By Stephen Jen (via Itau Global Connections).
Bottom line: The policies implemented in the US and Europe since the Great Recession of 2008 may have helped support aggregate demand in the respective economies. However, they came at the expense of creating serious moral hazard problems and have other negative side effects that are too meaningful for investors to ignore. Macro policies, like medicines, are often about trade-offs: positive versus negative, and short- versus long-term. We believe the benefits of the Fed’s QE operations and Europe’s repeated bailouts have waned significantly, while the costs have risen sharply. In fact, some of these policies may now be doing more harm than good. If the US and Europe maintain their policy stance, we fear that the global economy could be exposed to severe downside risks as well as high volatility in the coming years. We believe that, in the US, there has been too little emphasis on the supply-side reforms and too much fixation on demand stimulus, especially monetary stimulus. In Europe, while there has been the right conversation on structural reforms, there remain large political hurdles to their implementation.
The motivations for the Fed’s hyper-active policy stance since 2008 are clear: i) to prevent a repeat of the debt-deflation crisis in Japan, ii) to avert a financial meltdown (by reducing the cost of capital) whereby the solvent financial institutions are starved of liquidity, and iii) to artificially inflate asset prices so that the positive wealth effect could support consumption and general demand. Essentially, the US policies since 2008 have been predominately focused on aggregate demand, in contrast with Europe and China, which have taken a more balanced approach between aggregate supply and aggregate demand. Some pundits call this policy bias in the US a choice of ‘growth over austerity.’ Judging from the relative economic performance of the US, vis-à-vis other developed countries, this strategy seems to have worked so far.
However, we have long believed that a hyper-active Fed is dangerous, because these policies, though having yielded short-term gains, come with long-term negative consequences. The Fed recognizes that there are cost-benefit tradeoffs, with the doves having ignored the costs and focused solely on the benefits, and the hawks being more focused on the costs and downplaying the benefits. Given that the Fed officials have, over the past three years, elaborated on the theoretical benefits of QE, we believe it is important for investors to think through the potential costs. First, by artificially suppressing the costs of borrowing for the federal government, the Fed has helped ease the market pressures on Congress and the White House to act on the debt ceilings and the long-term challenges of entitlement spending. Second, persistent QE in the US has also shifted policy focus away from the much-needed structural reforms (e.g., educational reforms, job training) to help the US compete with the rest of the world. Both of these are major side-effects of QE. Even if QE in and of itself does not lead to breakages in the US economy, QE having dominated policy discussions and the Fed’s official stance that the US suffers from an insufficient demand problem have hurt the US, as the need for supply-side reform has been downplayed or dismissed outright. Third, with the long-term bond yield at a multi-generational low of 1.50%, it is unclear how further bond purchases would help the economy. In general, the Fed may have been overly focused on the traditional ‘macro’ aspects of monetary policy, and may not have addressed the ‘micro’ issues that have prevented its actions to influence ‘Main Street’ as much as they have driven ‘Wall Street.’ In addition, we highlight several other major concerns with the Fed’s QE operations.
Concern 1. The Fed rejects the idea of a lower ‘GDP Sharpe ratio’. Some time ago, we introduced the concept of a ‘GDP Sharpe ratio,’ defined as the expected economic growth rate divided by the volatility of the growth rate. We believe, post the Great Depression, the potential growth of the US and the world should be lower than that before the recession. First, growth prior to the Great Recession was artificially and unsustainably high.
So, naturally potential growth in the coming years should be lower. Second, just as in the case of Japan, the bursting of the financial bubbles led to a sharp rise in public debt and deficits, which in turn has constrained the capacity of the government to support research and education. Cutbacks in these important areas have probably played an important role in the low economic growth in Japan. The US is likely to experience a similar downshift in innovations, as a result of the cut-backs in government funding. Third, risk-taking in general could be curtailed.
Economic growth is not just about capital, labor, and technology. It is also a function of how entrepreneurs take risks by starting new businesses, and existing businesses take risks by trying out new methods and new products. In a sense, ‘risk taking’ – while difficult to measure – is the critical ‘glue’ that holds together capital, labor, and technology.
The volatility of business cycles should also be higher, after the Great Recession. First, the pattern of a 9- year expansion and a 1-year recession that we witnessed in the 1990s and the 2000s was probably unnatural, and not repeatable. Economies should exhibit natural business cycles, and, prior to 1990, the average duration of a business cycle was, from our memory, around 4 years, not 10 years.
In sum, we believe potential growth (the numerator in this ‘GDP Sharpe ratio’) should be lower, GDP volatility higher, and the ‘GDP Sharpe ratio’ inferior in the years following the Great Recession than in the years leading to the Great Recession.
