In the Great Depression of the 1930s, existing economic theory couldnt explain the causes of the severe economic downturn, neither could it provide a policy recipe to get out of the recession. British economist John Maynard Keynes came to the rescue with a revolutionary idea.
While prevailing theory stated that markets would adjust themselves, Keynes showed that stimulating aggregate demand was key: to drive growth higher, governments should spend money they dont have. Keynesianisms popularity faded in the 1970s, when it couldnt address stagflation and when Milton Friedmans monetarist theory proposed expanding money supply as a better policy alternative.
Since the 2008 crisis, both theories have been pushed to the limit. Monetary expansion to revive growth and inflation has proven to be unsuccessful in Europe and Japan, where an impaired financial system has prevented liquidity from flowing to the real economy. Similarly, fiscal stimulus has proven slow in raising aggregate demand, which has been offset by rising private sector savings.
Absent any alternatives, the policy response has continued to be more of the same: lower interest rates and expansionary monetary policy. While preventing the worst from happening during the crisis, lower/negative interest rates and persistent QE have also brought several collateral effects, including rising wealth inequality, misallocation of resources and asset bubbles. These have been a boon to bond investors, but have hurt savers and failed to spur investment. As we discuss in todays Financial Times, the tide seems to be turning, as central bankers start questioning their theory as well as their actions.
We believe we are about to witness a regime shift in monetary policy, fiscal policy and financial regulation.
From QE Infinity to Positive Interest Rates QE
QE helped to kick-start growth in the United States by lowering funding costs for firms, boosting asset prices and consumer confidence as well as keeping the dollar cheap. Only the last of these transmission channels has worked in Europe. Consumers have been saving rather than spending, with stagnant unemployment overshadowing any windfall from rising asset prices. Bond markets have funnelled cheap liquidity to large firms, some of which now get paid to borrow. Smaller firms, however, which generate over 80% of new jobs, have been left out: most rely on banks, not bond markets, to fund themselves. European banks, still hungover from doubling their balance sheets in the decade preceding the financial crisis to 35tn, or over three times Eurozone GDP, have been hit by a triple-punch. Low interest rates, tighter regulation and persistent non-performing assets have hurt profitability and choked the transmission of monetary policy to the economy.
Today, policymakers are re-thinking their strategy.
On the one hand, central bankers are growing increasingly sceptical about the efficacy of their own actions. As we discussed in The Silver Bullet | Perpetual Motion, policymakers are openly questioning the effectiveness of monetary easing alone, including Mr Draghi and Constâncio of the ECB, former RBI governor Rajan, Mr Kuroda of the BoJ and former RBA governor Glenn Stevens. The bottom line for central banks is well-summarised by Mr Stevenss last speech as RBA governor:
the problem now is that there is a limit to how much we can expect to achieve by relying on already indebted entities taking on more debt.
On the other hand, the collateral effects of prolonged QE and negative interest rates have become harder to ignore.
One major concern is likely the impact of QE and negative interest rates on bank profitability and hence banks ability to intermediate credit, which in turn influences the efficacy of QE itself.
The key issue is the sustainability of banks business models. As discussed at length by the BIS and ourselves previously, low interest rates support banks with a one-off gain on their government bond holdings, but they also erode profitability, equity valuations increasing their cost of capital and reduce the banks ability to lend. This is what has happened in Europe and Japan, and at the latest ECB press conference in August, ECB President Draghi specifically talked about the positive correlation between credit intermediation in the Eurozone and bank equity prices. The BoJ shares similar concerns, with some Japanese banks starting to impose negative rates on clients earlier this year. In a meeting to assess the effectiveness of QE, Mr Kuroda stated that central bankers should weigh the benefits of QE and negative interest rates on corporates and consumers with its negative impact on financial intermediation.
Another collateral effect of prolonged monetary easing is the potential creation of asset bubbles, and an increase in household savings rates due to the general compression in available returns. Recent reports show German households have started withdrawing funds from banks, stashing the cash elsewhere. A similar increase has occurred recently in Japan.
