Quantitative easing and helicopter money: What's next?
Now, the last time I gave a formal talk it was at the London Stock Exchange, during which I took our audience on a trip down the new silk road. Our journey through time spanning over two thousand five hundred years. We began in the fourth century BC, when Sparta and Athens were battling for regional hegemony; we then traveled along the ancient trading routes; we fought the opium wars; we witnessed the great famine; and then we experienced China's great modernization of the 1970s. It was a whistle-stop tour of Chinese history, all leading up to the opportunity for President Xi in 2013 to build the largest infrastructure project of modern times, to become the most influential leader of the 21st century and of course to take back the title of the undeniable hegemon of Asia.
Now, today's journey will be equally as important, but it won't be about ancient maps, nor exotic wares, and we will rather focus on a shorter span of time – a period during which we've witnessed stellar economic booms, dire financial busts, and extreme government interventions. To which period am I referring? Well, to the last 30 years of course. Today we survey the credit crunches and the financial crises which have helped to define our financial markets as we know them today. For without an appreciation of the challenges of the past, how can we possibly position for the future? Ladies and gentlemen, the four major central banks have ballooned their balance sheets by over 25 trillion dollars leaving us to ponder the biggest question on investors' minds today: With so much government intervention, can stock markets ever go down again or are we just heading over a financial cliff, which will end in tears? So let's begin our journey and turn back time. But where shall we begin? Well today we're going to start, this morning, in Japan, at the end of the 1980s, during the height of the Asian miracle. During this period, ultra-loose government policies propelled markets higher and higher, building up to one of the greatest stock market bubbles in history. Market speculation was so rampant that even Japanese manufacturing companies were setting up internal trading desks to speculate during this golden age. But alas, enter the Bretton Woods agreement – and like all great rallies it ended in tears, and Japan went from boom to bust, ushering in deflation, corporations on life support, and anemic growth – a period which would become known as the lost decade. But international markets eventually stabilized, investors regained confidence and began inching our way forward into the arms of the next financial crisis. In 1994 the Nordic markets froze; in 1996 the Tequila crisis left Mexico with a massive hangover; in '97 the Asia Tigers got bitten; and this was followed, of course, by my favorite crisis – because it was my first crisis – she was from Russia, with love. I'd been working at Oppenheimer in New York City for an impressive 15 minutes when the unheard of took place – a nation armed with nuclear warheads defaulted on their sovereign debt, breaking the unspoken rule, sending shock waves globally, and the best performing hedge fund in the world, which was annualizing 40%, into bankruptcy. The fund Long-Term Capital Management was making bets, some of which were levered one hundred to one, and the potential collateral damage was so feared that the New York Federal Reserve had to intervene to contain the fallout. If you're interested in learning more about that you should have a read of a book entitled 'When Genius Fails', which is expertly written and one of my all-time favorites. But just like all crises, markets stressed, volatility spiked, governments acted, and then markets bounced back, allowing Wall Streeters to start climbing their wall of worry once again. Fast forward to 1999 and internet stocks were on fire. Taxi cab drivers in New York City were telling me which call options on Intel and Oracle to buy in my trading account. The time the former chairman of the Federal Reserve, Alan Greenspan, he referred to this period as irrational exuberance. I used to just call it plain debauchery. Now, does anyone on this call today remember a company called theglobe.com? They invented Facebook before Facebook existed. I was friends with the CEO, he's a star entrepreneur, and Bear Stearns underwrote the IPO on the red hot NASDAQ exchange. It went from $9 to $63 on the first day of trading. At the after party I jokingly said to him, "If I were your investment banker, I'd advise you to make an all-stock offer for a utility company. That way you'll never run out of money." And alas, in March 2000, equity markets tumbled into just another financial crisis, this time taking years to recover, but they did – and global equities fought back with little knowledge of what was to come only a few years into the future.
