Animal Spirits – Caging our Wild Side

Money can bring out the worst in people so it might be time to rein in the finance sector which offers ways for us to get into trouble

Economists tend to assume that we are all boring (and the feeling is likely mutual).  According to economic theory, we are thought to act in a rational manner, assessing how best to spend our cash like calculators with legs.  Not only is this an overly simplistic view but it has resulted in economists ignoring how our emotional sides affect the economy.  The global financial crisis is an example of what can happen when animal instincts such as greed and fear take over.  Economists need to take a closer look at how our emotions can drive the economy and how we can be saved from ourselves. 

Reality is messy

Economics is the study of allocating scarce resources.  It focuses on how consumers make the most from what they have.  At the same time, competition between firms ensures that products are priced efficiently so that as much output as possible can be generated from limited input.  Economists would like to think that our sober side helps keep everything running as it should.  But when money (and everything that money brings with it) is involved, our primal nature can take over with ugly consequences.

The worst of our traits kick in over booms and busts.  When times are good, we hear stories of people making easy money and we want in too.  Like greedy kids in a candy store, we buy a second or get shares in the latest stock market fad in the belief that prices are sure to rise further.  Prices will climb as the lust for more wealth attracts more and more victims.  But with gains in asset prices typically outpacing the rest of the economy, this can only last for so long. 

When asset prices start heading downwards, fear is the overriding response.  Companies slash plans for investment and lay off staff in order to stay in business.  Consumers also retrench by cutting back on spending and asset prices slide downwards as higher prices no longer seem sensible.  Assets often end up being sold off at bargain prices as cash is needed to pay off debt taken on during better times.  Fear also reached chronic levels among banks who would not even lend to each other in the aftermath of the global financial crisis.

How we get ourselves in trouble

Change is a necessary part of an economy developing over time as certain sectors expand while others wither away.  But what Keynes labelled our “animal spirits” result in periodic bouts of instability that can hamper the expansion of any economy over time.  Rather than dealing with our insecurities, most economists choose to ignore them.  A common argument used by economists is that financial markets constantly adjust to new information and reflect the true value of any assets.  Yet, sharp drops in stocks or house prices cannot be reasonably explained away with this line of thought.

The devastating effects of our emotions getting the best of us are evident in the wake of the global financial crisis.  Instead of ignoring base instincts, economists should be thinking of ways to rein them in.  One of the key ways for greed and fear to influence the economy is through the finance sector.   Banks are geared to generate as much borrowing as possible but their loans more often than not go toward speculative investments in property or stocks.  Such lending creates unnecessary instability with the economy as a whole suffering as boom turns to bust.

It is no coincidence that the worst recession of a generation comes at a time when the finance sector has grown to dominate many developed economies.  Limiting the scope of banks, with more rules following decades of deregulation, would be a good place to start improving the system.  Measures such as taxes on financial transactions would also take out some of the volatility from markets for stocks and bonds by pushing investors to take a more long term view.  Such policies may lead to higher fees for loans and lower returns from investing but the costs of continuing with the status quo will only mount up.  Better to save us from ourselves than to let our passions run wild and cause even more havoc.

Greece – On the mend but still broken

The Greek government is selling bonds again but its debts require a further fix

Greece was always broken but it was not obvious until the Eurozone crisis.  With its increasingly shabby façade finally stripped away, Greece's dilapidated economy was shunned by investors and needed to be bailed out - twice.  But, with help from others, Greece is on the mend and recent progress has been rewarded by the Greek government regaining the ability to borrow from financial markets.  While this is a key step in putting the pieces back together again, a big chunk is still missing.

Shoddy foundations

The Greek economy had never been on the firmest footing.  A raft of regulations sapped the dynamism of the economy, making Greece an alluring holiday location but an unattractive place to do business.  To avoid cumbersome rules, companies typically remained small and often hide out in the shadow economy.  This resulted in Greece being mired in low productivity and chronic tax avoidance.

Investors were willing to overlook all of this once Greece joined the euro.  Despite its obvious faults, Greece was treated as if it were the same as any other country using the euro.  This gave Greece access to funds at a lower interest rate, triggering a boom in investment in property among other things.  The government joined in and ramped up spending on the assumption that the good times were here to stay.

Yet, what was seen as a blessing at the time proved to be the wrecking ball that was to bring down the house.  Cheap financing dried up with the onset of the global financial crisis and the weakened economy collapsed under the weight of excessive levels of debt.  The government needed to borrow more and more as the economy sank into recession but investors were no longer forthcoming with their cash. 

With no one willing to lend to the Greek government, the IMF and others stepped in to prevent a default due to fears that other countries in Europe would be put in peril.  The result was a prolonged economic slump as Greece struggled with the aftermath of its borrowing binge as well as with austerity measures needed to shore up the government’s finances.  The situation was so bad that Your Neighbourhood Economist was one of many who thought that the Greeks would leave the Eurozone lured by the illusion of an easy way out.

Major repairs still needed

The economic stagnation in Greece has continued with six consecutive years of recession leaving GDP around 25% lower.  Forecasters are now optimistic enough to predict that the Greek economy will grow slightly in 2014 with austerity measures expected to ease as government finances improve.  Another sign of progress is that investors are again willing to lend the government money.  The Greek government sold 3 billion euros worth of bonds earlier in April offering a yield of just under 5% after yields spiked to over 30% around two years ago.

Investors are keen to snap up debt from other peripheral countries in Europe.  This reflects brighter prospects for some countries such as Ireland and Spain.  Yet, in the case of Greece, it is more a reflection of a dearth of other investment options offering similar returns and of investors being more willing to take on risks.  That Greece can sell bonds again is a sign that the Eurozone crisis is over but the Greeks are still left with the harsh reality of excessive debt.

Exacerbated by the sharp drop in the size of the economy, the debt to GDP ratio is around 175% and still edging upwards.  Considering that the Greek economy is unlikely to generate enough of a surplus to pay off this debt, another bailout has always been on the cards.  The Greek people are also unlikely to be able to live with the burden that this brings.  Until the shackles of debt are removed, the Greek economy will never be properly fixed.

UK economy is growing but not yet in recovery

Some good news at last for the UK economy but don’t expect the tough times to be over

The outlook for the UK economy is finally beginning to brighten following a harsh recession and weak recovery.  The Office for Budget Responsibility raised its forecasts for the UK economy with growth of 1.4% expected in 2013 up from a previous estimate of 0.6% in March while 2014 is expected to see growth of 2.4% instead of a prior March forecast of 1.8%.  While the government was keen to publicise this as good news, much of the improvement is due to factors that are likely to be temporary.  Government measures along with monetary policy are behind the perkier economy but the effects will not last and a proper recovery may still be some time away.

The unexpected boost to the economy has come through higher spending by households.  Many UK consumers are feeling better off with UK shares near record highs and the UK property market going through a period of resurgence.  Stock markets in many developed countries have been providing stellar returns as extra cash being printed by central banks flows into shares.  House prices have benefited through a range of government schemes aimed at increasing the availability of mortgages.  This has translated into more consumer spending through a mechanism known as the wealth effect which is the notion that people will spend more if the financial assets which they own are worth more.  The UK government has tried to tap into this effect on spending using schemes such as Help to Buy to lift house prices as a means to boost the economy due to few other options (such as higher government spending) being available. 

