Monday, March 16, 2009

Private Capital in an Era of Government Intervention

The widespread manipulation of capital markets by the Federal Reserve, the legislature, and government agencies has continued to distort the balance between risk and reward. Previous efforts to soften the pain of recessions or stimulate economic activity in certain sectors (e.g. housing under Greenspan and Bush) have ended in complete disaster. Unable to learn from past mistakes, our current leaders fail to realize that distorting interest rates, housing incentives, and consumer demand causes sub-optimal economic outcomes with potentially devastating long run consequences. It is futile, however, to expect that policy makers will make the difficult decisions that lead to short term pain, but will ultimately lead to a stronger and more stable economy. They will inevitably pander to the demands of the populace who care only about their own interests rather than that of society as a whole.

Case in point is the entire premise of quantitative easing. Buying treasuries with the intent of artificially suppressing long term interest rates to encourage consumption will only lead to rampant inflation and a prolonged recession. Edward Chancellor published a piece in the Financial Times reports on the UK government's efforts to suppress interest rates by acquiring a significant percentage of outstanding Gilts.

"Economists applauded. Their reactions are mistaken. Quantitative easing, as it is called, poses a grave danger to Britain’s creditors. It is a perilous policy that threatens further disruption to the financial system at some future date.

On Thursday March 5, the Bank of England said it would acquire up to £75bn of gilts over the following three months. A further £75bn of Bank purchases have been earmarked. Relative to the size of the British economy, these are vast sums. The combined figure is roughly three times the stock of notes and coins in circulation and twice the country’s monetary base. It is also equal to almost a third of the stock of outstanding gilts. Put another way, the Bank is set to finance the largest peacetime deficit in British history.


Yet long-term bondholders have nothing to celebrate. The aim of quant­itative easing, after all, is to dispel deflation and achieve the Bank’s 2 per cent annual inflation target. There is no question that a determined central bank can get rid of deflation. It is simply a question of printing enough money. Economists have another term to describe the monetisation of government debt. The history of “seigniorage” goes back to the debasement of the coinage under the Roman emperors. Seigniorage is really a tax on holders of money and government debt which is paid via inflation. When carried to excess, it leads to hyperinflation.

The exponents of quantitative easing dismiss such fears. They claim that liquidity can easily be removed at some stage in the future. But what confidence should we place in the authorities to act in a timely fashion? After all, this crisis is largely the consequence of the Federal Reserve’s easy money policy at the beginning of the decade that fuelled the global housing bubble. If the economy remains stagnant, the Bank will probably be slow to remove the liquidity. In which case, there will be inflation.

An early experiment with quantitative easing occurred in Japan in 1932. At the time, the Bank of Japan financed a large fiscal expansion by printing money. In no time, Japan went from a severe deflation to near double-digit inflation. This monetary easing was never reversed and inflation escalated throughout the decade. After the second world war, the Fed likewise printed money to buy bonds. As a result, a mild deflation in 1949 was followed by inflation of about 10 per cent a couple of years later. Owners of Treasury bonds suffered heavy losses.


Still, there is a possibility the Bank will react to incipient inflation and reverse its quantitative easing policy in good time. But what will happen then? For a start, the bond market would likely crash as the central bank rapidly disposes of its pile of accumulated bonds. Furthermore, the apparent gains of quantitative easing may be reversed. Unless any recovery is robust, the reduction of central bank liquidity would hurt the securities markets and the real economy. This happened in 1937 after the Fed responded to rising inflation fears by removing excess reserves from the banking system. The US stock market was cut in half and the economy nosedived.

Central banks in Switzerland, Japan and the US are set to follow Britain’s lead on quantitative easing. Bondholders everywhere are anticipating windfall gains, as the owners of gilts have enjoyed. They should not be fooled. In the years to come, owners of government debt will be the chief victims of this great monetary experiment."