The True Cost of Quantitative Easing

Quantitative easing has been short-term pain relief with long-term damage and some ugly side-effects

Life on drugs must be great – but the high cannot last for ever.  Such has been the case with quantitative easing.  The financial markets have been buzzing due to the money pouring out of the Federal Reserve as part of its monetary stimulus program.  The costs of shot after shot of extra cash are easy to forget when times are good.  It is only now that the Federal Reserve has decided that it is time to wean investors off their quantitative easing fix that we are seeing the true repercussions of addiction to easy money.

Costs of kicking the habit

Investors are already getting the shakes as the Federal Reserve moves to lower the dosage of its monetary policy.  Stock markets around the world wobbled in early 2014 as the Federal Reserve trimmed US$10 billion off its monthly bond purchases in December and January.  The extent to which stock markets have benefitted from the monetary stimulus is unclear but substantial.  This means that volatility is likely to continue as share prices find their appropriate level without any interference from the Federal Reserve.

Investors have reacted strongly to any attempts by the Federal Reserve to renounce its role as drug dealer for the financial markets.  The policy of quantitative easing in itself has been like a drug habit – easy to start but tough to break.  As is often the case with bad habits, it is only when trying to quit that the real costs become apparent.

It looks as if the comedown will take the form of a lethargic economic recovery that may last for years.  Uncertainty is one of the primary stumbling blocks standing in the way of economic rehabilitation.  The slow tapering of quantitative easing followed by interest rates being gradually pushed upward will be enough to keep even the experts on edge.  Thus, while the monetary stimulus has eased the pain of the global slowdown, the economy will be held back by the “ifs” and “buts” of monetary policy.

Emerging Markets Hit by Side-Effects

If the past few weeks of stock market jitters are anything to go by, it may be emerging markets that suffer the worst withdrawal symptoms.  Many developing countries had benefited from the extra cash in the global financial system coming from quantitative easing.  Low levels of domestic savings mean that such countries rely on funds from overseas and their chronic cravings for growth make poorer countries prone to overdosing.  Their vulnerable position leaves them at the mercy of the money peddlers from wealthy countries who often have the upper hand.

It is a sad twist of fate that the worst consequences of monetary policy in the US will be felt far from its shores.  One of the reasons why quantitative easing has had little effect in boosting the US economy may be due to a considerable portion of the newly printed money heading overseas.  The amount of cash flowing out of the US has been large enough to warp the economies of some developing countries.  The hit on their financial wellbeing as the money returns back to the US has also been a downer.

A silver lining is that past crises have taught emerging markets to be more resilient – this time at least the IMF will not be kicking down any doors (like the police at a narcotics bust) as might have been the case in the past.  It is also clear that emerging markets still need to do more to better manage their addiction to foreign funds.  While emerging markets have learnt some lessons from past predicaments, we can only hope that the Federal Reserve can do the same. 

Nasty Breakup from Forward Guidance

Central banks have been led astray by the policy of forward guidance and it is time to move on

There has been a big breakup in the world of economics just before Valentine’s Day.  Central banks in the US and the UK had been wed to the concept of forward guidance.  This policy involves keeping interest rates low will have greater potency when combined with an outline of how long the policy will remain in place.  With the impact of low interest rates on the wane, central banks in the US and the UK were courted by the idea of forward guidance as a way to eke more out of current policies.  Yet both the Federal Reserve and Bank of England have been caught with their pants down due to the failure of forward guidance to deliver an economic boost.  The falling out has been made worse by debilitating issues with policy execution.

Seemed like a good idea at the time

The Federal Reserve slashed interest rates to 0.25% in December 2008 while the Bank of England pruned UK interest rates back to 0.5%.  In the face of the harshest recession in a generation, this normally dependable form of monetary stimulus failed to have much of an effect.  Continued weak economic growth spurred on a search for something extra and resulted in central banks delving into more unconventional measures.  Quantitative easing (buying bonds with newly printed money) is one example of such measures, forward guidance being another.

It was thought that forward guidance would act as a means to encourage economic growth as low interest rates were not having much of an effect on borrowing by themselves.  The hope was that a pledge that rates would be kept low for at least a few years would be the catalyst that would kick-start lending.  However, the assumption that there was a pent up demand for loans was wrong (as Your Neighbourhood Economist thought it might be). 