The wealth effect relies on growing levels of financial wealth which can be lifted by different measures but which ultimately rely on the health of the economy.  As such, temporary boosts are possible but asset prices (and wealth) can only be pushed up so far and may involve potential negative effects for the economy.  Higher prices for financial assets now come at the cost of price gains in the future  (such as a weaker property market in the future) with a reduced wealth effect.  This may be a necessary price to pay with few other avenues for generating growth but the tactic of pushing up property prices has also been used by the UK government to provide cover for its program of austerity measures. 

With public debt reaching around 75% of GDP in 2012, the government has given priority to cutting back its spending but this is controversial coming at a time when the overall economy is weak.  The government claims that the cuts are necessary as investors would not buy UK government bonds (resulting in the government having to pay higher interest rates) were government debt to get even more out of hand.  Concerns about debt levels have eased considerably since reaching near frantic proportions during the Eurozone crisis, but the government remains unrepentantly committed to slashing spending levels.  Cuts to government spending are going to continue for years to come with the stated goal of reaching a budget surplus by 2018 despite calls for a change in policy.

Other areas of the UK economy also have little to offer in terms of growth.  Exports from the UK have failed to pick up despite a weaker pound and the value of the currency has begun to rise again which does not bode well for UK exporters.  Investment is also weak with lending to businesses in decline.  It is proving tough to come up with an engine to drive growth in the UK – a recovery is long overdue but we may still have to wait.

Federal Reserve – preparing to taper

With crunch time coming up, the Federal Reserve puts in the groundwork for a key change in policy

In the long march of dealing with the aftermath of the global financial crisis, the recent baby steps taken by the Federal Reserve may be one of the most crucial parts of the journey.  The Federal Reserve is considering lowering the interest rate on reserves it holds for banks as part of a move to offset upcoming reductions (tapering) in its bond purchases which currently amount to US$85 billion each month.  This tapering is perhaps the most important policy change in the past 12 months with the health of the global economy in the balance, so the Federal Reserve is anxious to ensure all goes well.

The actions of the Federal Reserve have been keenly felt across the globe with stock markets everywhere buoyed by the extra cash sloshing around the international financial system.  This abnormal state of affairs where central bank policy dictates the movement of stock prices is increasingly creating distortions through excessive gains in stock prices.  A pickup in the US economy would mean that the extra stimulus is no longer needed, but a smooth transition as the Federal Reserve changes tack will be key to sustaining any economic recovery in the United States and elsewhere.

As such, the Federal Reserve has been keen to soften the blow to the stock markets with policies that act as a stimulus as it cuts back on the bond buying which has been the main focus of its expansionary policy.  The mere rumour that the Federal Reserve would buy fewer bonds resulted in the interest rates on 10-year US government bonds jumping from around 1.7% in May to almost 3.0% in September.  Forward guidance, with future hikes in interest rates linked to unemployment, was tried as a means to signal the intent to help the economy but investors did not buy it (see prior blog for more).  

Changes to interest rates on banks’ reserves which are under consideration will only probably have a minimal effect but it is the signalling by the Federal Reserve that may be more important.  By showing a willingness to continue to support the economy, the Federal Reserve eases concerns that its actions will trample over the nascent economic recovery.  Some of the best successes of monetary policy have taken effect through nothing more than the suggestion of future action, such as the promise by the European Central Bank to do “whatever it takes” to save the euro.  This convinced enough people that it put paid to the Eurozone crisis without a single bond being purchased or interest rate being changed.  

Your Neighbourhood Economist was previously critical of the Federal Reserve for not taking the opportunity to begin tapering in October but the extra couple of months have been put to good use in ensuring that the change in policy goes smoothly.  All eyes will now look to the next meeting of the Federal Reserve (17th to 18th December) when tapering may be announced especially if US job data released on the first Friday in December is seen as positive.  The Federal Reserve is taking a cautious line but it is worth ensuring that there are no stumbles in the finishing stretch.

Quantitative Easing - Harder to End than to Start

The Federal Reserve changes tack on its change of tack in monetary policy which will make it less credible in the future.

It is still a month away from Halloween but something seems to be scared Ben Bernanke, the chairman of the Federal Reserve.  Bernanke was expected to announce that the Federal Reserve would be buying fewer bonds in September but surprised most pundits (including Your Neighbourhood Economist) by deciding not to make any changes with the status quo.  The unexpected bonus of a delay to the start of “tapering” helped push stocks in the United States to record highs but gains were limited by worries about the future direction of monetary policy.  By backing down from a change in policy, the Federal Reserve has made its job of finding an exit from quantitative easing more difficult while also making it trickier for investors to understand the big question that still remains – how far off is the beginning of the end for quantitative easing?

The Federal Reserve began to signal a change in direction in May and June using its own version of forward guidance where central banks outline future policy through using economic data as markers.  The current policy of the Federal Reserves has entailed buying US$85 billion in bonds each month with interest rates set at close to zero – its forward guidance in July put forward an end to bond buying by the time unemployment reached 7% with interest rates to rise once unemployment had fallen to 6.5%.  With unemployment expected to reach its first target by the middle of 2014, there was an anticipation that the Federal Reserve would move to reduce its bond purchases before the end of 2013, so as to ensure a more gradual decline in quantitative easing which would be less painful for the economy. 

Yet, investors drew their own conclusions from the forward guidance and took it as an excuse to sell bonds whose prices had climbed to record highs (for more, see Managing Expectations).  As lower bond prices translates to higher interest rates for bonds, the bond sell-off resulted in interest rates on benchmark US government bonds increasing from around 2% to close to 3%.  This ran contrary to the gradual adjustment which the Federal Reserve was attempting to facilitate to ensure that the nascent economic recovery would not be choked off by higher interest rates. 

The jumpy market reaction along with slower improvements in the US job market were enough to spook the Federal Reserve into keeping the quantitative easing going.  Only time will tell whether the cautious approach was the right call but Your Neighbourhood Economist fears that Ben Bernanke may have been too timid for his own good.  While there is always the possibility of gremlins lurking in the economy somewhere, the timing did seem as good as it will ever be for starting the drawn-out process of tightening monetary policy.

Unemployment in the United States has fallen to 7.3% in August compared to 7.9% in January (even though part of the fall is due to some people not bothering to look for work any more).  And, while the size of the market reaction was a tad overdone, investors always factor in events ahead of time – as such, the bond sell-off was just the normal response to an end to actions by the Federal Reserve which have propped up both the markets for bonds and stocks.  So, any further movements in the financial markets were likely to have been muted.  But as it happens, prices for bonds and stock perked up as investors looked forward to continued efforts by the central bank to prop up the markets.

With the Federal Reserve forgoing an opportunity to pare back its bond purchases in September, market participants are trying to figure out the possible timing for the inevitable change in policy.  The Federal Reserve meets again in October but will have few new bits of economic data to sooth its concerns over the strength of the economy.  The subsequent meeting of the Federal Reserve is in December with this seen by many as the next chance for action. 

The cautious approach by the Federal Reserve does have its costs.  It is a fad among central banks these days to signal in advance of changes to policy, but by choosing not to follow through with the expected change of policy in September, investors will be less likely to believe the Federal Reserve in future.  In the short-term, it is unclear what will be sufficient to trigger the beginning of the end of quantitative easing – weak economic data for the rest of 2013 may see the “to taper or not to taper” saga drag on for a while yet.  The resulting uncertainty and likely volatility in the financial markets may be even more harmful than the expected tightening of monetary policy. 

A central bank is only as good as its word and the Federal Reserve has cheapened its own words.  That is a scary prospect considering the current hands-on management of the economy by the Federal Reserve and how much it will have to do to talk its way out of this management role.