The big one: the crisis which would engulf savers, institutional investors, even nations, and eventually lead to the biggest bailouts in history. US mortgage bonds, backed by some of the dodgiest assets globally, found their ways into the books of pension funds around the world – and when they realized these securities were worthless, banks dropped to their knees and contagion spread like wildfire. America, the bastion of innovation, the richest country in the world, was on the verge of financial collapse. At the peak of the crisis it was questionable whether General Electric was even going to make payroll. Now according to Moody's and Standard and Poor's, two of the most recognized rating agencies, the US housing market was the safest investment in the world. Why such high conviction? Because it never went down. Imagine never a down year since 1928. Just like insatiable demand from pension funds, insurance companies, hedge funds, along with the siren calls of high-yield bankers sat at trading floors, slicing and dicing these products fueled these excesses. Now, if you need a refresher on how these mortgages were packaged and sold to unknowing investors, after this call just type in the following three keywords into YouTube: CDO Margot Robbie. Now the explanation isn't exactly politically correct, but you'll get the picture. Now at the deafening point of near collapse, American central bankers and treasury officials rode in on their white horses to rescue the biggest banks and orchestrate the biggest bailouts in financial history. They slashed interest rates to zero, saved AIG, the world's largest insurer, and signalled to the market under no circumstances would they accept a banking collapse. This was forward guidance to end all forward guidances – and that's when it all started. The US government did the unthinkable: they brought trillions of dollars worth of bonds in wave after wave of large-scale asset purchases. In an attempt to make the illiquid liquid, gave a price to in some cases the unpriceable. Now, if you think modern-day alchemy doesn't exist think again. Ben Bernanke, the then Chair of the Federal Reserve, was a student of the great depression, and he knew how bad it got in the 1920s. Investors lost everything, businesses went bankrupt and families stood on food lines.
So what was the fed actually trying to do? Well, they weren't targeting growth nor inflation. They were just simply trying to avert a financial collapse, making sure financial markets could function and companies could pay their employees. The endgame? To avert a great global depression. And the bottom line is that they succeeded, and for that they deserve a big fat cigar. Central bankers went from nerds sat at the front of the class to rock stars wielding trillion dollar checkbooks, but we weren't out of the woods just yet. It didn't end there it was followed by the European Sovereign Crisis: Greece, Spain, Italy, Portugal, all engulfed in a crisis of sovereignty, identity, and philosophy. While capitalism was in crisis in America, socialism was on trial in Europe. So what did the Europeans do? Well, same playbook: slash rates, buy bonds, and promise the world they would do whatever it takes. And it worked. Fast forward to March 2020 when the unthinkable took place: a pandemic swept the globe resulting in a locking down of businesses, schools and the introduction of social distancing. The result? Stock markets collapsed, credit spreads spiked, and what did the central bankers do? They dusted off the crisis playbook and started buying bonds again but this time in larger clips. In America the Federal Reserve bought US treasuries to flatten the yield curve and to liquify the markets, mortgages to support the housing and suppress borrowing rates, and even corporate bonds to relieve stress in the credit markets, putting the taxpayer on the hook for potential defaults. And it didn't stop there; the bug spread from central banks to fiscal authorities. The calls on governments to pull fiscal levers were so great that central bankers like Mario Draghi finally got his wish as we witnessed huge fiscal bazookas being released into national economies. Germany for example throwing out its black zero and going all in with circa 13%& of GDP in fiscal aid, alongside the US, Japan, France, the UK – the list goes on.
So begs the question, did it work? Well, it depends on how you define success. To save the world from financial meltdown, families from losing their homes and multinationals from collapse? Well, if that was the objective, then mission accomplished, as US high yield credit spreads are back to normal at 300 over. But many are still claiming that QE failed, because growth is uneven, inflation is stubbornly low, and inequality has risen, and perhaps that's the central criticism. So let's take each in turn. On inflation, I ask, is it their fault that technology makes goods cheaper and that the internet has killed the high street? Should central bankers be blamed that globalization has facilitated the ease of exchange of goods from different economies, which in turn pushes down prices? Can a central banker realistically stop water flowing from high ground to low? No of course not, and we've all benefited from cheaper products, so let's stop complaining. On growth, many are critical that central banks have not done enough to foster growth but I say that's not their job. Growth is the domain of entrepreneurs, private companies, corporations and credit providers. The decision to extend credit and multiply up our deposits sits in the conversation between credit officers, bankers and borrowers – not in the halls of monetary policy committees.
And finally, on the claim that QE has fueled financial inequality, just making the rich richer and the poor poorer, my view you ask? This just ignores the pivotal role central bankers have played in averting financial crises. Yes, asset prices have inflated, especially real estate in European capital cities. But would you preferred the opposite? Imagine a scenario where credit spreads remained elevated, companies struggled to raise overall debts, unemployment spiked which then led to defaults in the mortgage markets – not an ideal set of dominoes. So I ask in response to those exact critics: what's your brilliant idea? Well the members of the MMT squad – stands for the Modern Monetary Theorists – are calling for helicopter money. They want governments and central banks to merge and turn on the printing presses to start handing out cash to citizens to level the playing field and foster growth. It's called 'QE for the people'. Now you may stop me and say, "but the printing presses are already on and they've been running over time since March..." and you would be wrong. QE is not money printing. It's a myth. It is but a maturity transformation exercise, swapping a long-duration asset which fluctuates in value such as a 10-year bond, with a fixed value asset – namely cash, or more precisely, reserves – with the objective of providing liquidity. So you might ask what does liquidity actually offer? Well, the more liquidity, the less volatility. Because if everyone that wants a price gets those prices and they're being met, then prices move less, and that increases certainty.
