Fascinating article from Professor Willem Buiter

Quantitative easing, credit easing and enhanced credit support aren’t working; here’s why.

July 3, 2009 11:07am

Quantitative easing - expanding base money in circulation (mainly bank reserves with the central bank by purchasing government securities) - isn’t working in the US, the UK or Japan. Credit easing - outright purchases of private securities by the central bank, which can either be monetised or sterilised - is achieving little in the US or the UK, although it has not been pushed too hard yet. Enhanced credit support in the Euro Area - providing collateralised loans on demand at maturities up to a year at the official policy rate - is not working either. These policies are not improving the ability and willingness of banks to lend to the non-financial sectors. They have had little positive impact on the corporate bond market. It is not surprising why this should be so, once we reflect on the actions and the conditions under which they are taking place.

In a nutshell: quantitative easing (QE), credit easing (CE), and enhanced credit support (ECS) are useful when the problem facing the economy is funding illiquidity or market illiquidity. It is useless when the binding constraint is the threat of insolvency. Today, liquidity is ample, even excessive. Capital is scarce. Capital is scarce first and foremost in the banking sector. A panoply of central bank and government financial interventions and support measures have ensured, at least for the time being, the survival of most of the remaining crossborder banks. It has not done enough to get them lending again on any scale to the household and non-financial enterprise sector.

Sure, as the economy weakens, the demand for credit is racing the supply of credit down, but there can be no doubt that many firms and households are credit-constrained, and cannot find external finance either from the banks or from the capital markets. Only the larger enterprises, and those with a good credit track record have access to the capital markets. Small and medium-sized firms and new firms without a credit track record cannot go the the markets. So with zombie banks and highly selective access to the corporate bond markets, we are set for a slow and anaemic recovery.

This is made worse by the poor state of household finances in many western countries. With property prices down and banks tightening credit conditions, households have suddenly woken up to the true horror of their highly indebted state. Fear and caution have taken over from optimism and an instinctive belief in the sustainability of a consumption plan financed through Ponzi finance made possible through house prices rising at a proportional rate in excess of the interest rate on housing debt. This rediscovery of prudence by households has lead to a form of Ricardian equivalence that makes tax cuts ineffective and limits the multiplier from public spending increases. Many highly indebted households have reduced their consumption to a (generally socially defined) ’subsistence’ level. Any additional income is saved or used to pay down debt.

Quantitative easing The central bank buying longer maturity government securities will help when the underlying problem is too high a value of risk-free long-term interest rates. That, however, is not the problem. If anything, long-term risk-free rates continue to be surprisingly and damagingly low. So outright purchases of government securities by the central bank do nothing to alleviate liquidity pressures on banks, let alone the banks’ capital shortage. They are no more than a sop to the ministry of finance and its deficit financing preoccupations. At best, such monetisation of the public debt will, if it not expected to be reversed, have a ‘fiscal’ effect - helicopter money. But if households are saving their windfalls, even this will fail to boost the economy.

Credit easing

The central bank purchasing private securities outright will help if there are liquidity problems in the markets for these securities, making for excessive spreads over corresponding maturity risk-free rates. Apart from that, such outright purchases help only if the central bank pays over the odds for the securities and thus helps recapitalise the banks. No doubt the massive past liquidity injections by the central banks of Japan, the US, the Euro Area, the UK and elsewhere in Europe have taken the liquidity spreads out of the corporate bond yields. Corporate borrowing through issuance in the markets is running at a high level, even in the Euro Area. Much of this substitutes for bank finance that is no longer available. If the authorities believe that the spreads of corporates over Treasuries are still in excess of what is warranted by differences in default risk, they should by all means buy more corporate debt. If they believe, as I do, that these spreads are likely to be a fair reflection of credit risk differentials, then even credit easing is a waste of time.

Enhanced credit support

Enhanced credit support to the banks, along the lines of the ECB/Eurosystem making a humongous volume of collateralised loans to the banks likewise only works if the Euro Area banking system suffers from a shortage of liquidity or if the ECB/Eurosystem offer too generous terms for these loans. Euro area banks take the ECB’s liquidity and re-deposit most of it with the ECB rather than using it to engage in new lending. Euro Area banks are among the most zombified by their capital inadequacy and excessive leverage.

Throughout the north-Atlantic region, the problem is not that the banks are illiquid. They are short of capital. Many of them would be insolvent but for the anticipation of further government support, on top of the massive support already given to the sector. In addition, while the fiscal authorities are prompting banks to raise more capital and have injected public capital in the wonkiest banks and while central banks are injecting liquidity in the economy on a scale never seen before, regulators and supervisors are often forcing banks to act procyclically, by building up their liquid assets now and by aggressively deleveraging now. Surely, if ever St. Augustin’s prayer - Lord give me chastity, but not yet - was appropriate, it is now for banks.

That banks are drowning in liquidity is apparent from the divergent behaviour of the stock of bank reserves with the central bank. which is increasing fast, and the broad money stock held outside the financial sector (for these purposes, the non-bank financial sector is just the off-balance sheet segment of the banking sector and should be consolidated with it). As pointed out by Ben Broadbent of Goldman Sachs (where I am an advisor - all views and opinions expressed are strictly and emphatically my own and not those of any organisation I am associated with etc.), the increase in M4 outside the financial sector in the UK has recently been much smaller than the growth of commercial bank reserves with the bank of England. Similar patterns exist in the US and in the Euro Area.

Conclusion

Pushing on a string is difficult. Pushing a zombie on a string is even harder. Pushing a zombie bank on a string is impossible. Unless the balance sheets of the banks are strengthened sufficiently, through massive further injections of capital, the removal of toxic assets and much lower leverage, unconventional monetary policy will not work. The banking system in the north-Atlantic region is not facing a liquidity shortage - it has got liquidity coming out of its ears. It is facing a capital shortage. Much of it still totters on the edge of insolvency. Recapitalising banks slowly through large spreads on low business volumes and through quasi-fiscal subsidies extended by the central banks in their financial support operations will take years - years of impaired intermediation and abysmally restricted external finance for households and non-financial corporations.

Recapitalising the banks and paying off private household debt through high unanticipated inflation would be possible, but undesirable. I propose a combination of mandatory recapitalisation of the banks and a debt Jubilee for the household sector to remove the two key obstacles to an economic revival. The mandatory recapitalisation would be first through new equity issuance in the market, then though mandatory debt-to-equity conversion and similar haircuts for unsecured bank creditors, and last through increased government equity stakes. All these capital injections should take the form of tangible common equity. Anything else would be cosmetic.

Subsequent regulation of the banking sector (broadly defined to include all highly-leveraged entities with serious maturity and/or liquidity mismatch on their balance sheets) will then be necessary to prevent a recurrence of the disaster we are now struggling through.

In preparation for the Jubilee, I am going long in ram’s horns. In good Torah/Biblical tradition, we should have one of these every 49 or 50 years.

We skipped a few. Let’s have a big one now.

KT - Don't agree about the Jubilee at all though, see the other comments on his blog!!!

Yen Intervention looming?

Reuters 09Jul09 06:49:31
By Vivianne Rodrigues and Nick Olivari

NEW YORK (Reuters) - Japan could be one step closer to intervening in the foreign exchange market for the first time in five years as a soaring yen further jeopardizes the country's chances of pulling out of recession.

Growing unease about the global economy has prompted investors to rush out of trades that bet against the yen while favoring higher-yielding but often riskier currencies.

The move accelerated on Wednesday and spurred talk of intervention or at least jaw-boning of the exchange rate by Japanese officials, after investors bought back yen, pushing it to multi-month highs against both the dollar and euro.

If the yen strengthens to trade below 90 to the dollar, "it is more a question of 'when' than 'if'," said Michael Woolfolk, senior currency strategist at The Bank of New York Mellon, in New York. "At this stage, the pace of the move rather than the absolute, is their main concern. They want to see stability, they have mentioned it many times before."

Japanese officials have said repeatedly the country is not considering intervention in currency markets. However, given the country's reliance on exports, they may be more motivated.

Investors are also mindful that the Group of Seven industrial powers in October issued a rare inter-meeting statement singling out yen volatility, giving Japanese authorities the green light to stem its surge at that time.

The yen also jumped against the Australian and the New Zealand dollars as it quickly broke through key levels around 93.40 to the U.S. dollar to touch its highest since February.

The yen moved more than 3 percent against both the dollar and euro Wednesday in its biggest one-day moves since March and November, respectively.

Japan has a long history of trying to stem yen strength by intervening to buy dollars, but it has stayed out of the market since a 35 trillion yen ($377 billion) campaign over 15 months ended in March 2004. The Ministry of Finance has gradually moved away from heavy intervention because that last campaign had mixed results.

A summit of the Group of Eight major economies in Italy starting on Wednesday was silent on currencies but the sharp moves are unlikely to go unnoticed, analysts said.