Beware of a Flood of Funds

Surplus cash in the global financial system has a history of leaving havoc in its wake and quantitative easing may be making the situation worse.

There is a lot of cash sloshing around the international financial system at the moment.  Central banks are still buying heaps of bonds and there are few places in the actual economy where people are willing to invest money.  Not having cash around in the financial system can make life very difficult as shown by the credit crunch where lending by banks ground to a halt and the global economy came close to collapse.  But too much cash in the financial system can cause its own troubles.  Cheap credit is one of the causes of the global financial crisis.  More recently, emerging markets have been tested by the coming and going of a massive tide of global funds.  What can be done to ensure that more of the world is not drowned in an excess of cash?

It may seem strange but there is a lot of spare cash around at the moment but no one wants to use it.  Companies are hoarding money as business people are not confident in being able to make money through new investments, and consumers are paying off debt while being worried if their jobs are safe.  Adding to this, banks are reluctant to lend as new regulations are prompting banks to be more cautious about the amount of loans on their books. 

Central banks have tried to alleviate this problem by making it cheaper to borrow, firstly, through reducing interest rates to close to zero, and when this has not worked, printing more money with which to buy bonds.  The bond purchases also serve to further lower borrowing costs, but businesses and consumers currently seem averse to taking out fresh loans no matter how cheap it is to borrow.  Nevertheless, the bond buying continues with the Federal Reserve alone buying US$85 billion in bonds each month.  The extra cash is not going into the actual economy as there is no demand for it and it is free to be moved to anywhere in the world.

So this money is not like a still pool of cash where money can be drawn as necessary, but rather more like a tidal system where funds will flow in one direction for a certain period of time before switching to another direction depending on the alignment of economic factors.  Any free funds will always move in search of higher returns and the flows shift as economic circumstances change.  The transient nature of the funds creates economic problems due to the temporary effect of lowering interest rates and creating a surge in lending, only for the money to flow out again at the first signs of trouble.  These flows of cash now dominate the world economy like never before and can leave havoc in their wake (for more, see Where is all the money going?).  

This ebb and flow of funds is given as one of the reasons behind the global financial crisis.  The size of the pool of cash had swelled due to a glut of savings in Asia which were invested in the United States.  The resulting lower borrowing costs spurred on excessive lending which extended to sub-prime loans, eventually causing the near collapse of the financial system.  Almost the reverse has been the case in previous weeks.  Extra cash generated by the bond purchases by the Federal Reserves and other central banks had found refuge in emerging markets which had continued to grow in the aftermath of the global financial crisis.  But the tide turned with the paring back of quantitative easing in the United States, which is expected to result in higher returns from investments in the US markets. 

The worst of the effects have been experienced by India, Turkey, and Indonesia who had grown more reliant on the money coming in from overseas due to imbalances in their own economy.  But emerging markets have shored up their defences after having often been caught up in the wash of global finances.  Countries with developing economies often build up large foreign exchange reserves which are used to counteract the outflow of funds (which was ironically behind the glut in savings in Asia seen as responsible for the global financial crisis).  The use of controls which restrict the movement of funds have also become commonplace and are even somewhat sanctioned by the IMF (who are typically ideologically opposed to any limits on the free movement of resources).  Even the new range of banking regulations in the United States and elsewhere, such as rules on higher levels of capital buffers, can be seen as a buttress against the swirling forces of global finances.

However, the new measures being adopted in developed countries and in emerging markets have the goal of merely preventing the symptoms of the problems created by the surplus funds.  Furthermore, foreign exchange reserves and capital buffers come with their own costs – this money could be put to better use when the economy actually needs the extra funds.  Would it not be better to deal with the problem itself?  Central banks could come up with a way of soaking up the surplus money in the world’s financial system.  Considering the global scale of financing, this might require a new role for an international organisation such as the IMF.  It would also involve a rethink of quantitative easing and the tools available to central banks since the freshly printed cash from central banks has added another deluge of funds and has created problems of its own (see Perils of doing too much for more detail).  It would be a sad day for economists if the aggressive policies from central banks to revive the economy from the latest crisis sow the seeds of greater instability in the future.  

Managing expectations as part of monetary policy

In trying to ease concerns about higher interest rates through forward guidance, central banks have ended up doing the opposite.

Managing expectations when you work with people in an office environment can be tough but imagine dealing with the multitude of global investors as well as the international press.  This is what central banks have to cope with.  Central banks have tried to provide greater clarity regarding the direction of monetary policy using forward guidance – linking changes in policy to improvements in economic data.  The plan was to ease concerns that monetary policy would be tightened too soon through fewer bond purchases and eventually higher interest rates.  But forward guidance instead triggered the selling of government bonds with investors now expecting tightening of monetary policy sooner than central banks are suggesting.  Why have investors reacted in this way and what might central banks do in return?

A change in monetary policy was always going to be a tricky proposition considering the influence that the central banks have built up over the markets due to their purchases of billions in bonds as part of quantitative easing (refer to Caution - Windy Road Ahead).  It all started with a statement by the Federal Reserve in the US in June that it was considering tapering off its bond purchases which currently amount to US$85 billion.  Any new policy initiatives in the US are predicated on the pledge by the Federal Reserve that interest rates will remain at their current low levels until there is substantial improvement in the labour market.  This is one version of forward guidance that has also been adapted by Mark Carney, the new governor of the Bank of England, who also linked future decisions on monetary policy to the unemployment rate in the UK (for more, see Same low interest rates but for longer).  The reasoning behind forward guidance is twofold – to assure potential borrowers that interest rates will stay low for a few years yet and to placate fears that tightening of monetary policy will hurt the nascent economic recovery.

Not much of a market reaction was expected from these announcements as central banks were signalling that changes to the status quo would be gradual depending on the state of the economy.  However, investors have reacted in a way that seems to suggest that tightening of monetary policy is imminent, that is, by selling off government bonds.  The interest rates on government bonds have risen from record lows and 10-year bonds issued by the US and UK governments have both reached close to 3% (lower bond prices due to selling results in higher interest rates on bonds).  Why did the markets respond in this way to seemingly innocuous comments?

Cautious investors had been big buyers of safe assets such as UK and US government bonds due to the weak state of the global economy coupled with the sovereign debt problems in Europe.  This had capped off a period where bond prices had followed an upward trend for a few decades, which is a long time in investment markets.  Higher bond prices had pushed interest rates to painfully low levels so the timing was ripe for investors to move their money somewhere else.  All that was needed was a trigger and this ended up being the statements on forward guidance.  It is as if the mere mention of the end of the current loose monetary policy got investors thinking that a bond sell-off was coming and that it would be better to beat the rush.

For holders of UK government bonds, data on the economy has added to the reasons to sell.  The OECD released economic forecasts in early September which predicted that the recovery in the UK would pick up pace faster than in other countries.  A potential housing bubble in the UK adds to concerns that the Bank of England will have to increase interest rates earlier than planned.  Mark Carney also left plenty of escape clauses in the forward guidance pledges which allows the central bank the freedom to act but gives rise to worries that interest rates will not stay low for as long as has been suggested.

The rebellion of the markets against the careful planning of the central banks does throw up a few issues.  Considering that both the US and UK have mountains of government debt, higher interest rates will translate through to greater limitations on government spending which, in turn, will hurt the economy.  The fortunes of the global economy have also taken a hit with higher returns on bonds prompting investors to repatriate money invested in emerging markets over the past few years when there were few other investment options.  But the rush of money leaving places such as India and Turkey has brought howls of protest as well as fears about the ramifications of the end of quantitative easing on international finance.

It is central banks that now have to make the next move.  Yet this could involve doing nothing.  The tightening of monetary policy was never going to be easy and the recent jumpiness of investors could be just seen as collateral damage.  This would be a prudent option if central banks believe that there is nothing else that they could do to dictate the directions of the market.  But, on the other hand, central banks may decide to wrest back control of the expectations of investors.  Such a course of action could be prompted by fears that interest rates on government bonds, which act as a benchmark for interest rates throughout the whole economy, are too high at a time when the economic recovery is just starting in earnest.  Since forward guidance has shown that mere words are not enough, central banks may have to act, possibly with more bond buying.  Such a shock would bring investors back into line and serve as a reminder not to second-guess central banks.  However, with central banks likely to be keener to step out of the limelight (for What's the rush?), investors are likely to be left to their own devices.

What Europe has to teach Japan

As the Japanese government mulls a higher sales tax to improve its finances, what do the experiences of Europe over the past few years suggest?

When thinking about the problems with the economy in Europe – feeble economic growth, high levels of debt, and banks shackled with bad debts – Japan has been seen as a lesson of what not to do.  Europe had the luxury of learning from Japan’s mistakes – Japan tried to ride out the problems while Europe has been more proactive in sorting out the mess following the global financial crisis.  It could be argued that Europe has come further in a few years than Japan has come over the past two decades, and with Japan considering a move to improve its dire finances through higher sales tax, it seems a good time to see whether Japan has anything it can learn from the experiences of Europe.

Talk of crisis in Europe is significantly more muted these days with the worst of the Eurozone debt troubles having been left behind in 2012 (for more, refer to Both good news and bad news for Europe).  Recent data showed that the economy in Europe grew marginally in the second quarter of this year giving rise to hopes that a brighter future awaits.  A key element of Europe’s gradual return to health has been its austerity.  Japan has been saved from the forced cut backs imposed by some governments in Europe as domestic savers in Japan are reliable buyers of government bonds there.  But the absence of any pressure to rein in spending has a downside as well in the form of more and more debt.  

Normally, gradual and mild rises in interest rates act as a warning signal as in Europe when buyers of bonds shun the debt of any country that seems likely to default.  So even without any signs of trouble being on its way, debt in Japan could all of a sudden reach a point where a large chunk of the holders of its debt decide to jump ship resulting in financial meltdown.  The lack of urgency has meant that austerity has never taken off in the same way that it has been embraced by leaders in Europe. 

Japan is trying a different tack as a means to sort out its finances – a higher sales tax.  This option has long been thrown around as a possibility in Japanese politics and has dominated headlines in Japan with the Abe government considering a two stage rise in sales tax from 5% to 10% by October 2015.  The two different approaches – to cut spending or raise revenues – are both plausible solutions but it seems strange that Japan and Europe have chosen different routes to solve similar problems.  Europe has had more success with its way of doing things but that may be a sign of great resolve instilled through higher interest rates.  Some countries in Europe have adopted measures to increase their income but it begs the question – why has the Japanese government not made more of an effort to rein in its spending?

Government spending in Japan was 15% higher in 2012 compared with 2007 before the global financial crisis but government revenues have fallen by over 8% over the same period.  One of the key reasons behind Japanese politicians’ aversion to cutting spending is its patronage style of government.  Political leader divvy up the resources that come with the levers of power in the same way that traditional community bonds would dictate.  Support of those in power comes through rewarding your followers, and even though this old-style source of power is on the wane, it is where the current ruling party has a reliable support base in rural districts which are overrepresented in the Japanese parliament.  So the reasoning behind the approach of the Japanese government would be that higher taxes will spread the pain whereas cuts to spending will hurt your supporters.

The Abe government in Japan has been trying lots of other tricks including even greater increases in spending in 2013 through a fiscal stimulus package (see When Keynesian policies won't work for why this is not likely to work) along with expansionary monetary policy (which is unlikely to do much good either – see Don't hold your breath).  Yet, spending seems to have passed being useful considering the countryside in Japan is already covered with roads and bridges that see little traffic as well as a multitude of small plots of land farmed by the elderly with government support.  This seems even more incongruous considering that the population in Japanese is declining which will see further falls in revenue and higher spending on pensions and medical bills for the elderly.  This means that the reforms proposed by the Abe government are even more crucial in order to make the falling number of workers even more productive.  Or else, Japan might have to resort to another policy option used in Europe – default…

Why is the economy still stuck in a rut?

As the last hope for an economic recovery, monetary policy has proven lacklustre at best and here is why things have not turned out as planned.

It has been more than five years since the onset of the global financial crisis but it still seems as if we are stuck cleaning up the mess.  The task of getting the economy back on track has been made even trickier with policy makers being side-tracked by a number of misadventures such as the Eurozone crisis and the fiscal cliff in the US.  Governments everywhere have been shackled by large debts and central banks have been relied on to save the day.  Despite having a better track record in the past, the inability of central banks to use monetary policy to fix the problems created by the unique circumstances of our current dilemma have prolonged the economic stagnation.  Your Neighbourhood Economist looks at why the central banks had to try new things and why even this fresh approach has not improved the outlook for the future.

Monetary policy had always provided a road map back to economic recovery in the past.  The directions were simple – lower interest rates would help get the economy back on the right path. The theory behind this was that making it cheaper for firms or households to borrow would give the economy a boost at a time when other sources of growth were flagging.  Interest rates could be topped up again once the economy had been kick started with inflation used as a gauge on the strength of the economy (i.e. low inflation suggests weak demand with rising inflation seen as a sign of an overheating economy). 

However, even interest rates close to zero have failed to gain traction amid the consequences of the global financial crisis.  There are two main reasons for this which relate to borrowers and lenders.  On the lending side, banks have shrunk their operations due to chronic uncertainty that pervaded both the financial well-being of the banks themselves and any borrower they might lend to – banks were unsure of the potential for losses on their own books, let alone those of other business which they may lend to.  A wave of new regulations also acted to hamstrung banks who reacted by lending less to lower the level of risk on their balance sheets with other options such as selling shares not available (this problem was most pronounced in Europe – see Another reason not to bank on Europe for more). 

Borrowers too weren't in the mood with many companies and households having already taken on too much debt during the years of cheap credit which led up to the crisis.  Uncertainty was another factor as wage earners worried about their jobs while firms were more concerned with their own survival rather than borrowing to expand their operations.  Rather than borrowing, the opposite was more likely to be the case as consumers paid down their credit cards while firms repaid their debt and kept cash for a rainy day.  A lack of willingness on both sides (lenders and borrowers) meant that more debt was out of the question no matter how low interest rates would be set.  This put pay to conventional notions of monetary policy and required a fresh approach.

Quantitative easing was taken on-board as a possible solution.  This involved central banks buying bonds to provide funding for banks and companies wanting a different source of cheap funding.  The bond buying also lowered the returns on these safer assets and pushed investors to put their money into more risky assets such as buying bonds of struggling countries in Europe like Greece or Spain.  The extra money in the global financial system was expected to help grease the wheels of banking which had seized up.  But little of this additional cash has reached the real economy and has been hoarded by banks or companies or has gone to pump up share prices.