So what's the difference between helicopter money and QE? Well, QE is supposed to be temporary, whilst heli-money is a permanent forgivable transfer. I'll give you a stylized example: in helicopter money, governments issue bonds, central banks buy those bonds, and then they get cancelled whilst the government uses that new money to make direct payments to citizens to encourage them to consume, thus more evenly spreading wealth and encouraging consumption. Now the MMT squad thinks it's a panacea – that's why they call it the magical money tree. But if there's one thing I've learned in over 20 years as a portfolio manager, is there's no such thing as a free lunch! And helicopter money is no different. Helicopter money is not free because the money ends up back in the form of reserves, and some central banks, such as the Fed, end up paying interest on excess reserves to preserve the floor and rates. So it's not really free. Secondly once the bonds are paid for, and then cancelled, the central bank has to adjust for those transfers. What adjustments, dare you ask ? Well, a loss in equity – and it's if it's significant enough then the central bank begins operating under the specter of negative equity. Don't forget, a central bank has a balance sheet just like any other financial institution. Thirdly, it's easier said than done. Now recently there have been some calls on the ECB to forgive some Italian government debt. How did Christine Lagarde, the chief at the ECB, respond? Sorry Charlie, but that's illegal. Fourthly, there's no guarantee that citizens would actually spend the money. What's stopping them from just saving the cash, just like in Japan? And finally, the nail in the coffin. Who would decide the size of those helicopter drops? Because once the government dictates that to central banks, its independence is like a horse which has bolted from the stables. My view? In order to promote financial stability and a well-functioning economy, we need to ensure central banks remain strong, solvent and independent, period. To be clear, the job of the central banker is to bring champagne and cheap money to the party when there is max pessimism and conversely take the punch bowl away when investors are partying like it's 1999, literally. It's at that moment when their job is to prick the bubble, just like they did in Japan at the time when the grounds of the emperor's palace in central Tokyo was more valuable than all the land in the state of California, and it's for that reason central bankers need to keep their independence, because politicians – let's face it – won't ever take the punch bowl away.
Let's draw to a close. People have been calling for the end of the world since the beginning of time, and the last time I checked we're still here, and after each crisis, regardless of the catalyst or circumstances, our technology improves, and our markets recover to make new highs. It's true there are excesses mounting in the system such as polluting government debt, sky high tech valuations, which all seem to be creating a financial cliff. But the housing market has served as a harbinger of stability in developed markets thanks to mortgage buying and a little bit of DIY. Unemployment appears to be manageable for the time being, and credit markets are flowing and functioning with China out in front signaling their desire to temper leverage. The most dangerous words in financial markets are, "this time is different" and if you haven't read Reinhart and Rogoff's book sharing the same title, it's highly recommended. But in this instance, our investment committee thinks it's just too early to cash in all your chips and buy that farm in New Zealand. But if our view changes and you're a client of Arbuthnot Latham's, then you'll be the first to know.
Quantitative easing, at its simplest, impacts interest rates – and interest rates affect almost every financial decision governments, corporations and individuals make: taking out a mortgage for a family home, putting the summer holiday on your credit card, extending an overdraft, borrowing to invest in your business, and the cost of government borrowing.
In this recently-recorded talk on QE and helicopter money, our Co-CIO Gregory Perdon looks at the history of financial crises, what central banks have done in recent years to maintain stability and what the future might hold.
Has QE failed?
And is helicopter money the final frontier? Our latest research delves into how the largest economies in the world have adopted QE, what this means to investors, and the longer-term implications. Uncover for yourself the $24trn monetary experiment called Quantitative Easing and its far reaching implications.
Quantitative Easing Explained
To find out more about quantitative easing, we developed 'Everything you always wanted to know – but never dared to ask – about the exciting world of central banking', a light-hearted story about helicopters, printing presses and money creation.
In the press
Helicopter money: large-scale cash handouts are no panacea for economies
There is a difference between helicopter money and quantitative easing
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