 For a full analysis of how much cash you can stash in a safe, see also The Silver Bullet | Alice and the Mad Interest Rate Party, April 19, 2016.
Put differently, Keynes and Friedmans theory worked well in an environment of positive productivity and population growth, where per-capita debt burdens would be gradually absorbed by future generations. But the trick of spending government money you dont have no longer works neither does expanding money supply to increase nominal prices and create a money illusion to boost demand. In a recession where both public and private balance sheets are overburdened, productivity and demographic growth stagnate, you can no longer kick-the-can with fiscal and monetary policy alone.
For these reasons, we believe central bankers are turning increasingly sceptical of their policies.
Rather than a sharp change of tack, however, central bankers are likely to gradually tweak their policies, pushing back on further interest rates cuts or extreme measures like helicopter money. We are also likely to see more pressure on governments to do their part with fiscal stimulus.
What are central bankers likely to do next?
The ideal policy mix in our view would be a gradual normalisation interest rates coupled with QE and fiscal policy what we would call positive QE. This is unlikely to happen in the short run.
But in the meantime, what we are likely to see is more reluctance to cut interest rates further in negative territory, to preserve bank profitability and allow credit transmission.
BOJ Governor Kuroda said that there is ample room for easing in his last speech, but at its August meeting, the central bank delivered just the bare minimum by stepping up its ETF purchases. Ahead of the upcoming September meeting, BoJ board member Makoto Sakurai suggested that the bank will focus on refining current policy steps, with more radical options like foreign bond purchases or helicopter money off the table.
The ECB has a range of options to step up monetary stimulus. Cutting rates further into the negative territory, extending the length of QE, relaxing the restriction of capital keys or expanding QE purchases to include bank senior bonds.
We think the ECB will not cut deposit rates further in September, focusing on maintaining bank profitability instead it will likely expand the length and flexibility of its QE programme. Potentially Mr Draghi might take a step further, announcing the purchase of investment grade senior bank debt. This would address both the problem of asset scarcity, adding over 1tn of eligible bonds to buy, as well as providing a temporary boost to bank valuations. In the medium term, however, Eurozone banks will still need more consolidation and de-leveraging to shrink from over 31.8tn in balance sheets, over three times GDP.
The BoE is likely to stay on the side lines as well, after its attempt in August to manage the Brexit fall-out by unleashing a combination of low interest rates, a corporate bond purchase programme and a new funding-for-lending scheme. The next move could be another rate cut, but without going into negative territory.
The Fed is ready for one rate hike this year, and we think it could even come in September. The policy talk has shifted from one concerned about growth and jobs, to concerns about normalisation and having the right amount of ammunition to react to another crisis, and while not fantastic, the last job market data leaves the door open to a hike.
Fiscal stimulus to the rescue?
The G20 is no longer debating growth versus austerity but rather how to best employ fiscal policy to support our economies.
US Treasury Secretary Jack Lew, at Septembers G20 conference
Despite repeated calls from the IMF, most developed countries have kept their purse strings tight since the crisis. However, consensus could shift after elections.
We have seen recent stimulus steps in Canada, South Korea and Japan. In Canada, PM Trudeau in March pledged C$60bn in new infrastructure spending over the next decade. South Korea in June announced a fiscal package of over 20tn won, including a 10tn won extra budget to create jobs and support regional economies. In Japan, after a strong victory in the Senate elections, PM Abe was able to consolidate support and announced a ¥28.1tn stimulus package, including investment in infrastructure and welfare.
The most important shift could come from the US after the November elections, with both candidates likely to step up fiscal spending. Clinton has vowed to boost infrastructure investment, provide tax incentives for investment in hard-hit manufacturing regions and business tax credit to enhance worker retraining options. Similarly Trump has also voiced support for infrastructure expansion and proposed across-the-board tax cuts.