The limited extent to which their policies fed through to the economy prompted central banks to throw more and more funds at the problem with the Federal Reserve in the US buying US$85 billion in bonds each month and the Bank of Japan pledging to double the money supply in two years (for more on this gamble, see All bets are ON).  The acceleration of monetary policy has not driven the economy much faster through the slowdown.  However, even just the notion of an eventual retreat by central banks has caused jitters among investors who have benefited most up to now from the real-world consequences of monetary policy (refer to Caution - Windy Road Ahead to see how monetary set the tone of stock markets).

So the outlook for the stagnating economy is not good.  Governments remained mired in their debt with even relative bright spots such as the recovery in the US economy in peril when factoring in likely cuts to government spending in years to come.  Central banks have dug themselves into deep holes by trying to do too much and even the limited effects of monetary policy will be difficult to maintain (for more on why thus might be the case, see The perils of doing too much).  The result being that problems in the economy such as a shortfall in demand and uncertainty over the future continue to drag on consumer and business sentiment.  All it would take to ignite economic growth again is a commonly held belief that the future will be brighter.  But, considering all of the above, it is proving a hard sell.  

So what’s the rush?

Having vanquished the threat of economic disaster, the Federal Reserve sets its sights on a return to normality.  

It would seem to be anyone’s fantasy to have the power to influence the direction of the global economy and have investors hanging off your every word.  But it is more of a nightmare for Ben Bernanke, the chairman of the Federal Reserve.  Despite concerns over the strength of the economic recovery in the US, the Federal Reserve is already planning to shed its guise of defender of the economy.  But why the rush?

The Federal Reserve has been thrust into the role of hero with monetary policy deemed to have mythical power to heal the ailing economy.  The limited resources at the hands of central banks have required the use of heavy firepower to stave off economic disaster.  But it is a victory that has come at a heavy price with central banks now deeply involved in the management of the global economy which is proving a difficult position to retreat from (for more, see The perils of doing too much).  Statements by Bernanke in the previous weeks which suggested that the day had been saved and further actions could be tapered off prompted investors to run screaming (refer to Monetary Policy in the Real World). 

The haste at which the Federal Reserve is keen to head for the exit despite concerns that the risk of economic meltdown has not been put to rest is mostly due to the perceived consequences of monetary policy.  Economists who run central banks typically have the personality of the bookish and reserved Clark Kent rather than that of a caped superhero.  Rather than believing in their own powers, economists have a faith in the ability of the markets to generate optimal outcomes.  So any actions taken from the top down which are not governed by market forces will generally result in distortions in the natural order of things.  The extent to which the Federal Reserve has had to ride to the rescue – slashing interest rates to close to zero and buying US$85 billion in bonds each month – has created forces that if left unchecked could result in the Federal Reserve being cast as the villain.

The Federal Reserve has been caught out in the past when led by Alan Greenspan for setting interest rates too low for too long.  The cheap rate of borrowing helped to fuel growth but this proved to be unsustainable when the global financial crisis kicked in, as the amount of debt had become too much to bear.  Low interest rates have not yet had anywhere near the same effect this time round as firms and consumers have been so worried about the future that they have been paying back their loans instead.  The key concerns regarding distortion at the moment is in the prices for stocks and bonds which have benefited from the Federal Reserve’s efforts to keep the economy moving (see Doing more harm than good).  Inflating an asset bubble at this time would be like fighting off one crisis only to plant the seeds of another.  And the Federal Reserve not only has to worry about the reactions of investors but also about the value of its own investments considering the US$3.5 trillion in assets already on its books. 

But it is perhaps the psychology of those running the Federal Reserve that is the overriding reason behind a desire to retreat into the shadows.  The Federal Reserve is not comfortable in the spotlight and prefers to operate in the background as a steady hand on the wheel rather than a dashing hero.  The improving economy in the US provides an escape route while other central banks are still on call ready to fight off economic stagnation.  The decision to move first out of the central banks and put down the big guns of monetary policy is bold but it is also prompted by a fear that further actions will require even more of a superhuman effort to tidy up the resulting potential mess.  

How Monetary Policy plays out in the Real World

The past week or so has shown hints of what is in store as the Federal Reserve hands back the reigns to the US economy.

The theory about the ramifications of the inevitable changes in monetary policy have been spelled out in this blog over the past couple of weeks (Caution - Windy Road Ahead) but market movements at the end of last week show how it will play out in practice.  Heavy selling last week was triggered by the rosy outlook painted by the chairman of the US Federal Reserve, Ben Bernanke, which was more upbeat than had been expected and is likely to signal that the end to bond buying by the Federal Reserve is nearer than many had thought.  It is worth taking a closer look at the reactions of the markets to get an idea of how future actions by central banks may impact on us all.

Bernanke’s statements around a week ago made the case that the economic recovery in the US was sufficient enough for the Federal Reserve to move forward with its plans to reduce its buying of bonds later in the year with a target of stopping completely in the middle of 2014. Pains were taken to get across the notion that the change in tact was not a tightening of monetary policy but just loosening at a slower pace and that any changes in monetary would depend on a continued recovery in the economy. Yet, because the bond buying by the Federal Reserve has become a crucial support holding up the prices of bonds and stocks, its imminent demise has rattled investors who were caught out by the bullish comments by Bernanke.  

The degree of surprise was spelled out in the sharp movements in the investment markets with prices of bonds plunging and the interest rate on 10 year US government debt jumping from around 1.5% to 2.5% (lower bond prices equate to higher interest rates). This will feed through into the real economy as government debt is typically the benchmark for which all other interest rates in the economy are set. The result will be higher interest payments for mortgage holders which will act as a damper on the promising recovery in the housing market in the US. The higher costs for borrowing will also be a point of concern for companies who are thinking of making new investments.

There are further negatives for the US economy from the changes in monetary policy – the ensuing volatility in the stock market will make households worry about their pensions and other investments making them less likely to spend. A slower pace of bond buying will result in a fall in the amount of new currency getting into circulation which will raise the value of the US currency.  A stronger dollar will make life more difficult for exporters, many of whom are already struggling in the global marketplace. 

This all puts the Federal Reserve in an awkward position of its own actions creating a headwind blowing in the opposite direction of where it is trying to get to – an end to its role of propping up the economy. Bernanke is trying to lessen negative effects of its bond buying plans by outlining in advance a clear schedule for its changes in policy. But the Federal Reserve also needs to ease concerns that it will act too fast and has allowed itself flexibility to modify its plans if the economic recovery weakens. The overall effect is the level of certainty which is craved by many investors will remain out of reach, and the twists and turns of monetary policy will be played out in jumpy markets that will keep everyone on their toes.

Where to next for central banks?

Saving the global economy might have been the easy bit – now central banks have to find a way to get out of the limelight.

The outlook for the world economy is far from sunny but talk of impending doom regarding the fiscal cliff in the US or the collapse of the Eurozone seems to have passed.  Central banks have been called on like never before to save us from economic catastrophe and have developed new strategies to deal with the unique problems thrown up by the global financial crisis.  But the deeper the central banks get involved, the more difficult it will be for them to extract themselves from their new dominant roles in propping up the global economy.  Signs of economic recovery mean that this tricky task is at hand but the way out will not be easy.

The first to have to come up with an exit strategy is the Federal Reserve in the US due to a relatively robust economy with the US economy expected to expand by 1.9% in 2013 and growth of 3.0% forecast for 2014.  The third round of quantitative easing means that the Federal Reserve is currently purchasing bonds worth US$85 billion each month with a promise to continue this until there is substantial improvement in the labour market.  With the unemployment rate having edged downward from 8.1% in August to 7.6% in June, the chairman of the Federal Reserve, Ben Bernanke has begun to talk of tapering off its bond buying which will be the beginning of the a long process of winding up the aggressive loosening of monetary policy.

