled with the forceful fiscal expansion of the New Deal, the easing successfully helped shape a bottom in the money supply, real GDP and inflation in 1933. It’s difficult to disentangle the tailwinds from easier credit conditions and the devaluation of the USD. At $35 a troy ounce in January 1934, the USD retained just 59% of its pre-crisis gold content which is a huge macroeconomic shock. Indeed, Eichengreen and Sachs (1985) make a compelling case that the mechanical devaluation of the USD relative to gold was the real stroke of genius that reflated the US economy.

Fast forward to today and I argue that we find ourselves in a more precarious monetary quandary. Although an impactful response to the Lehman shock was certainly warranted — particularly to shore up the flow of short term credit in the banking system — multiple rounds of quantitative easing by the world’s largest central banks (Fed, ECB, BoJ etc) over the ensuing decade have been largely ineffective at stimulating a self sustaining recovery in broad money creation and growth.

In the post-Lehman era of coordinated global MB expansion, the backdrop had been more favourable until around mid-2014 due to a somewhat hidden magnification effect. As the Fed expanded its monetary base USDs traded softly in FX markets. Whether that’s logical or not is another discussion as broad money is created in the banking system, not by the central bank — case in point Japan and the collapse of their money multiplier. In any case, the PBoC (People’s Bank of China) was persistently on the bid scooping up USDs as part of their currency management program, and they were buying those USDs with CNY effectively created out of thin air (a CB balance sheet expansion of their own). Other central banks with managed/pegged currencies also do this, but China holds the largest amount of FX reserves globally so is the most important player. Here you can inspect the evolution of global FX reserves. We find that from Q4 2008 to mid-2014 when the combined Fed+ECB+BoJ balance sheet increased by roughly 6 trillion USD, we saw a 4.5 trillion increase in global FX reserves which peaked at just over 12 trillion. That’s some policy leverage! And all of those reserves have to be reinvested back into markets. Typically it’s in US government bonds but the more audacious CBs like the SNB and BoJ haven’t shied away from lifting stocks onto their balance sheets either via their FX reserves or as part of the easing program directly (at the end of March the BoJ was a top-10 shareholder in 49.7% of all Tokyo-listed companies, while the SNB has about 20% invested in equities making it the largest hedge fund in the world ahead of Bridgewater).

So how successful has this grand experiment been? Well, we can inspect European monetary aggregates here, Japan money stock here, and M3 growth (annualized) in the US here. The reality is that despite the radical stance global central banks have taken over the past decade, the rate of broad money creation — that is, the money circulating in the economy for goods and services which plays an important role in GDP growth — has been broadly slowing across the globe. Indeed, in China, arguably the nation with the most glaring signs of unsustainable indebtedness, broad money growth has slipped to multi-decade lows. What the policy(ies) have been tremendously successful at, though, is propping up financial market assets which central bankers claim is a boon via the so-called wealth effect.

But the wealth effect is somewhat tenuous. I think we can all agree that housing markets sit at the heart of most economies as households typically have the majority of their equity tied up in their homes. A housing market downturn can foreseeably weigh on consumer confidence and spending. Connecting consumption with stock market prices and appetite for credit with short or long-end yields, however, is drawing a long bow. In fact, you can argue that making capital too cheap incentivizes financial leverage and malinvestment, leading to the creation of bubbles at the expense of longer-term GDP growth. Perhaps Harris Kupperman summarizes the issue most succinctly… “capital markets exist to finance businesses — they should not exist to drive economic growth through a distributed wealth effect that narrowly benefits the wealthy who have capital market assets.”

So here we find ourselves a little over a decade on from the Global Financial Crisis and it feels like once again, people are long risk but suffering from short memories. Soaring asset prices and artificially suppressed borrowing rates have led to burgeoning non-financial corporate and household debt burdens. Meanwhile, however, our productive capacity to service those debts has languished amid lacklustre inflation/growth rates due to sluggish broad money growth, resulting in higher debt-to-GDP ratios across most sectors of the global economy. The transmission mechanism on current European and Japanese (base money) QE is weak simply because you can lead a horse to water but you can’t make her drink. In other words, print all the base money you like but unless the non-financial private sector is willing and able to borrow money from the banks for productive purposes (the true source of money creation), base money expansion offers little traction for the real economy.

Post-WW2 Japanese central bankers were acutely aware of this as they championed “window guidance” — essentially forced quarterly broad money expansion or ‘credit allocations’ via the private sector banks to corporations — until it was formally abolished in July 1991. There’s no denying that window guidance got out of hand in the late 1980s when Toshihiko Fukui (head of the BoJ’s banking department and responsible for window guidance quotas) drove a rapid expansion in bank credit which effectively fuelled the Japanese asset bubble. Interestingly, some even argue that BoJ leaders orchestrated the bubble in the name of structural reform, as the only way they could dismantle the power structures that existed at the time — particularly the influence of the MoF — and gain BoJ independence, was to create a crisis. But regardless of what transpired politically, the monetary dynamics and resulting bubble economy of Japan serve to demonstrate the importance of broad money creation in determining inflation, growth and asset prices. Base money expansion in isolation, on the other hand, has an underwhelming track record.