"As the yen starts getting close to the 90 mark, we are going to see Japan stepping up the rhetoric at least," said Vassili Serebriakov, currency strategist at Wells Fargo Bank in New York. "It's inevitable."

Central banks have become more active in currency markets in recent months to prevent price volatility from threatening a nascent economic recovery.

FOLLOWING THE SWISS EXAMPLE?
The Swiss National Bank surprised the market in March by buying euros and U.S. dollars and selling the franc. It was the first time that the SNB had intervened since 1995.

The SNB denied they intervened to weaken the currency -- instead acting to stop it from rising. Swiss monetary authorities have sold the franc several times after the March announcement, with more aggressive forays in the last days of June, traders said. As a result, the Swiss franc has fallen about 4 percent versus the euro since March.

The Japanese currency has also strengthened in the past as investors unwound carry trades, trading around 88 to the dollar late last year as the global economic crisis intensified.

Momentum is now building again to hold yen as risk aversion rises. "As risk aversion goes up, the yen is regaining some of the safe-haven characteristics it has lost," said Serebriakov. "Carry trade positions now are not as large as they were pre-crisis, but the yen will keep benefiting. And let's see what happens if we get to the 90 mark.

That's probably the line in the sand."

Quantitative easing debate

This is an excellent explanation of the current debate around quantitative easing issues:

Morgan Stanley - Global QE, Global Inflation

July 03, 2009

By Joachim Fels & Manoj Pradhan, London

Inflation complacency:

With headline inflation gauges in negative territory in many countries and the global economy only just emerging from the ‘Great Recession', it may seem absurd or at least premature to worry about inflation risks.

Indeed, most investors appear to be undaunted by inflation, a view that is also reflected in market-implied 10-year inflation expectations for the US and the euro area of less than 2%, which would be lower than actual inflation over the past decade. In our view, however, markets are too sanguine about longer-term inflation risks. It appears more likely to us that in the coming decade inflation will significantly exceed the levels seen over the past decade.

Three reasons to expect higher inflation:

Our inflation view is based on three pillars, which we discuss in turn:

• We think that most observers vastly overestimate both the size of the ‘output gap' and the importance of this gap for determining inflation. Our earlier research has shown that global factors, rather than national output gaps, are the main determinant of inflation these days.

• The ‘secular' global forces that helped to push inflation lower or keep it low over the past couple of decades - productivity, deregulation and globalisation - will likely be less prevalent in the years ahead.

• Quantitative easing (QE) is in full swing globally, and we think that central banks will be slow to exit from it collectively, especially if economic growth remains subdued. The longer super-easy global monetary conditions remain in place, the more likely it becomes that inflation expectations and actual inflation will start to rise significantly.

Output gap approach problematic: The most frequently voiced argument for low inflation in the foreseeable future is that the Great Recession has created a huge gap between actual and potential output and thus much spare capacity that will take years to be absorbed.

However, we are inclined to discount the output gap argument for two reasons:

• First, any real-time estimates of the output gap are highly uncertain due to data revisions and because estimates of potential output evolve as more data become available. For example, as work conducted by Athanasios Orphanides during his time at the Fed has shown, monetary policymakers' misperceptions about the size of the output gap were a major factor in the inflationary surge in the 1970s. For a long time during and after the mid-1970s recession, the Fed believed the output gap to be larger than it actually was. The reason for this was that it overestimated potential output, which later turned out to be much lower than initially thought.

In fact, there is reason to believe that the credit and economic crises of the past year have led to a downshift not only in actual output but also in potential output. With the end of the consumer and housing boom in the US, the UK and other countries, resources and excess labour need to be shifted into other sectors, which will take time and could keep structural unemployment high. Also, the cost of capital is likely to stay higher than in the bubble years, and the plunge in capex will contribute to lower potential growth, too, in our view.

Our more sceptical view on potential output and thus the size of the output gap is supported by our natural interest rate model, which also generates an estimate of potential output. Tellingly, our model produces an output gap for the US that is much smaller than the ‘official' one generated by the Congressional Budget Office (CBO). Similar results have been reported in a recent study by San Francisco Fed economists Justin Weidner and John Williams ("How Big Is the Output Gap?" FRBSF Economic Letter, June 12, 2009).

• The second reason why we are inclined to discount the ‘output gap' argument is that in our previous research we found that output gaps only have a weak influence on inflation. Rather, global inflation has become the dominant driving force for domestic inflation rates. If our estimates are anything to go by, an output gap of 1% pushes inflation down by barely 15bp in the US (see Inflation Goes Global, July 16, 2007).