The loose monetary policy has not only involved central banks becoming considerable buyers in the bond market but also interest rates being set at record lows.  It is fair to assume that these policies have helped ease the pain stemming from the global financial crisis, if not having staved off economic meltdown.  Yet, the flipside of the dominant role taken by the central banks is that the reversing of these policies brings its own problems.  Central banks have typically been supported for their actions in the face of possible disaster especially considering the squabbling of politicians.  While policies that boost the economy during slowdowns will always be welcomed, measures that add headwinds to an economic recovery (tightening of monetary policy) are unlikely to make central banks popular.  Yet, the bond buying and record low interest rates distort the economy and may create problems in the future. 

So a return to normality in terms of monetary policy is inevitable but it will be a protracted process with purchases of bonds by central banks being pared back followed by interest rates being nudged upwards all depending on the state of the economic recovery.  This chain of events may start this year in the US, maybe in the summer but probably later in the year or in early 2014, and will take at least a few years.  The decision making of the Federal Reserve will face even more intense scrutiny in the media considering the influence that its actions have over the markets for bonds and stocks (see Caution - windy road ahead for explanation).  The glare of the media will make it difficult to keep the majority onside as even the much-revered former chairman of the Federal Reserve, Alan Greenspan, discovered after falling from grace due to having been seen in hindsight to have left interest rates too low for too long.

The other major central banks will have the luxury of following behind the Federal Reserve.  The European Central Bank cut interest rates in May 2013 in a mainly symbolic sign of its continued intentions to bolster the Eurozone where the economy is expected to weaken by 0.3% in 2013 according to the IMF.  The real possibility of a breakup of the Eurozone was almost single-handily put to rest by the European Central Bank’s willingness to do “whatever it takes” to save the euro (for more, refer to "Whatever it takes"). Yet, the lack of a recovery has left the European Central Bank on red alert – everything is on hold in case another crisis breaks out.  The central bank in Japan is heading in the opposite direction to its US counterpart and is ramping up its monetary policy in the hope of kick-starting an economy which has been stagnating for the past two decades (for the details, see All bets are ON).

So trying times lay ahead for central banks and the rest of us left trailing in the wake of their actions.  Not only will the direction of prices for stocks and bonds depend on developments in monetary policy but gauging the suitable tempo of change by central banks will be crucial in encouraging the nascent recovery in the global economy.  It may be the beginning of the end in terms of central banks saving the world but there is still a long way to go to get to safety.

Close your eyes and hope for the best

Some advice for how to ride out the upcoming twists and turns in the markets.

Your Neighbourhood Economist tries to remain impartial when writing, but like many people, has a certain amount invested in the topics that are mentioned on this blog.  For most of us, it is our employment which can make us vulnerable to the ups and downs of the global economy.  But for some who have a bit stashed away here and there, putting any extra cash to good use is a tricky predicament at this time.  It seems to be like riding a roller coaster in the dark – hence the title of this article – is the best investment advice that Your Neighbourhood Economist could come up with and here is why.

Investment options can be categorised into two types (or a mixture of both) – safe or risky.  With many countries in the developed world still suffering a hangover from the aftermath of the global financial crisis, it would seem as if the clever move would be to go down the safe route.  But the safe option - bonds - has been jumped on by so many investors that returns from bonds have hit record lows in many places, such as debt from countries like Germany or the UK, which are seen as refuges from the turmoil elsewhere. Even the banks with their own problems are paying out higher interest rates than the more prudent options in the bond market.

With such a meagre pay-off from playing it safe, money has been migrating to riskier options with higher returns with shares being the obvious example of a riskier investment.  As such, some of the indices for the big stock markets such as the Dow Jones in the US have hit record highs.  This may seem a bit strange considering the doom and gloom surrounding the outlook for the global economy but it is a phenomenon which has been engineered by central banks across the globe.  Their policy of printing loads of cash has been targeting increased lending and a boost to the prices of assets that you and I might hold such as real estate or stocks.  This increase in asset prices is meant to help us open up our wallets and be more willing to spend (a phenomenon referred to as the “wealth effect”) despite the lingering possibility of job losses and sluggish increases in wages. 

There is a fatal flaw in this scenario that makes investing in this seemingly booming market for stocks even more of a risk.  Central banks will have to shut off the flow of cash sometime.  The main concern for central banks is inflation and keeping it at a sufficiently low level.  But more money, when people actually spend it, leads to higher prices which will be the result of the central bank policies once economic growth returns in earnest.  So the flow of extra cash from central banks which has pumped up share prices will end at some point in time over the next few years.

The timing all depends on the state of the economy in different countries with the Federal Reserve in the US already signalling that it will soon taper off its buying of bonds depending on a continued fall in unemployment.  The European Central Bank has its monetary policy on hold for the moment as the economic situation in Europe gradually improves but may act if another crisis kicks off, while the central bank in Japan has ramped up its monetary policy with the stagnating economy seemingly impervious to previous bouts of monetary stimuli.

This puts potential investors on a scary part of the metaphorical roller coaster ride of investing in the stock market.  There has been a big drop in the market with the financial crisis and the upward turn as share prices bottomed out, but where to next?  To complicate matters, it is the cash coming out of the central banks more than the actual state of the economy that seems to dictate share prices.  This has led to a paradoxical situation where the stock market can fall due to positive news on the economy as robust economic growth would prompt central banks to shut off the flow of cash.  

The result is a lot of twists and turns ahead as the market players try to assess the future of monetary policy, the direction of the global economy, and how other investors will react amongst all of this.  What is bound to ensue is a lot of screaming over both the good and bad.  But with few other easy investment options available, there may be little else to do but invest in stocks, close your eyes and hope for the best.

Winning the Ugliness Contest

Once popular with all the investors, the United Kingdom is beginning to fall out of favour as the diet of austerity measures proves to be too harsh.

A beauty contest is all relative.  It is not hard to be the prettiest when everyone else is ugly.  Such was the fate of the British economy during the Eurozone crisis.  It was not in the best shape but it still looked attractive compared to the turmoil in Europe and this lured in investors who snapped up bonds issued by the government.  But, with the worst of the Eurozone crisis now over and Europe no longer being shunned, it is the United Kingdom that is the object of attention for all of the wrong reasons.

The economy in the United Kingdom did see some benefits from the debt crisis across the English Channel in Europe.  The United Kingdom was seen as a haven in troubled times when investors needed to find somewhere secure to put their money.  As a result, the interest rates on government debt dropped below 2.0% to record lows (for more on this, see Not All Investors in Bonds Have Lost Money).  This has provided some relief as, even though slightly separated from the Eurozone and its troubles, the United Kingdom was in a spot of bother of its own with government debt of 82% at the end of 2011 climbing to 89% 12 months later.

But now that Europe is not the mess it was, the United Kingdom does not hold the same allure and its faults are starting to show through.  The austerity measures which have been introduced to tackle the budget deficit are sapping life out of the economy as money goes toward paying off government debt.  Following a decline in real GDP in the last three months of 2012, Britain is set to make headlines of the wrong sort with a triple-dip recession on the cards if the economy remains weak.  The dismal state of the economy means that Moody’s stripping UK government debt of its illustrious triple A rating last week was not much of a surprise as the reasons for the downgrading – the sluggish economy and high debt levels – were obvious to all.  But the attention on the ugly side of the UK economy is adding to the calls for more to be done to stimulate economic growth.