Today, broad money growth is sputtering across the world against a backdrop of heavy indebtedness in relation to growth. The slowdown in China is particularly worrisome as their growth has been feeding off a multi-decade investment-led boom, which incidentally, has been powered by a system of managed credit allocation similar to what the Japanese implemented during the window guidance era, but instead funnelled primarily through the public sector to local governments and state-owned enterprises.

Attempting to time sovereign or banking crises is a fool’s errand. The world is chaotic, catalysts that tip the system into a state of instability can be hard to pinpoint, and it’s difficult knowing how or when or how effectively the government will respond. Having said that, the combination of high debt and low growth has historically been a recipe for economic turmoil. In the case of China specifically, we’ve seen the credit-fueled investment crazed economic blueprint before with the Soviet Union in the 50s-60s and Japan in the 70s-80s. Both were deemed “economic miracles” at the time but ended in tears as you can’t rely on non-productive investment to boost the numbers forever.

Given the backdrop, I’ll elaborate on a couple of key risk scenarios that arguably follow, with one being more likely than the other. The first is that China has to pump the brakes on investment growth. As the economy slows we see defaults, asset write-downs and a quasi-forced rebalancing of the CNY in order to stabilize their economy. FX reserves are likely tapped to recapitalize the banks. A managed devaluation is not politically palatable with the US given ongoing ‘trade-war’ tensions and hence they choose to float the CNY. This scenario is extremely bearish asset prices globally. Not only would the PBoC sell bonds (mainly UST) to finance FX reserve deployment domestically, a weaker CNY (I think it devalues in a float) would present a deflationary shock to the globe triggering defaults and money destruction abroad. Commodity exporters are hit the hardest as the world tips back into recession. Alternative scenarios where USD strength, weak global demand and FX reserve erosion force the PBoC to float the CNY before domestic credit issues come to bear result in the same global malaise so we can group them all together. Let’s call it “CNY-deval driven global deflation”. It’s hard to predict how BTC might perform in this scenario as we haven’t witnessed how it trades in a real crisis. Interestingly though, in recent times when USDCNY has been rubbing up against the key psychological 7.0 level Bitcoin has been bid, perhaps due to the Chinese experiencing an increased sense of urgency to get wealth offshore. Although some claim Bitcoin could act as the perfect hedge against failures in the traditional banking system, it’s still an asset prone to liquidation if people have to pay debts and it’s difficult to forecast collective human behaviour in a panic. If this scenario plays out we get to see if Bitcoin really is “digital gold” or just flat-out sold. Gold obviously does well in this landscape.

A more likely outcome, in my view, is that the Fed pivots towards a very dovish stance. You may counter that a lot is already priced into the Fed funds curve in terms of rate cuts but I am alluding to cuts being followed by a return to balance sheet expansion to monetize fiscal deficits, potentially as early as 2020. Although the US economy is doing quite well, I think a dovish Fed is likely for several reasons. Weakening the USD alleviates pressure on emerging market economies that have borrowed in USD (fx unhedged), as well as taking the pressure of the USDCNY soft peg (PBoC FX reserve drain). Most commodity markets are priced in USD terms so a weaker USD helps stoke reflation which softens the global debt burden in nominal terms. Lastly, the US government’s fiscal position is poor and is projected to deteriorate. Indeed, some pundits forecast gross interest on government debt + entitlements to eclipse tax revenues within just 2–3 years. Also, recall that foreigners on balance have been largely absent from funding the US government for several years now (China a net seller since 2014). Unlike Japan, who runs a steady current account surplus, the US runs a twin deficit. As foreigners retreat, the US private sector must step in to fund the government, and that funding burden is getting heavier and heavier (Trump hates tax but loves to spend). You can see this already biting with the effective fed funds rate recently pushing 7bps over IOER — a symptom of a USD shortage in the US banking system. In this scenario, an uber dovish Fed buys the world time. Even if endless balance sheet expansion is set to ultimately fail due to the drag of unfavourable demographic trends, a return to balance sheet expansion yields a suite of benefits internationally and gives us another chance of potentially sparking a self-sustaining era of global reflation. Particularly under the current administration, this isn’t so hard for the Fed to justify. Clearly, this scenario favours Bitcoin strongly. Gold also does well, but Bitcoin has a higher beta to global monetary conditions. It’s a smaller market which takes less real inflow to drive a boom in price, and the media will have a field day with the Fed turning the printing press back on thereby supporting its image. While gold wins in both scenarios, a splash of Bitcoin in your portfolio would provide a welcome kicker if the Fed starts pumping out ‘Benjamins’ again.