Bad idea made worse by shoddy execution

If the thinking behind forward guidance was not the best, the implementation was worse.  Both the Federal Reserve and the Bank of England based the forward guidance on the unemployment rate.  Unemployment was seen as a reliable yardstick of economic performance so the two central banks used it as a marker for changes in policy.  This later became a stumbling block when the number of people out of work declined faster than expected catching out many others along with the central banks.

Having to readjust the policy of forward guidance has been a PR disaster for central banks for whom reputation is key to influencing the financial markets and achieving their goals.  The Bank of England recently explicitly dropped the link between interest rates and unemployment and the Federal Reserve is sure to follow suit.  The necessity for central banks to assuage concerns that interest rates may rise defeats the whole purpose of forward guidance in the first place.

The Bank of England has instead stated that it will rely on a wider range of economic data.  Despite protestations by Bank of England governor Mark Carney that forward guidance is working, the new policy is too vague to act as any guide to the future of interest rates.  The reworking of forward guidance has failed to find any love from the markets.  Expectations that the Bank of England would not be faithful and would hike interest rates sooner rather than later resulted in the value of the UK currency jumping following the statements by Carney.  The saga over forward guidance has left central banks wondering what went wrong but it is time to get out and start afresh. 

Fragile Five – the Silver Lining

A deeper look into the problems of the Fragile Five shows that the fault does not lie with global finance.

There are times in life when it is tough to figure out who is the hero and who is the villain.  Such may be the case with the current turmoil engulfing emerging markets.  Adding ignominy to injury, economists have tarred Brazil, Turkey, India, Indonesia, and South Africa with the dubious epithet of “the Fragile Five” as an outflow of funds has sparked a multitude of economic imbalances.  Investors have been quick to yank their money out as higher investment returns are expected to follow the paring back of monetary stimulus.  First impressions might suggest that the blame lies with the fickle nature of global finance. 

Yet, as with all good detective novels, it is not always the obvious culprit who is in the wrong.  It is entirely logical that money should move out of badly run countries in the same way as shoddy companies are shunned by investors.  It is more often corrosive politics that are to blame for driving investors away.  With this in mind, a shake-up at the (invisible) hands of the financial markets may work out for the best.

The blame game

Politicians themselves have been quick to blame the Federal Reserve in the US.  The Federal Reserve was buying US$85 billion in bonds each month in 2013, which drove down the yields on US bonds and prompted investors to shift their money overseas in search of better returns.  Reductions in these monthly bond purchases have triggered a return of funds from overseas which has caught out many emerging economies.

If politicians in emerging markets were honest (admittedly, an odd concept), their fingers would be pointing closer to home.  Many emerging economies benefited from the cheap capital but came to rely on it too much.  Economic growth which had been sustained past the global financial crisis began to slow as governments put off reforms to keep their economies going.  Instead, governments tapped into funds from overseas to ramp up spending and cover growing shortfalls in demand.  This only masked the problems which have since been laid bare by the countries being stripped of their external financing (see No need to fear for the Fragile Five for more on this). 

No more excuses for politicians

All of the talk surrounding the Fragile Five tends to focus on their economies but the real issue is with their politics.  The rise of the middle classes in these countries has been a catalyst for more responsive government.  Minor issues have triggered large protests fuelled by frustrated voters.  A rise in transport costs incited upheaval in Brazil.  A sit-in protest at a park in Istanbul escalated into unrest throughout Turkey.  The rapid rise of an anti-corruption party threatens to derail the major parties in elections in India.  Workers strike in South Africa demanding higher wages.

The faltering economic growth has revealed the inadequacies of government.  Slower economic growth means that voters cannot be bought off with higher incomes.  Their dissatisfaction has now been coupled with that of investors who hold the upper hand in terms of where they stash their cash.  Being spurned by investors does involve some short-term pain.  However, this can be limited by countries building up foreign currency reserves.  Other measures such as controls over inflows and outflows of funds are increasingly gaining acceptance (for more, see beware of a flood of funds).

