The U.K. and the euro zone are in a recession, the U.S. economy is teetering, and a hard landing is unfolding in China. Softness in these three paramount economies is dragging down the rest of the world. So why do most investors seem totally unconcerned over the unfolding global contraction?
This is what I call the Grand Disconnect between weak and weakening economies worldwide, on one hand, and optimistic investors, on the other, who are hooked on massive monetary and fiscal stimulus programs.
Economies and financial markets have become so dependent on monetary and fiscal bailouts -- and investors so enamored of them -- that all seem to have forgotten the dire circumstances that continue to make these rescues necessary. Many market participants yearn for conditions that are so troubled that central banks and governments, be it in China, the U.S. or Europe, will be spurred to greater easing, with positive implications for stocks.
“Conditions are so bad that it’s good for my equity portfolio,” the thinking seems to be.
This almost total reliance on monetary and fiscal stimulus, with little regard for fundamental economic performance -- except to hope that growth will be weak enough to spur more government action -- is a new phenomenon. Until quite recently, there was strong faith in government action, but it was coupled with the belief that such measures would quickly re-establish robust economic growth.
I have often been asked what monetary or fiscal actions would rapidly restore economic growth, as if a magic bullet would bring back the salad days of the 1980s and 1990s. My reply was that no such cure existed. The immense monetary and fiscal stimulus in the U.S., including the $1 trillion-plus annual federal-government deficits, the $2.3 trillion in quantitative easing and about $1.5 trillion of excess bank reserves held by the Federal Reserve, probably made the economy and financial markets better off. Nevertheless, slow and now faltering global economic growth indicate that these huge efforts were more than offset by gigantic deleveraging in the private sector. The only thing that would restore normal global growth, I argued, was time -- the five to seven years it will take for deleveraging to be completed.
The search for a magic bullet seems to have been abandoned. The emphasis is now almost solely on the opiate of government stimulus, increasing quantities of which will probably be needed to keep investment addicts satisfied. The recent announcements of quantitative easing by the Fed and the European Central Bank have had a diminishing impact on the Standard and Poor’s 500 Index. And recent market actions suggest that QE3 may be a classic case of buy the rumor, sell the news.
What more can be done? The Fed’s commitment to purchase $40 billion in mortgage-backed securities a month is open-ended, and is scheduled to last until the unemployment rate, now at 7.8 percent, drops to the Fed target range of about 5 percent to 6 percent and there is robust job creation. That will probably take a number of years. Meanwhile, excess bank reserves will continue to increase.
So why did Fed Chairman Ben Bernanke push through the third round of quantitative easing? Sure, the Fed has a dual mandate to promote full employment as well as price stability, but QE3 on top of Operation Twist, QE2 and QE1 and all the Wall Street rescue measures the Fed took in 2008 have pushed the central bank deep into the realm of fiscal policy, compromising its fiercely defended independence. Also, the open-ended and unprecedented nature of QE3 might suggest that Bernanke has lost control.
Furthermore, the effectiveness of previous rounds of quantitative easing is questionable. Even though the Fed has bought $2.3 trillion of long-term securities, economic growth is marginal at best and unemployment remains very high. Of course, we will never know what would have happened had the Fed not acted. History isn’t a controlled experiment where you can change one baffle in the maze, run the rats through again and see if they take a different path.
Two weeks before the Sept. 13 announcement of QE3, Bernanke delivered a speech in Jackson Hole, Wyoming, defending the Fed’s aggressive policy. He stated that asset purchases until then had reduced the yield on 10-year Treasury notes by 0.8 percent to 1.2 percent and said, “These effects are economically meaningful.” He also noted the increase in stock prices during those quantitative easings. And Bernanke said a Fed study found that QE1 and QE2 had raised output by 3 percent and boosted private payrolls by 2 million “while mitigating deflationary risks.”
Maybe so. What we know for certain is that the Fed’s asset purchases have had a limited effect on the normal financing process. Yes, when the Fed buys Treasuries or mortgage-backed securities, the seller has the proceeds to spend or invest elsewhere. Meanwhile, these funds are deposited in a bank, increasing bank reserves at the Fed. In normal times, these funds are lent and relent by banks in the fractional reserve system, and the net result is that every dollar of reserves turns into about $70 of M2 money supply.
Currently, however, banks are reluctant to lend except to the most creditworthy borrowers, and those people aren’t much interested in borrowing, despite negative real interest rates. As a result, since August 2008, before quantitative easing began, bank reserves have increased by $1.5 trillion and M2 has grown by $2.3 trillion. That’s a 1.5 multiplier, far below the normal 70-fold level. Another way of looking at this is to note the accumulation of excess reserves -- the difference between total and required bank reserves at the Fed -- which now amount to about $1.5 trillion.
Another issue that might have given Bernanke pause in pursuing QE3 is the strain it puts on the Fed’s credibility. In his Jackson Hole speech, he said a “potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability.”
This is a serious risk. Bernanke has stated that the Fed could easily get rid of excess reserves by agreeing, in a 15-minute policy committee phone call, to sell securities from its vast $2.8 trillion portfolio. But let’s imagine the economy five to seven years down the road when deleveraging is completed and real growth moves from about 2 percent a year to its long-run trend of 3 percent to 3.5 percent.
Even then, it would take several years to use excess capacity and labor, as measured by the Commerce Department’s output gap, which is calculated from the difference between current real gross-domestic-product growth and an estimate of the growth potential of the economy.
In any event, when Wall Street gets the slightest hint that the Fed is thinking about removing the excess liquidity, interest rates will surge and the danger of a relapse into a recession will seem very real. Political pressure on the Fed might be intense, and it might be accused of taking away the punch bowl before the party gets started.
Nevertheless, the Fed is much more worried about deflation than inflation. In Jackson Hole, Bernanke said central-bank security purchases were “mitigating deflationary risks.” In deflation, even zero nominal interest rates are positive in real terms, as we have seen repeatedly in Japan.
In deflationary times, to create negative real rates such as those we have now, the central bank can’t reduce the federal funds rate below zero -- although recently, yields for short-term Treasuries, as well as German and Danish government securities, have turned negative. Investors were so eager to hold these securities that they were willing to pay for the privilege. Still, in times of economic weakness, the Fed wants negative real rates to encourage borrowers to borrow. In inflation-adjusted terms, lenders are paying borrowers to take their money.
Furthermore, in deflationary conditions, the federal funds rate is likely to remain close to zero, where it is at present. But the Fed would like the rate to be high enough so that the central bank can cut it significantly in times of economic weakness as a way to stimulate the economy.
Finally, the Fed fears that deflation, if it becomes chronic as I continue to forecast, will spawn deflationary expectations. Declining prices will encourage buyers to wait for still-lower prices. Their restraint creates excess inventories and unutilized capacity, which push prices lower. That confirms expectations and persuades prospective purchasers to wait for still-lower prices. The result is a self-feeding, downward spiral of prices and economic activity. This, however, hasn’t happened in Japan, which, in the past two decades, has more often experienced deflation than inflation.
(A. Gary Shilling is president of A. Gary Shilling & Co. and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.” The opinions expressed are his own. This is the first in a five-part series.)
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