The unintended consequences of financial policy intervention are providing fresh evidence for chaos theory’s idea that the flap of a butterfly’s wings can spark a tornado on the other side of the world.
Five years into the age of deleveraging, financial markets have become addicted to central bank intervention, from the U.S. Federal Reserve to the European Central Bank and beyond, aimed at stimulating growth. Markets anticipate further action, with the Fed, ECB and Bank of England committees meeting on monetary policy this week.
But no flap of a central banker’s wings goes quite as expected.
Take China’s heroic 2008-2009 stimulus program, which helped fight back a global recession. It also led to huge overinvestment and bad debt, and the policy is now viewed by many economists as an error.
Similarly, the ECB’s long-term multibillion-euro refinancing operation, announced in December 2011, saved Europe’s banking system from a funding crisis. But it created a dangerous web of links between an overleveraged banking sector and already indebted sovereigns.
Official lending rates are close to zero, and their manipulation, the traditional mainstay of monetary policy, is effectively impotent. The new go-to tool for central bankers, quantitative easing, is suffering from declining marginal returns.
As the International Monetary Fund economist Manmohan Singh notes in a working paper published this month, the Fed’s quantitative easing policy replaced long-term Treasuries with short-term bills or cash, which circulate less quickly through the system as collateral for bank funding.
The bottom line is that the very actions central banks and regulators have been taking to increase confidence in the banking sector might be undermining banks’ ability to lend. Although central bank actions have lowered longer term borrowing costs, this has not spurred credit demand. Businesses and households are either so frightened or so overleveraged that they’re saving and cutting debt, no matter how cheap it is to borrow.
In part because lending remains weak, and in part because some of their own efforts are starting to work against them, central banks are forced to become increasingly unorthodox in their efforts to stimulate growth. In one measure announced last week, the Bank of England, together with the U.K. Treasury, started a “funding for lending” initiative, in effect channeling central bank money directly to consumers and businesses -- an unprecedented move.
The ECB has made some of the most striking innovations, yet these do not seem to be boosting bank lending either. At its meeting in July, for example, the ECB cut its deposit rate to zero in an effort to get more than 800 billion euros ($980 billion) -- equivalent to 8 percent of the euro area’s gross domestic product -- that commercial banks had parked in the ECB’s accounts out into the wider economy.
The amount held on deposit at the ECB declined by more than half, but the money didn’t flow into new lending. Instead, some depositors started using the central bank’s reserve facility, which also pays zero rates but offers better liquidity. Other investors drove Austrian, Dutch, Finnish and German two-year bond yields negative as they rushed to place their cash. They also took on more risk, either by buying longer-term paper (five-year German bund yields fell by 0.12 percentage points in the two weeks after the cut) or by investing in riskier short-term paper (AA-rated French two-year bond yields fell by 0.28 percentage points). Even yields on Bulgarian six-month euro-denominated bonds halved in the two weeks after the ECB action.
These ripples in the market have reduced yields available on the high-quality bonds that banks are required to hold, and cut the spread between short- and long-term interest rates to a three-year low. Both outcomes make it less profitable for banks to lend.
Of course, the fall in profits from bank lending is not the sole fault of the ECB. New regulatory capital requirements, designed to make banks safer and boost confidence in the system, require banks to deleverage and cut lending. McKinsey & Co. estimates that the return on equity for retail banks has dropped to 6 percent (from 10 percent) as a result of new regulatory requirements.
The question today is not whether the ECB’s latest action in cutting deposit rates will boost lending, but whether it will unintentionally crimp lending further. A number of euro-denominated money-market funds were forced to close to new entrants after the ECB’s deposit rate cut, because returns after fees became negative. Further closings could cut off an important source of funding for the banking sector.
Now some ECB members are discussing the possibility of introducing negative deposit rates. This would send investors on a renewed hunt for yield, and leave banks with the options of lending, hoarding physical cash in vaults or paying for the privilege of holding cash at the ECB. That’s a stark choice, but it still might not boost loan growth. A survey of the ECB’s money-market experts suggested that 75 percent of banks would not change their behavior, even with a negative rate. If this proves to be the case, central banks may need to get more daring still. And each new action will risk new unintended consequences.
Central bankers have taken bold actions in recent years to stave off systemic collapse and to try to fight slow growth. But chaos theory teaches us that dynamic systems are sensitive and unpredictable. From now on, central bankers need to pay more heed to what the real impact of their policy measures will be.
There are ways of boosting growth and lending without having to experiment with untested policies. Investors’ aversion to risk, banks’ aversion to lending and business’ aversion to borrowing are as much about a lack of confidence in the future as anything else. Firmer statements of support from central bankers, politicians and regulators could go a long way toward solving this crisis of confidence.
ECB President Mario Draghi’s promise last week to do “whatever it takes” to preserve the euro was a case in point, and led to a sharp rally in risk assets. Similar pledges to act as the euro area’s lender of the last resort and tolerate higher inflation would be just as beneficial -- and without having to leap further into the unknown.
(Alexander Friedman is global chief investment officer at UBS AG and Kiran Ganesh is a cross-asset strategist for UBS Wealth Management, overseeing $1.6 trillion. The opinions expressed are their own.)
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