There are clear long-term benefits from keeping politicians in emerging markets honest by means of checks rooted in global finance.  Voters everywhere are disillusioned with their politicians (a sentiment shared by Your Neighbourhood Economist) and emerging countries are no exception.  But levels of wealth in poorer countries are considerably more dependent on the quality of their politicians.  Governments in developing countries also have a tendency to fiddle with the economy through state-owned firms or measures against free trade.  Argentina is probably the best example of this - the country is so badly run that it does not even attract enough foreign capital to merit inclusion in the Fragile Five.

Extra incentives for governments to adopt appropriate policies should thus be welcomed.  Trying to stick to the economic equivalent of a diet may not be easy but there are rewards at the end of it.  In conclusion, there is no point in blaming someone who keeps you on the straight and narrow, in fact, there is a lot to gain.

No need to fear for the Fragile Five

While it may look like emerging markets are being tormented by global investors, there could be a happy ending.

What's in a name?  Well, the moniker “Fragile Five” suggests all is not rosy but the countries (Brazil, Turkey, India, Indonesia, and South Africa) labelled thus have things other than name calling to worry about.  Namely, the fact that it appears as though the Fragile Five are being picked on by the international financial system.  The leader of the pack has been the Federal Reserve whose trimming back of its stimulus package has triggered a massive shift in global finances.  While no country would choose to be browbeaten by investors, a lecture on bad economic policy might help these countries avoid a story of more woe in the future.

What is going wrong?

Emerging markets have fallen victim to the fleeting nature of foreign investors.  The global financial system has been awash with money due to central banks such as the Federal Reserve printing cash to stimulate Western economies.  Low financial returns in developed countries have prompted investors to look abroad for places to park their money.  Perkier economic growth in developing economies has been an oasis for investment as options elsewhere dried up.

Emerging markets are typically in need of extra cash.  There are little savings available to fund the investments needed to build homes, roads, and factories as the economy develops.  These cash-starved countries are a good fit with cash-rich investors but there is a need to get the balance right.  Unfortunately, many emerging economies come to overly depend on the cash provided by investors to fund their economic growth.  As is the case with things offered up on the cheap, the good times don’t always last and investors always have the option of taking their money elsewhere.

Along with slumping stock markets, the effects of emerging markets falling out of favour with investors are most keenly felt through a drop in currencies in emerging markets.  A weaker currency results in emerging markets having to pay more for their imports, which exacerbates the problem of high spending on overseas goods such as oil.  Higher prices for imports also push up inflation which is already too high in many emerging markets.  Many of these countries also struggle with large government budget deficits as slower economic growth prompts greater fiscal spending.

How things are being put right

While the Federal Reserve has been measured in its approach to changing policy, central banks in the Fragile Five have been all action.  The central bank in Turkey lifted its overnight lending rate for banks from 7.75% to 12% while their counterparts in other countries also increased their rates by smaller amounts.  The higher interest rates are designed to make it more attractive to hold the currency of that country as part of an attempt to stem the selling on the foreign exchange markets.  An increase in the costs of borrowing also has the effect of cooling the economy and reducing the demand for imports.

It is lucky for the Fragile Five that the most important actions have already been taken to prepare them for the ebb and flow of global capital.  Emerging economies have learnt from the Asian financial crisis in 1997 when many economies in Southeast Asia were decimated due to high levels of foreign debt and a system of fixed exchange rates.  The adoption of floating exchange rates along with large foreign currency reserves means that another crisis is unlikely.  Inflows of foreign funds are treated with less welcoming arms and greater acceptance of the need for controls over the movement of money in and out of economies with less developed financial systems (for more info, see beware of a flood of funds).

Your Neighbourhood Economist would even argue that there are some positives.  The global financial crisis and the Eurozone crisis have shown what can happen when imbalances in an economy get out of hand.  Investors can be a fickle bunch (many people are where money is concerned) but investor sentiment is typically a good gauge of how well an economy is operating.  If subprime mortgages or lending in southern Europe had also led to a revolt in the market, most of us would be better off (see bond investors ain’t all bad for more on this).  With this in mind, perhaps foreign investors should not be seen as bullies, but more like an older brother (who may not always be nice) keeping you out of trouble.