Global factors less disinflationary:

So how about the global factors determining inflation? In the last one or two decades, central banks were helped in keeping inflation low by a confluence of three factors: globalisation, deregulation and faster technological progress.

However, the tailwinds for central banks from each of these factors have turned into headwinds:

• Globalisation is likely to proceed less rapidly in the next several years due to the creeping protectionism that has been reinforced by governments' reactions to the Great Recession. Increased support for national industries is likely to slow restructuring and reduce import competition.

• Deregulation has been largely achieved in most sectors. Now, consolidation in deregulated sectors and government-induced re-regulation in some areas are reducing competition, and thus potentially adding to inflation pressures.

• The big boost to productivity from the IT boom of the 1990s is behind us, and trend productivity growth in the technology leader, the US, has probably slowed significantly. Lower productivity growth that is not accompanied by slower wage increases implies rising unit labour cost pressures.

But monetary policy matters most:

The most important factor for the global inflation outlook, however, is the current and future stance of monetary policy. Central banks have responded to the crisis with an unprecedented amount of monetary stimulus, and we fear that the accommodation will be kept in place for too long.

QE is alive and kicking...

The sharp increase in US 10-year yields and mortgage rates, with 10-year yields reaching 4% in mid-June, led many investors to question the effectiveness of the QE programme. While a continued increase in yields would certainly create headwinds for economic recovery, it is important to keep in mind that keeping yields low was only one aspect of the programme. As important, if not more so, is the increase in money supply and excess liquidity. On this measure, the Fed has continued to run a successful campaign, as have a host of other countries that have implicitly or explicitly turned to QE.

...globally:

On our count, the Fed, the ECB, the BoE, the BoJ, the Swiss National Bank, the Swedish Riksbank, the Norges Bank and the Bank of Israel all adopted some form of QE around September 2008 (see "QE2", The Global Monetary Analyst, March 4, 2009). M1, the measure of narrow money supply, has been growing strongly in most of these countries since then. M1 growth in the G4 is ticking along at 12%, driven by M1 growth of nearly 20% in the US, around 8% in the euro area, and a move into positive territory for M1 growth in Japan. Outside the G4, money supply is moving up strongly in Switzerland and Israel, with the latest M1 growth numbers showing 42%Y and 54%Y growth, respectively. The Norges Bank's QE programme has kept the monetary base at highly elevated levels and M1 growth has begun to shrug off the effects of previous tightening and is now in positive territory. Finally, the increase in the monetary base allowed by the Riksbank has pushed up M1 growth to over 6%.

While there has been no QE announcement from the Chinese monetary authorities, the efforts made to increase money supply and credit in China over the past few months have been highly successful. M1 growth has clocked in at 18.5%Y while loans are growing at 28%Y. India briefly flirted with QE-type policies (see India: Flirting with QE, April 7, 2009) by buying a sizeable chunk of government bonds since April. However, efforts to push up money supply don't seem to have been pursued vigorously since then. Both economies are expected to outperform the global economy. If anything, our economics team sees the dramatic rally in equities and property as a development that central banks will have to monitor closely (see Rise in Asset Prices: New Challenge for Asian Central Banks, June 30, 2009).

More to come:

In the major economies, there is plenty more to come. The Fed is about halfway through its US$1.75 trillion purchase programme, while the Bank of England has about 18% (£23 billion) of its programme yet to go. Meanwhile, the ECB will start purchasing €60 billion of covered bonds this month. In short, there is plenty of firepower waiting to come out of the central banks' QE muzzles. If the impact on money supply so far is anything to go by, we can expect excess liquidity to continue to grow (see "The Global Liquidity Cycle Revisited", The Global Monetary Analyst, May 27, 2009) and support economic recovery and asset markets.

....but the way out is tricky:

While talk about ‘QExit' has started, we believe that central banks will most probably not be able to withdraw monetary stimulus rapidly without putting at risk the tenuous recovery that our global team expects. On our latest forecasts, the G10 economy will shrink by 3.5% this year and grow by only 1.3% in 2010. In such a scenario, central banks are likely to unwind QE and normalise policy rates fairly simultaneously and very slowly (see "QExit", The Global Monetary Analyst, May 20, 2009), raising the risk of inflation.

Importantly, given the importance of global factors that we pointed out earlier, keeping the inflation genie bottled up will mean that it probably won't be sufficient if one or two central banks get the timing of exit right - this is a feat that a majority of central banks will have to achieve in order to keep global inflation subdued, in our view.