In many ways, the Fed’s desperation and exasperation reflect a rejection of business cycles, in that the general population and the government in the US may have become used to long periods of expansions and very averse to recessions, however necessary and unavoidable they may be. In other words, the Fed most likely outright rejects the idea of a ‘lower GDP Sharpe ratio.’ It is fixated on aggregate demand precisely because the Fed doesn’t think potential growth has changed after the Great Recession (the numerator). At the same time, the Fed believes it can defeat business cycles (the denominator). The US economy is far from a recession, yet the doves at the Fed are contemplating resorting to extreme policies such as QE3 just because both growth and inflation are slightly below 2.0%. In our view, it is quite extraordinary what some at the Fed are willing to do just to avoid a mild economic slowdown.
Real interest rate changes shift demand through time but don’t generate new demand that would not otherwise have been there. Specifically, by depressing the real interest rates, the Fed has been able to bring forward demand from tomorrow to today. The problem is that when tomorrow comes, the Fed will be forced to do more just to bring more demand forward. The Fed remains puzzled by the slow economic growth and the diminishing impact of its policies on aggregate demand. However, these features of the US economy are very consistent with the concept of a lower ‘GDP Sharpe ratio.’
Concern 2. Future financial volatility. The Fed’s QE policies have sown the seed for future financial volatility. This worry of ours goes beyond the inflation risk associated with such a large Fed balance sheet.The table below shows a simple framework to help us think about the performances of bonds and equities, or growth and inflation.
There are four broad shocks to consider: a positive or a negative aggregate demand shock, and a positive or a negative aggregate supply shock. These four scenarios could generate quite different responses in bonds and equities. For example, bonds tend to go up while equities go down when there is a negative demand shock. With a negative supply shock (e.g., a spike in oil prices), both bonds and equities could go down. However, what QE has created is an artificial rally in both bonds and equities that has little to do with the real economy or inflation, but more to do with liquidity and portfolios. The Fed calls this the ‘portfolio channel’ through which monetary policy could influence the real economy. We don’t buy this argument. In fact, we believe such gross distortion of market pricing not only deprives investors of important signals they could have extracted from it but also sows the seeds for greater financial volatility in the future. Specifically, by artificially holding up the values of both bonds and equities, the Fed runs the risk of both bonds and equities selling off in the future. Much like how global warming could lead to a protracted period of strange weather patterns, those damaging the ‘financial environment’ won’t realize the full consequences of their actions until later.
Concern 3. Debasing the dollar is dangerous for the world. In 1971, as the Secretary of the Treasury under President Nixon, John Connally famously said to a group of European politicians regarding the US decision to close the ‘gold window’ that the dollar was ‘our currency, but your problem.’ The US decision to de-peg from gold in 1971, which in turn was a result of years of fiscal over-spending related to the Vietnam War, eventually led to the end of the Bretton Woods System. In conducting its hyper-active monetary policy, the Fed seems to have had a similar attitude about the negative side-effects on the rest of the world. We believe it is a serious mistake to intentionally debase the dollar and run policies that hurt the dollar’s credibility in the world.
First, in 1971, the decision was about de-pegging to gold. Now, it is about the Fed conducting large-scale quasi-fiscal operations that debase the internal (through inflation) and external (through the exchange rate) values of the dollar. In many ways, the policies today are more damaging to the dollar’s credibility than back in 1971.
Second, in the post-Bretton Woods era of fiat monies, the stability of the international monetary system has depended on central banks’ credibility – a nebulous concept to replace a hard peg to gold. This makes it essential that all reserve-currency-issuing central banks act in a responsible manner, especially the Fed. However, the Fed’s policies, while they may have helped provide temporary support for equity and bond prices, have introduced an immense amount of uncertainty in the world. Prior to 2008, the US had been an ‘absorber’ of uncertainties, monetary and otherwise. After 2008, the US has become a source of uncertainty, and the Fed has exacerbated the situation.
Third, the EUR was supposed to rival the dollar as the dominant reserve currency. At a minimum, it was supposed to provide a counter-weight to the dollar. However, in light of the European Crisis, the dollar has, again, become the dominant reserve and international currency. The Fed’s policy of dollar debasement, in the absence of a meaningful counter-weight in the world, has created an especially uncertain environment for the world. It is not right that the world waits with bated breath for the FOMC statements – which are more like coin tosses, in terms of how binary they have become.
Fourth, the world does not have a viable check-and-balance framework to keep the reserve-currency issuing central banks in check. The IMF was set up to deal with non-reserve-currency countries that encounter balance-of-payments problems, not to keep the Fed from undermining the core integrity of the international monetary system. If the Fed experiments with new and potentially dangerous policies, the world does not have an institution that could deal with the situation in the event the Fed ‘messes up.’ The Fed has immense moral responsibility to ensure that its policies don’t harm the international financial system. But we believe that repeated QE operations have already caused serious damage.
Concern 4. Imbalances in the Emerging Market economies. This is a derivative of Concern 3. EM countries are called ‘EM’ because of their underdeveloped ‘markets’ and the financial systems. For most EM countries, the dollar is the anchor currency and the foreign currency of choice. The Fed’s policies have important implications for the EM countries, regardless of whether the EM currencies are pegged to the US dollar.