The Productivity Puzzle and the Rise of the Self-Employed

Economists are struggling to explain why labour productivity is so low but Your Neighbourhood Economist could be part of the underlying reason

Puzzles can be fun but also frustrating if a solution proves elusive.  Such is the case with the “productivity puzzle” which is a phenomenon economists are having a tough time explaining.  Productivity of workers measured in output per worker has fallen following the global financial crisis and has remained weak.  The lack of an explanation for this is even more irritating as growth in productivity is one of the key factors in pushing up wages and generating higher levels of wealth.  But this dilemma may not be worth all of the worry.

What is so puzzling?

There are a number of pieces to this puzzle which are not fitting together.  The first is that companies are not investing as much.  This in itself is difficult to explain at a time when interest rates are at record lows and profitability for many companies is high.  One reason typically given is that firms are reluctant to risk money on long-term bets as the future is clouded with uncertainty.  Banks have also cut off funding to many smaller up-and-coming businesses who want to expand.  Others have pointed the finger at companies paying their executives with bonuses which prioritise rising share prices rather than investment for the future.

The next part of the riddle is falling unemployment.  A typical recession involves companies taking the opportunity to trim back their workforces.  This results in a jump in productivity as similar amounts of work are carried out by fewer workers.  Yet almost the opposite has proven true over the past few years.  Unemployment has not been as severe as in the past and the number of people out looking for work in countries such as the US and the UK is already falling.

This enigma appears even stranger when considering that unemployment in the UK has fallen to a four-year low of 7.1% while real GDP is still less than in 2008.  Companies seem to be holding onto their workers and hiring more staff instead of buying new equipment or upgrading their offices.  This may be a strategy to deal with an uncertain future (which would be temporary).  Alternatively, it could be a part of a larger shift in the way that business is done.

A reason not to worry

One of the key missing pieces could be technological change shaping new forms of work.  The Internet, along with innovations such as cloud computing, has brought down start-up costs for businesses.  Running a business these days can require little more than a laptop.  This combined with a dearth of decent jobs has seen a dramatic rise in the number of self-employed in the UK (including Your Neighbourhood Economist).

The self-employed are apt to rely mostly on manpower with little need for investment.  Output from operations with just a few workers is likely to be low or else others would have already taken advantage of such business opportunities.  Examples might include freelance web designers or landscape gardeners willing to live off sporadic work while enjoying extra spare time.

This is still not likely to be sufficient to entirely account for the low productivity that is vexing economists.  It is true that business is changing on many levels as people find new ways of harnessing the Internet and economists (including yours truly) are still grappling with what it all means.  However, if the solution involves making work less of a burden and more days working from home, it need not be so troubling after all.

Insights from Asia: More infrastructure for everyone

Infrastructure is like eating vegetables – more is always better (with one exception) 

Infrastructure was on the mind of Your Neighbourhood Economist during a recent trip around Asia.  Roads
in Cambodia were so bumpy that it was often difficult to think about anything else.  Investing in infrastructure is a no brainer for developing countries – it helps the economy run more smoothly by lowering the costs of doing business as well as helping to create jobs.  The same logic also applies to richer countries although it is tougher to decide where to spend any available funds.

Infrastructure – what is it and why is it good?

Infrastructure is easy to spot but hard to define.  Essentially, it is the facilities that are necessary for an economy to function.  Companies need electricity to power their factories and offices, roads to be able to move goods around, and phones and the Internet to communicate with others.  The concept of infrastructure could also be stretched to include the courts and laws which govern business, hospitals to heal sick workers, schools to produce the necessary skills in the workforce, and police to reduce the effects of crime.  However, let’s stick to the basic definition to keep things simple.

A lack of proper infrastructure can get in the way of doing business.  Clogged up roads or an intermittent power supply will create delays which put operations behind schedule.  The extra costs of power generators or the time taken in transporting goods will eat into profits.  A patchy phone or Internet network will hamper access to information needed for key decisions.

Shortfalls in infrastructure are more obvious in developing countries as by definition major parts are still being built.  Construction typically struggles to keep up with rapid growth in economic activity.  The large number of new cars on the road in Phnom Penh was a surprise but the amount of work being done on the roads was not.