The coalition government in the United Kingdom which is headed by the Conservative Party has been adamant in its stance that reducing the debt is the best way to perk up the economy.  But this has been increasingly called into question as the theory behind such policies has stumbled in the face of the economic realities.  Studies done by the IMF also show that cuts to government spending have more of a negative impact on the economy than previously thought (for more detail, see Time for Plan B?).  The downgrading of the debt will add to pressure for a change in tact as it may prompt investors to move their money elsewhere and interest rates on government debt will rise as a result.  The higher cost of borrowing will increase the government expenses and eat into the savings the government has made through its austerity measures.  The weaker economy will also reduce the tax revenue for the government adding to its woes. 

With the economy not looking so good in comparison to elsewhere, the government and the central bank will have a harder task to win over the confidence of investors and to come up with a suitable regime of policies to keep the economy in reasonable health.  One consolation is that the constantly changing political and economic situation in various countries struggling with the consequences of the global financial crisis means that the time that the UK economy spends in the spotlight may be short.  In the same week, an indecisive election result in Italy makes it likely that it will be dragged out in front of the international media as the new candidate for the winner of the ugliness contest. 

The danger of positive thinking

With global stock markets in the midst of a major mood swing at the beginning of 2013, a new found optimism brings its own perils.

It is as if the market as a whole decided to focus on the positives as its New Year’s resolution.  Global stock markets have taken off in January 2013 as investors have shrugged off the worries that had weighed down on stock prices in 2012.  But while chronic pessimism has plagued markets over the past few years, the opposite has been the case in the New Year as stock prices have rebounded to levels which are tough to justify amid weak growth in the global economy.  So even though too much negativity has wreaked havoc in the markets, unfounded optimism can bring its own problems.

The prices of shares had been due for a rebound.  Investors had been on a knife edge with the potential for disaster seemingly around every corner as leaders in Europe dithered during the Eurozone crisis, politicians stepped up to the edge of the fiscal cliff in the United States, and the economy in China slowing during changes at the top of the Communist Party.  But along with Mayan predictions of the end of the world, all major catastrophes were averted in 2012 and this prompted a change of heart after investors returned from their holidays. 

Bonds are the typical haven for investors in times of woe and the past few years followed this pattern with investors having snapped up the bonds of prudent countries that have manageable debt levels even though interest rates have been below two percent.  Yet, bond prices have risen so high that further gains are not likely, but there were few other attractive investments at the time. And, as 2012 drew to a close, investors aching for higher returns had already shifted from the safer government bonds into the bonds of previously shunned countries such as Spain and Italy as well as corporate bonds. 

The new signs of life in the stock market tempted many into believing that the time was right to take on more risk and cash in their bonds to place a bet that improvements in the global economy would pick up pace in 2013.  This scenario has prompted talk of a “great rotation” as a swing in sentiment prompts investors into moving money from bonds in stocks.  The continued printing of money by central banks to shore up ailing economies has also helped to buoy the spirits of investors.  This all suggests an abundance of cash which will be heading into the stock market.  Yet, although it makes for a nice story to help prop up share prices, it may just turn out to be a fairy tale.

One of the main sticking points is that, while share prices have rebounded, the outlook for the global economy is still grim.  Higher share prices need to be backed up by companies generating larger profits and this cannot happen until the global economy has regained more vigour.  While an economic armageddon has seemingly been avoided in 2012, growth in the global economy will remain sluggish as high levels of government debt in many countries are trimmed back over years of austerity (for more details about Europe in this context, see Both Good and Bad News for Europe).  

Despite the holes in the story of the “great rotation”, many investors have been keen to believe in a new beginning.  Even the temptation of dubious scenarios can draw buyers back to the market due to concerns about being left behind if the market rebounds.  Investors also buy on expectations of what will happen in the future rather than based on the here and now so a dramatic improvement in economic growth in the following 12 months could prove that now is the right time to buy.  But with many having suffered heavy losses as share prices plummeted during the global financial crisis, a false dawn will do little to reassure investors that it is safe to return to the market.  An overly inflated stock market will also create a conundrum for central bankers and may prompt them to tighten up monetary policy while the economic recovery is still tenuous.  So here’s hoping that investors wake up from the pipe dream of soaring share prices before it turns into a nightmare.  

The Demand and Supply of Money

Economists love the idea of demand and supply.  It is one of the basic concepts we use to describe almost everything.  Yet, thinking about demand and supply with regard to money may seem strange.  Money is something that everyone wants more of and there is never enough of the stuff.  But with central banks across the globe printing more money but banks and companies being cautious about using the bundles of money they have, there is plenty of it around but no one wants to spend it.

The supply of money has been on the rise due to the policies of quantitative easing which central banks have used to try to revive sluggish economies.  The central banks have been creating money from nothing to buy bonds in an attempt to push down interest rates so as to prompt firms and households to borrow more. 

Typically, an increase in the money supply will result in inflation as more money chasing the same number of goods pushes up prices.  But much of the extra cash is being hoarded by banks and companies who are too scared to put it to use.  On the other hand, consumers are being squeezed with downward pressure on wages for those that manage to hold onto their jobs.  Any extra money for households is typically being used to pay off debt after a borrowing binge in the build up to the global financial crisis. 

Central banks have tried to boost the demand for money by lowering interest rates.  It may sound like a bizarre concept but the interest rate is the price of money as it is the cost involved in obtaining cash that is not yours.  The interest rate is determined by the demand and supply for money in a market environment.  That is, an abundance of savings (excess supply) will push down the interest rate while lots of borrowing (excess demand) will have the opposite effect.  In practice, interest rates are also influenced by central banks that set the interest rate, which acts as a base rate for the interest rates on different types of debt, to keep inflation within a target range – typically inflation of around 2.0%. 

The global financial crisis in 2008 and 2009 can be seen as the result of interest rates deviating from what would have been appropriate.  There were massive inflows of savings from China in the banking system in the United States as the Chinese government built up foreign currency reserves which were in US dollars and invested in US government bonds.  This kept interest rates artificially low and resulted in increasing levels of debt as companies, households, and even the government took advantage of cheap borrowing.  Fingers have also been pointed at the US central bank, the Federal Reserve, for not acting faster to clamp down on the excessive borrowing by increasing the interest rate.  But it proved difficult for even the Federal Reserve to end the debt fuelled party – the results of which have only become obvious with hindsight. 

But now interest rates cannot be low enough.  The central banks have set the interest rate close to zero but this is still too high to prompt companies to borrow considering that it is unclear whether investments will generate profits given the uncertainty that clouds the global economy.  Central banks have tried printing more money through quantitative easing which is another way of pushing down interest rates which firms actually pay when borrowing.  While this new cash has helped somewhat in this regard, much of the money has gone elsewhere – some to stocks which has helped to boost the share market but some of the funds have headed overseas with undesirable effects (but more on this in my next posting).

The nitty gritty of economic is not for everyone, and while it may not be that interesting (Your Neighbourhood Economist cannot work miracles), hopefully the workings of the economy will make a little bit more sense (and please comment or email if you would like to know more).

“Whatever it takes”

This is the bold pledge made by the governor of the European Central Bank (ECB), Mario Draghi, in reference to what the Europe’s central bank is willing to do to help stop countries leaving the euro.  This statement of intent was made at the end of July but investors had to wait until the beginning of September for the details of how far the ECB was willing to go.  And the ECB has brought out the big guns to prove its resolution but it remains to be seen whether the full might of the ECB will be enough.

