SIDE EFFECTS THAT SHOULD CALL TIME ON THE QE MEDICINE / THE FINANCIAL TIMES

September 22, 2013 9:26 pm

 

Side-effects that should call time on the QE medicine

 

By John Authers

 

An incomplete list of how quantitative easing is damaging

 

Here is a Monday morning challenge. In how many ways is QE damaging? (For the uninitiated, QE stands for quantitative easing, the central bank policy of buying bonds in an attempt to stimulate the economy.)

We now know, after last week’s surprise announcement from the Federal Reserve, that the US central bank has decided it must keep up with QE at full throttle. We also know, from its efforts to prepare the markets for a move away from QE, that it would like to end it if at all possible.

 

This is not an argument about higher macroeconomics. The biggest argument made against QE when it started was that money-printing would necessarily lead to inflation. That has not happened yet, and in any case the Fed governors who voted for QE in the first place plainly did not share that macroeconomic judgment.

Whether or not QE proves useful in bringing the economy back to life, the policy has painful side-effects, which is why the Fed wants to exit. Here is an incomplete list. There are surely many more where these came from.


● Defaults are unnaturally limited


QE messes up the traditional capitalistic process of “creative destruction”. Perhaps the clearest example is in the high-yield bond market, where defaults are at a historic low.
 

According to this year’s study of historic default rates by Deutsche Bank, which this column explored in May, the average default rate over the past 10 years, which saw first a credit bubble and then a deep recession, has been only 1.6 per cent. Going back to 1983, as the junk bond sector was taking shape, the average default rate has been 5.3 per cent.

 

Nobody is wishing default on anyone. But defaults are capitalism’s way of ensuring that capital no longer flows to businesses that cannot put it to good use. Lower rates, driven by QE, make it easier for troubled companies to service their debts and loosens this tight discipline. At the margin this means that enterprises better deserving of receiving the credit do not get it.


● The mortgage market is distorted


Even in the mortgage market, which it is most directly aimed to help, QE makes life harder. In the aftermath of the first programme of buying, “QE1”, the US mortgage-backed securities market was bedevilled by an unprecedented level of “failures to deliver” by fund managers. With the Fed sucking out of the market huge quantities of mortgage-backed bonds, people could not lay their hands on the collateral needed to complete deals.


● Central banks cannot raise rates


QE muddies the trade waters. It has been a while since Brazil and other large emerging market exporters were complaining about “currency wars”. That is in large part because US yields have been rising and the dollar gaining. But the weaker dollar entailed by QE still makes life more awkward the world over, in some unlikely places. The central banks of both Norway and New Zealand – not otherwise countries with a great deal in common – are nearing the point where they will raise rates.

QE in the US forces up their currencies. The rise in the past few days increases the risk that rate rises to avert any overheating at home will instead choke off exports.


● Reforms can be postponed


QE also helps governments avoid necessary structural adjustments. Taper talk, starting in May, contributed to a sharp run on several emerging market currencies, with those of India, Turkey and Brazil prominent among them.

What looked like a potential impending crisis has been averted for now, although these currencies remain significantly weaker than they were in May. But the important point is that that impending crisis was not indiscriminate. It was focused on those countries that had fundamental problems, in the form of high current account deficits.

This was not solely an issue of an indiscriminate shift in financial flows. The undiscriminating flows came earlier, when they helped out countries such as Turkey and India, and made it easier to avoid necessary action there. The postponement of tapering raises the risk that adjustment will be painful when the end of QE finally comes.


● Pension deficits increase


By reducing bond yields, QE pours on the pain for defined-benefit pension fund managers. The problem of deep deficits for big old-line pension funds is well-known. It is less widely grasped that this is directly worsened by low interest rates, as this reduces the rate at which future liabilities can be discounted – and therefore requires pension funds to raise more in the present.

Higher yields have helped many pension fund managers breathe more easily. But they still have a long way to go. Any situation where many pension funds remain far short of meeting their promises to employees is uncomfortable in the extreme. The sooner it ends the better.


 

Copyright The Financial Times Limited 2013.