In order to generate higher levels of wealth (which will typically mean more new cars), a developing economy needs people to move from working on the land to engaging in more economically productive activities in the cities.  Insufficient infrastructure is an obstacle that can inhibit economic expansion and trap a country at a lower level of income.

Tough decisions lead to neglect of infrastructure

The potential benefits from infrastructure also extend to richer countries.  More developed economies typically already have considerable infrastructure but this requires maintenance as well as extra spending due to shifting economic conditions.   It is far trickier for governments in developed countries to figure out what new infrastructure is worthwhile.  That spending on faster internet connectivity will be beneficial is a given, but it may be less obvious where to allocate the budget for, say, transport infrastructure.

Whether to invest in more roads, better railways, or bigger airports depends on predicting the lifestyles people will adopt in the future.  Ideally, the private sector would take on this burden but the copious amounts of cash along with the risks involved in major construction projects and the long-term scale of such operations are too much for businesses to handle.  Consequently, it is left to governments to determine the best courses of action.

This often results in tough infrastructure decisions being kicked down the road. Despite large budget deficits, the case for ending the neglect of infrastructure seems stronger than ever (following this link for the exception) due to high unemployment and the fact there are few engines of economic growth.  Just like your mother would tell you to eat your veggies, more infrastructure would be good for our economic health.

Insights from Asia: New Opium Needed

China has always been a tricky country to trade with but there are still ways of tapping into its growing wealth

Your Neighbourhood Economist has just returned from a four week trip around Asia which provided a few insights worth mentioning.  The first of these came during a layover in the bustling metropolis of Hong Kong with its unique mix of the old and new.  It was the history behind Hong Kong becoming a British colony that caught the attention of Your Neighbourhood Economist because it now seems as if history is repeating itself.

Similarities between Past and Present

In the 18th century China was beginning to open up to trade with European countries.  Goods from China including tea, silk, and porcelain were proving popular in Europe but there was nothing that Europeans merchants could tempt the Chinese into buying in return.  Thus, payment for Chinese goods was made in the form of silver which became a drain on finances.  As a solution, Britain increasingly relied on bringing opium into China but this created conflict between the two countries as importing opium into China was illegal.  The result was the Opium Wars which ended with a British victory and the island of Hong Kong being ceded to Britain by the Chinese as part of their surrender.

Move the clock forward a hundred and fifty years or so and some things are still the same.  China is again exporting goods that the West is keen to purchase – nowadays it is not luxuries but items produced using cheap Chinese labour.  Further similarities include the strong grip exerted by Chinese leaders over the management of the local economy.  Western firms are still eager to sell to Chinese consumers but their options for doing so are limited.  However, this is not because foreign companies have nothing with which to entice the Chinese.  This time the reason is that the Chinese government is acting to stall an invasion of multinational firms until local businesses become large enough to compete.

It makes sense for China to keep control over one of its main resources – a domestic consumer market with one billion enthusiastic participants.  Your Neighbourhood Economist would also advise the same policy of protecting up-and-coming Chinese firms from their battle-hardened Western rivals.  There are few things that China needs at its current state of economic development that it cannot provide for itself.  One of the handful of sectors where imports are important is commodities but China already gets most of its supplies from other emerging economies.

What to do differently this time around

All this has left Western governments scratching their heads with regard to selling to China.  Some countries such as Germany have prospered by selling machinery for Chinese firms to use in their factories.  But most other developed countries are struggling to find their own niche products to sell to China.  As a consequence, large numbers of container ships sail back to China mostly empty.  Opium is obviously no longer an option yet countries like Britain do need to find a way to tap into the growing wealth in China.

It is trade in services that is likely to be key.  Britain has lots of creative and business savvy firms specialising in the design and technology sectors.  Finance is one area which is still out of bounds in China but other sectors are open to outsiders.  Education, on the other hand, is a service that China is finding it hard to provide for itself in either sufficient quantity or quality.  Countries such as Britain can access Chinese wealth while also expanding its educated workforce either through Chinese students who study aboard or foreign schools set up in China.  In the future, higher paying service jobs rather than employment in declining industries such as manufacturing are more likely to provide the bulk of “good jobs”.  China will not always be so closed off or in need of education services but a focus on education seems like a winning formula in the meanwhile.