The central part of the new policy was that the ECB would purchase an unlimited amount of bonds of indebted countries suffering from high interest rates.  The fact that the ECB has set no limit on funds available for bond purchases is meant to stop investors selling bonds of European governments in the expectation that the interest rates will rise (interest rates get higher if bonds are sold off and their price falls).  If the ECB is always ready to buy bonds, the price of bonds is less likely to fall and this will create an environment where other investors will be motivated to also buy. 

And in theory, it is a good time to buy.  The worries that a breakup of the Eurozone will prompt governments to default on their debt have prompted investors to sell off the bonds of countries such as Spain who are expected to have difficulties in paying their bills.  If the fears of default can be soothed, the prices of bonds will seem cheap.  So, the ECB is betting on its ability to calm the nerves in the market and could actually make a profit on its buying of bonds.

This new stance is not without its problems.  The help for troubled countries from the ECB is not unconditional and governments must agree to reforms to the economy which would be supervised by the EU and the IMF for the ECB to buy their bonds.  Spain is seen as a prime candidate for this support but the harsh reality of having to submit to orders from others has made the government reluctant to seek assistance. 

 

The ECB could be caught in a dilemma if a country does not toe the line after having their bonds propped up by the ECB despite having signed on for reforms.  If the ECB stops its bond purchases for such a country, default would be highly likely and this is exactly the result that the policy is intended to stop.  There are concerns with the ECB along with the EU and the IMF having control over governments which have been democratically elected by their citizens.  While an undesirable outcome of the sovereign debt crisis, the greater power of these unelected bodies is the result of governments being unable to sort out the problems themselves. 

But perhaps the biggest concern is the slim possibility that that the unlimited firepower of the ECB will not have enough punch.  Pessimists may bet against the ECB to test its resolve.  There are numerous parties which are unhappy with the new position taken by the ECB.  In particular, policies makers in Germany have made public their displeasure and this will grow with the amount of funds which the ECB uses to buy up bonds increases.  Investors will also second-guess the efforts of countries receiving support as to whether they will stick to what is expected of them by the ECB.  The policy of the ECB has been compared to a bazooka – if you have a big enough gun, no one will mess with you.  But there is the smallest chance that even a bazooka may not be big enough faced with an army of doubters.  

Another dose of medicine but will it help…

Vital signs suggest that the global economy in 2012 is not healthy.  Europe is the main cause of concern as politicians argue about the right course of action with regard to the sovereign debt crisis.  But problems in other major economies such as the United States and China are also adding to the ailments of the global economy.  This deteriorating outlook for the global economy has also sapped the willingness of many firms who operate on a global level to spend and invest.  The typical economic prescription in cases where a lack of optimism dents spending by firms and consumers is Keynesian – the government is to step in and increase spending to cover the drop in demand from elsewhere.

But governments in many countries such as the United States have their hands tied due to large amounts of government debt which limits further spending.  Central banks have also tried the textbook response to a weak economy by cutting interest rates to close to zero.  But this has had little effect as business will not borrow even at low interest rates if the prospects for the economy are dim. 

So central banks have been pushed to try less conventional medicine.  The new prescription is referred to as quantitative easing and involves the central banks printing money and using this to buy bonds issued by their government or by businesses.  This acts to further lower interest rates on the bonds and the lower return for investors in bonds prompts some of them to move their money to other investments such as shares which acts as a shot in the arm for the stock market.

Growing concerns that the global economy is on its sick bed have jolted the central banks in the United States, Europe, and Japan into ordering a further dose of medicine.  The European Central Bank released plans to buy as many bonds of indebted countries as necessary to help out the sick patients of Europe after its pledge to do “whatever it takes” to support the euro (more on this in a future posting).  The Federal Reserve in the United States followed suited and announced it would buy an unlimited amount of bonds until unemployment began to come down.  The Bank of Japan also jumped on the bandwagon with its own plans to buy up bonds.

 

This new consensus among central banks has not pleased everyone.  There are concerns over the new roles for central banks who have traditionally been bastions against inflation.  Inflation is seen as a negative influence as it reduces the value of money which hurts savers.  Central banks have killed off inflation by increasing interest rates but this has been possible due to the targeting of inflation by central banks.  But attempts by central banks to revive flagging demand through quantitative easing also could result in the resurrection of inflation.  As quantitative easing also involves central banks creating money for nothing, it also acts to drive down the value of the currency (as will be described in a future posting) and this is controversial as a weaker currency boosts exports at the expense of other countries. 

Even if the quantitative easing by central banks is seen as a necessary evil, there are further fears about whether the policies themselves are having the desired effect.  Because quantitative easing involves buying bonds in the hope of influencing investment decisions of other buyers of assets for investment, the effects are not clear and the continuation or even worsening of economic problems suggests that the policies are not a cure-all.  This is reinforced by the fact that, for example, this will be the third round of quantitative easing in the United States (hence the abbreviation “QE3” in the newspapers). 

In effect, there are few differences from when Your Neighbourhood Economist first started this blog in November 2011 (So what is going on…???).  The problems that central banks are grappling with are beyond the scope of the current understanding and available tools.  It remains to be seen if the unlimited resources now being tapped by the central banks will in fact be enough to resuscitate the major economies.  There is not much else that can be done.  Even Your Neighbourhood Economist does not know what to expect in twelve months’ time.

Not All Investors in Bonds have Lost Money

While some countries such as Greece have been terrorized by the bond markets, the governments of other countries have seen the interest rates on their debts fall to record lows.  So while some bond investors have been losing money in Europe, there have been others who have raked in good returns.

There can be considered to be a large pool of money which moves around the global financial markets looking for the highest returns.  This pool of money is made up of pension funds, cash from wealthy individuals, as well as sovereign funds run by various countries.  The money typically follows a predictable pattern over the business cycle – to shares and other risky investments when times are good and to bonds and other safer investments during a downturn. 

This time around, the severity of the recession has heightened the sense of fear in the market and investors have become picker about where they park their money during the slump.  This coupled with the high level of debt that many governments (and companies) took on-board during the boom time has resulted in the sovereign bond market being split into winner and losers.  The previous post dealt with the losers. But if money is to be invested in bonds during the recession and some governments and many firms (considering all of the bankruptcies) are out of bounds, it has to go somewhere and it goes to the winners.  

And the winners have been the governments of the US and the UK among others.  The interest rates on 10-year government bonds for both countries have fallen below 2.0% to record lows.  Along with investors seeking safety, the reduction in interest rates has also been driven by the central banks buying large quantities of government debt as part of their efforts to lift the respective economies out of their slump. 

But the thing that investors are asking now is whether bonds will remain popular.  When the global economy starts to pick up again, investors will be willing to take more risks.  And the buying by the central banks is near an end.  The Federal Reserve in the US has not suggested that it will again buy more bonds issued by the US government even though the Bank of England has committed itself to buying more UK government debt.  Furthermore, not many investors will be happy with a return of 2.0% in comparison to recent strong gains made in the share market.  Rallies in both the share market and the bond market is a contradiction that cannot continue for too long and either the optimist buying shares or the pessimists sticking with their bonds will be proven wrong.

However, despite some signs of better prospects for the global economy, there are some who still think that interest rates for these bonds have further to fall.  If the economic recovery is weak, the factors that have been driving the rally will continue.  Then, a return of 2.0% and more gains in bond prices (interest rates and bond prices move in opposite directions – see the previous posting) may be a clever bet if things turn out for the worst.  This is where those bankers are supposed to (but don’t always) earn their exorbitant pay packets.