In the UK, the new Chancellor has suggested that he could use the Autumn Statement to reset fiscal policy in the aftermath of Brexit. In our view, the potential policy steps could include cuts to corporate taxes, VATs or more support to house buyers. Nevertheless, with an above 5% fiscal deficit, the room for more fiscal easing is limited in the UK.
Broad-based fiscal easing in the Eurozone is still a distant prospect for now. So far only 20.4bn of public financing has been approved under President Junckers flagship investment plan, which is expected to trigger 115.7bn of total investment still far below the already modest target of 315bn. While the European Commission has become more lenient towards national governments compliance with the budget rules, the country with the most room for fiscal easing, Germany, continues to keep its purse closed. Nevertheless, we could see a more positive shift towards fiscal easing after French and German elections next year.
China could continue with its strategy of mini stimuli to accompany its soft landing, and in our view a major fiscal package is unlikely. After some support to the housing market at the start of the year and infrastructure projects, Chinese policymakers seem to become muted on additional stimulus in the second half. It is allegedly due to an internal disagreement at the top management level, with the President wishing to speed up the supply-side reforms he proposed in contrast to the Premiers priority of supporting short-term growth. This inconsistency in thinking could lead to a policy stalemate, further reducing the likelihood of a more broad-based fiscal package.
Will it work? If we look at Japans experience, recent attempts to boost demand with fiscal stimulus appear to have failed. This may be due to Japans specific situation after two lost decades. But one possibility is that in a balance sheet recession where debt burdens continue to stay elevated, consumers may react to higher government spending by saving more.
In short, we think fiscal stimulus will be better than monetary policy alone, and in a best case scenario, it could also help to normalise interest rates. However it is not the long-term cure which in our view is about growing productivity and reducing debt burdens, and diversifying the financial system from banks, as we explained in World Economic Forum, 6 July 2016.
Bank regulation: taking a breath after reaching the peak
Being seen as one of the main culprits for the crisis, banks have faced increasing regulation. Undoubtedly this has helped to strengthen the system: European banks now have around 400bn more capital compared to 2008, and are leaner with total assets at 3x Eurozone GDP vs 3.3x when the crisis struck. In focusing on capital strength, however, banks have reduced lending activity to firms, which has declined by around 560bn since the crisis.
Recently, however, regulators are trying to strike a better balance between prudence and pragmatism. For example, the ECB in July clarified the impact of pillar 2 requirements on banks Maximum Distributable Amount (MDA), reducing the risk for bank bondholders to miss coupons on subordinated debt. The EU is also reportedly considering a new rule to require banks to pay coupons on contingent capital before stock dividends and bonuses. Other initiatives supporting a market for non-performing loans or securitisations could also be a tailwind for banks and for the transmission of policy to the real economy.
Eurozone banks remain still too large and too many to be sustainable, and consolidation should continue particularly in countries that have lagged behind like Portugal, Italy and Germany. Yet after many years of tight regulation, some easing could be a welcome measure to transmit stimulus to the economy.
- Keynes and Friedmans theory worked well in a world with growing demographics and productivity. Today, fiscal spending in countries overburdened by debt and ageing populations has proven to be ineffective, like in Japan. Similarly, a monetary expansion strategy a la Friedman works in financial systems able to outsource losses after a crisis, like US bond markets. In Europe and Japan, the bank transmission channel is impaired by bad loans and low profitability, and negative interest rates can be self-defeating.
- Central bankers have realised that prolonged QE and negative interest rates policy (NIRP) are ineffective and are shifting their thinking.
- This means caring about bank profitability and lending, and putting a floor on negative rates.
- Fiscal stimulus is likely to happen in the US after elections and in the UK, in response to Brexit. Europe could implement a plan after German and French elections in 2017.
- Regulators are showing willingness to ease pressure on banks.
- Bond investors are complacent about the probability of Fed hikes in September or December and about expectations for further rate cuts in the Eurozone and Japan.
- A shift away from NIRP and QE Infinity towards a floor for negative interest rates or even positive interest rate QE would be good for savers and for firms hurt the most by NIRP: banks and insurers, while it could hurt short-dated core government debt.
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