Just as QE becomes popular, it’s probably too long in the tooth

Back in 2008 when the US commercial and investment banking systems were in deep difficulty (even before Lehman) and the private sector became obliged by the drying up of credit availability to close its cash flow deficit, it was widely expected that the US government would be obliged first to expand its own balance sheet via an increase in its budget deficit, and that sometime in the following year the Federal Reserve would also be obliged to use its own balance sheet as lender, dealer and Treasury funding principal of last resort. Such thinking assumed that the US would move forward with something similar to the Bank of Japan’s Quantitative Easing (QE) regime of the early 2000s – and back in 2008, the acronym ‘QE’ caused eyebrows to be raised. But the most extreme consequences were expected to be perhaps a $1 trillion US budget deficit and maybe a few hundred billion dollars of Federal Reserve Board (FRB) balance sheet expansion.  Certainly a peak budget deficit of $1.8 trillion (the peak quarterly annualised rate) was not foreseen and neither was the extent to which the FRB would be obliged to expand its balance sheet and embrace QE as a foundation for its policy response to the crisis.

At the time, we thought that we were controversial suggesting that Japan-style budget deficits and Quantitative Easing would be used in the US, we did not anticipate the extent to which QE would come to dominate not just the financial landscape but even the general public’s consciousness. Now, we find need to consider if QE has served its purpose of stabilising the commercial banking sector and should be withdrawn. This may be regarded as something of a heresy given that it is widely seen as the preferred way forward but it’s important to think through what’s at stake.

From first principles, what is described as QE typically involves a central bank either buying assets itself (the FRB and BoE versions), or lending money to the commercial and/or investment banking systems, so that they can in turn buy financial assets in the primary or secondary markets (the Japanese & ECB versions). In a monetary sense, both approaches are broadly similar, although if it works as intended, the second (the Japanese/ECB) model can be more effective since it tends to have a positive impact on bank profitability and therefore capital ratios, while the advantage of the US/UK example is that it has a more certain outcome. By either route, however, there is an inflow of money into financial markets and bond markets in particular.

When the central bank invades the debt markets, either directly or via the banks with LTROs and similar, it naturally creates easier funding conditions for would-be issuers in these markets, and real interest rates tend to fall or become negative. Corporate bond issuance tends to surge despite the fact that governments also tend to have large borrowing requirements at the very time that QE is deemed necessary. For example, the USA has a budget deficit of c.10% of GDP but the net issuance of corporate bonds is running at 3% of GDP, and this is one of the highest rates in the last sixty years (if not ever) and on a par with the extreme levels of issuance seen in the 1999 ‘dotcom’ bubble. In Europe, corporate bond issuance was running at 1% of GDP, on a par with level seen in the boom in the late 1990s until last year’s crisis, and it has recently even started to rebound despite the ongoing fiscal crisis. Meanwhile UK corporate bond issuance has also picked up of late.

In addition, when central banks buy securities in the markets, they also create more bank deposits in the system and this tends to lead to a higher level of bank reserves in the financial system, which implicitly creates much easier funding conditions for the banks. (Alternatively, a central bank may simply lend to its commercial banks under what might be termed ‘QE’ by the market, such as the ECB’s LTROs and while this may be QE using strict definition, it plainly does improve the funding situation of the banks.)

As a result, the main practical impact of QE is to make it easier for governments, large companies and banks to fund themselves. These easier funding conditions then make it easier for these public sector financial institutions to expand their balance sheets. But it is at this point that the first of many contradictions of QE begin to arise. Thus QE may lead to expansion the public sector’s balance sheet, which may be expected to be unproductive. It may act against financial discipline and efficiency, and incentivise use of the easy funding conditions to indulge equity buybacks, takeovers and corporate speculation generally, but not necessarily real investment in the economy. With specific focus on commercial banks, with QE, they are incentivised to expand their balance sheets but are likely to divert these new funds to financial sector borrowers rather than real sectors because financial sector borrowers tend to want short term funding and will be able to offer liquid acceptable collateral whereas real world borrowers may want longer term funds, but will have little in the way of useful or liquid collateral and may have already over-borrowed, struggling in the very conditions that led to QE being brought in. Moreover, banks have to raise capital to lend to the real sector whereas much of the lending to the financial sector is capital efficient.

With regard to households, low real interest rates reduce returns on savings but this can encourage people to save harder as they try to protect the real value of their nest eggs. This was certainly apparent in the low real interest rate and unstable economic environment of the 1970s. Moreover, households often end up chasing yields in riskier investments which may or not be prudent. Where the low rates do encourage spending, it tends to be amongst either the financially less prudent or a relatively small subset of the more well-off members of society.

The consequence of these implications is that financial markets love QE, but the real economy may not benefit, at least in terms of sustainable longer term growth. Certainly activity rates do tend to improve during QE phases but, as Japan has shown, surges can prove to be temporary and may be reversed when QE ceases.

Arguably QE fails to deliver sustainable growth because although it creates bubble-like funding conditions in the debt markets, the resulting funds rarely end up being used for investment in the real sector and instead simply allow a period of enhanced consumption by governments or the more well off members of society. Indeed, reliance on QE may depress real investment activity and add to income and wealth inequality in society while bearing down on those that wish to save and live within their means. As the economic, social and political implications of QE become more obvious, so the tide may turn against QE and with living standards perceived to be democratic proxy for economic health, governments that rely on QE as the key policy tool may lose office.

There may instead be a rising appetite for long term growth boosting supply side reforms and proper consideration as to whether there should be an orderly dismantling of the Euro, which could ultimately raise global growth prospects by restoring economic efficiency to Europe.

The backcloth is that QE has not delivered what was expected, although it did save commercial banks from failure. The ‘failure’ was to be expected: with Japan’s experiments in the 1990s and 2000s, capex was weak, employment trends poor, and household income growth negligible despite fiscal easing on top of QE. The trend in Japanese equity prices reflected this lack of success but we can note that before the Bank of Japan moved away from QE and instead explored monetary stability as an incentive for supply side reform, Japan’s equity market experienced a number of periods of near triple digit percentage gains in equity prices when it enacted some form of QE. Importantly the gains were subsequently lost when QE ceased and there is little evidence of a feasible QE exit strategy that isn’t likely to depress asset prices. This supports the case for a new approach but absent a coherent plan, we may reasonably expect further QE which can support asset prices indiscriminately. However for long term investment strategies, we need a firm foundation of sustainable growth, and this will likely deliver superior long term returns to patient investors.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla