Central bank interventions: Drunks searching by the light …

“That’s where the light is …”

The oft repeated joke about the drunkard looking for his car keys under the street light rather than in the bushes where he lost them because “this is where the light is” is useful when looking at the actions of governments and more pertinently, central banks in the face of the broader market turmoil over the month of August.

Over the past seven years, this author has railed against the “Keynesian[1]” orthodoxy at the heart of central bankers’ response to the global financial crisis. Instead of stepping back and allowing market forces to take care of what was essentially an excess leverage and resulting resource misallocation problem, central bankers since 2009 (“TARP”, QE and the rest) focused on expanding the availability of liquidity with a view to arresting price declines across broad asset classes.

This central banking intervention quickly came to be viewed as a “put” by the markets – when in trouble, simply put the assets back to the central bank and they would buy them whatever the change in fundamentals and pricing dynamics meanwhile. Pavlov’s basic premise holds here – you treat the markets like pets that would respond to a specific variable (a sharp market decline, for example) and pretty soon, they start doing just that.

In so doing though, the efficacy of policy responses declines over time – markets go up because loose liquidity is (eventually) expected to translate into higher economic growth and when the growth doesn’t come through, you have a correction. To counter the asset correction, central banks start loosening policy, which keeps some people in risky assets for a little longer than justified by fundamentals.

Pretty soon, you end up in bubble territory. Economists from Robert Shiller to Mohamad El-Erian have cautioned on the permanent nature of excess liquidity provision by central banks; and its resultant impact on asset pricing. With the primary purpose of quantitative easing namely to kick start the economy absolutely failing to deliver its intended results, all we are left with is a mountain of (new) debt, higher asset prices and continued overcapacity that was funded by the first tranche of debt.

Attempting to borrow one’s way out of a debt crisis is like trying to drink one’s way out of alcoholism or eat one’s way out of obesity. It is plain stupid, in other words.

A quick sidebar to explain a couple of concepts:

GDP or Gross Domestic Product is often defined as C+I+G+NX where C is Consumption, I is Investment, NX is Net Exports and G is Government

The “Keynes effect” is the impact of lower interest rates (or monetary easing) arising from falling prices (or deflation) on demand. i.e. at lower prices, people would demand more, classic price elasticity of demand in other words.

For the rest of this article, we will largely ignore NX because of course globally, NX is a zero sum game as far as “Global GDP” is concerned.

To hear the “Keynesians” tell it though, the old notion of maximizing C+I+G is central to all policy responses; never mind that in C, I and G are all related to each other and indeed, feed off each other. Thus the orthodoxy of trying to boost G when C+I are down (classic private sector recession), has gained ground but without the underlying logic being fully appreciated.

In economies with demographic support –i.e. the constant entry of new populations into the workforce either organically or through immigration – any short-term decline in C+I can indeed be reversed by increased G. As the government spends more, it boosts incomes which are then circulated into C+I.

However, when an economy faces a demographic decline (or has living standards that are pretty close to optimal i.e. individuals are satiated and cannot consume more at lower prices) then price declines do NOT produce any increase in aggregate demand. Furthermore, negative demographics create increased pressure on debt servicing as borrowers can longer hope to inflate their way out of their mounting debts. In such a situation, increased government spending or G ends up being counterproductive as it causes price volatility and also increases the fears of future tax hikes; thereby necessitating further savings by a population already concerned about deflation.

Many of the world’s major economies – Japan and the EU – face negative demographics;  while others such as China face the quandary of growing old too quickly on account of government policies. Anglo-Saxon economies such as the UK and US continue to be magnets for immigration but here, the political forces – from Donald Trump and the Tea Party to the rabid nationalists of the UK – are increasingly agitated on the subject and could cause a reversal over the next 10 years.

Given the negative demographics, the best way for boosting consumption in major economies could be counter-intuitively, tightening monetary policy. Increased interest rates would shift the balance of power to savers from borrowers; such savers have a sure footing on their financial futures and are more likely to spend over time as they see enough stability in their income profiles to warrant a splurge here and there. Today’s borrowers in contrast have to curtail their consumption, and rebalance the books; eventually emerging as savers who can spend with a stronger balance sheet.

Asset prices will adjust downwards and sharply under these circumstances, but once they start recovering, would be a on a sure footing as against currently where the foundations of any market rally appear to be made of tofu.

Preaching normalized interest rates to the faux-Keynesian crowd isn’t easy; and indeed there isn’t much of a point to it. Already, there is a lot of clamour for the US Fed to delays its planned rate hike in September while other central banks from the ECB to the Bank of Japan are being asked to do “more”. How one does “more” than zero interest rates and willy-nilly buying of all government debt is beyond the purpose of any reasonable mind to enquire.

Instead of using the current bout of market volatility as an opportunity to re-examine the monetary policy failures of the past 5 years, central banks are likely instead to double down and loosen the purse strings once more.

Its a nice job when instead of having to account for one’s failures, one is given the opportunity to repeat the mistakes in bigger volumes each time on the forlorn hope of eventually being right. For the rest of us, namely the people who don’t work with central banks, the current phase is a useful reminder to focus on real assets producing appropriate income that are priced correctly for any monetary policy situation.

Everything else is humbug.

[1] The reference here isn’t so much to Keynes who had nuanced and broadly sensible views on using monetary and fiscal levers to intervene in the real economy during a recession; rather it refers to the people who frequently misuse (or selectively use) quotations from his books to justify interventionist policies.

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