With ultra-loose monetary policy coming to an end, it is best to tread carefull
IN HIS classic, “The Intelligent Investor”, first published in 1949, Benjamin Graham, a Wall Street sage, distilled what he called his secret of sound investment into three words: “margin of safety”. The price paid for a stock or a bond should allow for human error, bad luck or, indeed, many things going wrong at once. In a troubled world of trade tiffs and nuclear braggadocio, such advice should be especially worth heeding. Yet rarely have so many asset classes—from stocks to bonds to property to bitcoins—exhibited such a sense of invulnerability.
.. Rarely have creditors demanded so little insurance against default, even on the riskiest “junk” bonds. And rarely have property prices around the world towered so high. American house prices have bounced back since the financial crisis and are above their long-term average relative to rents.
.. If today’s asset prices have been propped up by central-bank largesse, its end could prompt a big correction. Second, signs are appearing that fund managers, desperate for higher yields, are becoming increasingly incautious. Consider, for instance, investors’ recent willingness to buy Eurobonds issued by Iraq, Ukraine and Egypt at yields of around 7%.
.. But look carefully at the broader picture, and there is some logic to the ongoing rise in asset prices. In part it is a response to an improving world economy.
.. A widespread concern is that the Fed and its peers have grossly distorted bond markets and, by extension, the price of all assets. Warren Buffett, the most famous disciple of Ben Graham, said this week that stocks would look cheap in three years’ time if interest rates were one percentage-point higher, but not if they were three percentage points higher.
.. But if interest rates and bond yields were unjustifiably low, inflation would take off—and puzzlingly it hasn’t. This suggests that factors beyond the realm of monetary policy have been a bigger cause of low long-term rates. The most important is an increase in the desire to save, as ageing populations set aside a larger share of income for retirement. Just as the supply of saving has risen, demand for it has fallen. Stagnant wages and the lower price of investment goods mean companies are flush with cash.
If you drew up a list of preconditions for recession, it would include the following: a labor market at full strength, frothy asset prices, tightening central banks, and a pervasive sense of calm.In other words, it would look a lot like the present.
.. Companies meanwhile have responded to slow, stable growth and low rates by borrowing heavily, often to buy back stock or pay dividends. Corporate debt as a share of economic output is at levels last seen just before the past two recessions.
.. Last week Janet Yellen, the Fed chairwoman, said she thought there wouldn’t be another financial crisis “in our lifetimes.” Fair enough: crises as catastrophic as the last happen twice a century. But small crises are inevitable as risk migrates to financial players who haven’t drawn the attention of regulators.
.. in a world with permanently lower inflation and growth, businesses will struggle to earn their way out of debt
I argue that taken to its most extreme conclusion, CBcoin issuance could have far-reaching consequences for commercial and central banking – divorcing payments from private bank deposits and even putting an end to banks’ ability to create money. By redefining the architecture of payment systems, CBcoin could thus challenge fractional reserve banking and reshape the conduct of monetary policy.
.. Because banknotes and coins circulate in the economy, they are also referred to as ‘currency’. Yet currency is only a very small part of money (see McLeay et al (2014)). Money mostly consists of electronic deposits: broad money consists of (currency and) households’ and firms’ deposits with commercial banks, while base or CB money consists of (currency and) commercial banks’ deposits with the CB (‘CB reserves’).
.. Another scenario would see a large-scale shift of customer deposits into CBcoin, forcing banks to sell off their loan books. Bank deposits could still exist but as saving instruments, no longer used to make payments. Banks could still originate loans, provided they lent money actually invested by customers, say, in non-insured investment accounts that couldn’t be used as a medium of exchange. Banks would operate like mutual funds, losing their power to create money and becoming pure intermediaries of loanable funds, as described in economic textbooks.
.. Under this scenario, the contraction of broad money (bank deposits), and the attendant emergence of ‘private-sector base money’ made of CBcoin would mark the demise of fractional reserve banking (see Sams (2015)). The conversion of bank deposits into CBcoin deposits at the CB would amount to 100% reserve backing for deposits. This could usher in a system similar to the Chicago Plan, a set of monetary reforms proposed by Irving Fisher during the Great Depression and recently revisited by Benes and Kumhof (2012).
The Plan’s call for the separation of the credit and money-creating functions of private banks would be addressed – with 100% reserve backing, banks could no longer create their own funding – deposits – by lending.
But, as the world’s leading central bankers finished a weekend of brainstorming in Basel, Switzerland, as to what their next move might be, some feared that this time around they might do more harm than good.
.. Global central bankers had already planned to convene at the annual meeting of the Bank for International Settlements, a clearinghouse and research shop that provides a private forum for central bankers to gather and exchange views.
But the British referendum results and the sharp fall in the markets that followed brought an extra urgency to the two-day meeting.
.. Playing a central role were exchange-traded funds, which at one point on Friday accounted for close to 50 percent of overall trading volume in stocks. That is an extraordinary statistic, given that the funds were largely unknown a decade ago as an investment option for investors.
The ability for investors to quickly and successfully buy and sell stocks and bonds, the crucial advantage that exchange-traded funds have over mutual funds, is seen by regulators as critical in times of acute financial stress.
.. Mr. Jen, the hedge fund manager, scoffed at the notion that the extraordinary central bank interventions of recent years were designed to stamp out deflationary threats and spark an increase in prices and economic activity in stagnant economies in Europe and Japan.
“We have plenty of inflation, it’s just asset price inflation,” he argued, referring to elevated equity, bond and housing markets that have been one consequence of these policies. “People can’t live in cities anymore, and they are grumpy about their jobs.”
.. Persistent central bank interventions have not only created dangerous distortions, they have added to a sense of worldwide cynicism that these measures have not accomplished their central aims: lifting economic growth and increasing wages.