Prior to the Great Recession of 2008, EM received large capital inflows primarily due to the ‘pull factors,’ i.e., the perceived superior economic fundamentals that attracted international capital. After 2008, however, a part of the capital flow heading to EM was motivated by ‘push factors,’ as six of the G7 central banks adopted QE that repelled capital away from DM. While it is difficult to disaggregate these flows into ‘pull’ or ‘push’ types, it is likely that the latter were significant. So the intrinsic quality of the credit cycle post-2008 was inferior to that before 2008. In general, EM countries have been in a positive credit cycle for more than a decade, and there are signs that some of these credit cycles are starting to look tired. The point here is that QE has helped propel some EM economies into a more dangerous phase of their credit cycles. Could some EM countries now be in a similar position to the DM countries in 2007? The risk of a ‘sudden stop’ in capital inflows, or even capital flight, could generate crisis-like price action in some EM currencies, even in the absence of an actual crisis in EM.
Policy short-termism has also been a major problem in Europe. We add two more concerns related to Europe.
Concern 5. Trying to fix long-term structural problems with short-term policies. The main reason why the repeated bailouts in Europe in the last two-and-a-half-years have had diminishing impact on the markets is that the European officials and politicians have by and large sought short-term fixes to long-term problems. The latest example was the ‘victory’ of Messrs. Monti, Hollande and Rajoy over Mdm. Merkel. Heading into the EU Summit, the focus of the discussions was on what Europe could do to move toward a genuine fiscal union, and what could be done to establish a robust zone-wide banking supervision framework, with zone-wide deposit insurance. How Italy and Spain hijacked the summit is now public information: Italy and Spain insisted on short-term relief, instead of making meaningful long-term commitments toward fiscal and banking unions.
Further, these short-term fixes contradict some the fundamental long-term principles that are required for the structural integrity of the EMU. Pressuring the ECB to directly support the sovereign bond markets is one example of the tradeoff between short-term relief and loss of reputation and credibility. (By the way, the Fed’s QE operations are different from what some are hoping the ECB may do. The Fed’s QE operations could potentially be described as a monetary operation, albeit with negative consequences for fiscal discipline, while selective purchases of European peripheral bonds would make such an ECB operation non-monetary and purely fiscal in nature.)
It is true that there is no ‘silver bullet’ to solve the problems in Europe. However, the solution is quite clear and has been mostly laid out by Berlin. The challenge is primarily Europe’s aversion to pain.
Concern 6. Increasingly costly for the EMU to adjust its membership. The repeated bailouts in Europe have also raised the fixed costs of adjusting the EMU’s membership. In an earlier note (‘The EMU Crisis, Hysteresis, and the Zone of Inaction’), we proposed the idea that entering and exiting the EMU is an ‘options-like’ decision. The value to waiting to enter a monetary union is like the value of a call option. Similarly, the decision to leave the EMU is subject to some fixed costs that will need to be overcome before this ‘option’ is exercised.
In contrast, the popular view is that all Europe needs to do is to buy time with regards to the crisis-hit countries so that a robust firewall could be built to protect the rest of the union if any country were to leave the EMU. The reality, however, is very different: the very act of buying time has raised the costs of any country leaving the EMU. In terms of the diagram below, the value of Y has increased substantially: the cost of Greece leaving the EMU two years ago would have been a lot lower than it is now. In particular, Germany has already been forced to commit more financial and political capital so that, in the current trend, Germany may find itself not having any more leverage in Europe because the series of short-term fixes will have made it impossible for any member country to leave, ever.
Bottom line. It is time for investors and policy makers to think hard about the negative side effects of many policies, such as the Fed’s repeated QE operations and Europe’s repeated bailouts. We suspect the marginal costs of these policies have already begun to overwhelm their marginal benefits. A continuation of these policies would probably not lead to major benefits but could spark significant financial and economic volatility.
Stephen Jen is the managing partner at SLJ Macro Partners.
Prior to establishing SLJ Macro Partners in April 2011, Stephen was a Managing Director at BlueGold Capital (since May 2009), working as the key risk-taker in currencies and as its macro strategist. Before BlueGold, Stephen was a Managing Director at Morgan Stanley and, from October 1996 to April 2009, held various roles, including the Global Head of Currency Research and the Chief Global Foreign Exchange and Emerging Markets Strategist. Prior to Morgan Stanley, Stephen spent four years as an economist with the International Monetary Fund (IMF) in Washington, D.C., covering economies in Eastern Europe and Asia. In addition, Stephen was actively involved in the design of the IMF’s framework for providing debt relief to highly indebted countries. Stephen holds a PhD in Economics from the Massachusetts Institute of Technology, with concentrations in International Economics and Monetary Economics. He also earned a BSc in Electrical Engineering (summa cum laude) from the University of California at Irvine. Stephen was born in Taipei, Taiwan, and now lives in London with his wife and two children.