There Is A Surprising And Totally Counterintuitive Way For Central Banks To Fix The Global Economy by Andrew Hunt author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor.
The last few years have not been easy for the global economy or for the world’s central banks. The aftermath of the financial crisis has left most major economies wrestling with slow growth, high debt, growing inequality and inflated asset prices.
Unfortunately, the tools hitherto employed by central banks to kick-start growth have had very mixed results, and may have actually exacerbated some of those imbalances. The twin policies of QE and ultra-low interest rates have been linked to rising inequality, distorted markets and investment bubbles – from Nordic real estate to internet start-ups. In a desperate search for income, savers of all kinds are saving even more than they otherwise would do, while chasing yield in high risk and often unsuitable asset classes.
The latest central bank tool – negative interest rates – appears to be making these problems even worse, and threatens to undermine the whole banking system. When you have to pay banks to lend, or even contemplate banning cash outright, it is clear that the medicine is becoming more harmful than the disease.
At the heart of all these problems is the very nature of central bank policy: it manipulates markets. In short term crises that may make sense, in the long term it is ruinous. The whole point of markets is to allocate capital efficiently and thereby use society’s resources well. Policymakers need to relearn that manipulating markets is negative for growth, and hence, so is monetary policy.
We need not look far to see the physical and human costs of QE and low interest rates. The housing bubble saw millions of homes built across America that no one really wanted, while millions of bright, hard working individuals trained as builders, estate agents and investment bankers, only to see their careers wrenched from them. Then we threw money at energy and commodities. Now, we’ve done enormous environmental destruction to produce energy and minerals that no one really wants. Across Africa and Australia, high cost mines lie idle and rusting, while desperate Brazilians take to the streets in disgust at the excesses of boom and bust. If there is one book that should be on every central banker’s bedside table, it is surely . Heart of Darkness is a journey into the surreal and terrifying world of colonialist misallocation of capital. No other book captures the pervading sense of madness, waste and the human cost of a world hell-bent on throwing good money after bad. Nothing is quite what it purports to be, leaving everyone trapped in time while they wait for a sense of reality to return. “The horror! The horror!” Quite.
If the existing policies aren’t working, is there a better solution? The answer is yes. However it involves two seemingly contradictory actions. On their own, each part would be disastrous; yet together they work perfectly.
The first part is to hike interest rates right back up to pre-crisis levels. This returns the banking system to a viable and socially valuable industry charged with the job of pricing risk and allocating capital rationally. Raising the cost of capital stimulates creative destruction by putting all those zombie businesses to the sword while reining in future investment bubbles.
In addition – and this is the really important part – high interest rates encourage deleveraging, bringing down those nosebleed levels of debt across the system. The great advantage of rising interest rates is that they “get in all the cracks” rather than just shifting financial excess to another part of the financial system. By using a combination of rising interest rates and macroprudential regulation, central banks can effectively target a gradual and sustained reduction in debt.
However, if you just hiked rates and cut back on lending, that on its own would likely trigger a full blown recession along with steep deflation, which is where the second act comes in.
The second part involves Direct QE – that’s right, QE and raising interest rates! However, this is QE in a different form to what we’ve seen so far, and is designed to reach everyone by stimulating the economy directly without distorting markets. Under Direct QE, the central bank gives the government money directly in return for a zero-coupon, perpetual callable bond. The government then spends the money on expansionary stimulus, such as universal tax breaks and infrastructure projects – projects that actually grow the real economy and encourage business.
The overall result of combining these seemingly contradictory policies is reflationary deleveraging. However, the inflation is only modest; as the expansionary QE is offset by the deflationary process of deleveraging (the bank multiplier goes into reverse). Basically we’re unwinding the inflationary debt binge of the past few decades, but without a deflationary shock.
In some cases, asset prices may fall, but this would be offset by the stronger economy. For example, a homeowner might see his house price fall and mortgage payments rise, but this would be mitigated by better employment prospects and inflationary wage growth. In other words, under reflationary deleveraging, asset valuations may slip, but the fundamentals of the underlying assets improve.
Over many years, the high-rates plus high-QE combo would eventually return us to a sustainable and more resilient economy, thanks to lower debt levels and responsible lending rates. As for those perpetual callable bonds? Well they could just sit in a drawer at the central bank, depreciating with inflation over many centuries. However, should fiscal policy ever get out of control, the power to call them would give the central bank some useful leverage against any profligate government of the future.
Andrew Hunt is an Investment Manager and author of Better Value Investing: A Simple Guide to Improving Your Results as a Value Investor.
