Central Banks, Credit Expansion, and the Importance of Being Impatient
John Mauldin
Apr 03, 2015
We live in a time of unprecedented financial repression. As I have continued writing about this, I have become increasingly angry about the fact that central banks almost everywhere have decided to address the economic woes of the world by driving down the returns on the savings of those who can least afford it – retirees and pensioners.
This week’s Outside the Box, from my good friend Chris Whalen of Kroll Bond Rating Agency, goes farther and outlines how a low-interest-rate and massive QE environment is also destructive of other parts of the economy. Counterintuitively, the policies pursued by central banks are actually driving the deflationary environment rather than fighting it.
This is a short but very powerful Outside the Box. And to further Chris’s point I want to share with you a graph that he sent me, from a later essay he wrote. It shows that the cost of funds for US banks has dropped over $100 billion since the financial crisis, but their net interest income is almost exactly the same. What changed? Banks are now paying you and me and businesses $100 billion less. The Fed’s interest-rate policy has meant a great deal less income for US savers.
It is of the highest irony that Keynesians wanted to launch a QE policy that would increase the value of financial assets (like stocks), which they claimed would produce a wealth effect. I made fun of this policy some five years ago by calling it “trickle-down monetary policy.” Subsequent research has verified that there is no wealth effect from QE. Well, it did make our stocks go up, on the backs of savers.
We’ve transferred interest income from savers into the stock market. We’ve made retirement far riskier for our older pensioners than it should be.
We’ve transferred interest income from savers into the stock market. We’ve made retirement far riskier for our older pensioners than it should be.
As Chris writes:
Indeed, in the present interest rate environment, to paraphrase John Dizard of the Financial Times, it has become mathematically impossible for fiduciaries [brokers, investment advisors and managers of pension funds and annuities] to meet the beneficiaries’ future investment return target needs through the prudent buying of securities.
Everywhere I go I talk with investment advisors and brokers who are scratching their heads trying to figure out how to create retirement portfolios that provide sufficient income without significantly moving out the risk curve at precisely the wrong time in their client’s lives. It is a conundrum that has been made for more difficult by Federal Reserve policy.
Economics Professor Larry Kotlikoff (Boston University) and our mutual friend syndicated financial columnist Scott Burns came by to visit me last week. I have talked with Larry on and off over the last few years, and Scott and I go back literally decades. A few years ago, Scott and Larry wrote a very good book called The Clash of Generations. Now, Larry has branched off on his own and written a really powerful manual on Social Security called Get What's Yours: The Secrets to Maxing Out Your Social Security.
I will admit I have not paid much attention to Social Security. I just assumed I should start mine when I’m 70, as so many columns I have read suggested. Larry and I recently spent an hour discussing the Social Security system (or perhaps it would be better to call it the Social Security Maze). Three thousand pages of law and tens of thousands of regulations and so many nuances and “gotchas” that it is really difficult to understand what might be best in your particular circumstances. Larry asked me questions for about two minutes and then proceeded to make me $40,000 over the next five years. It turns out I qualify for an obscure (at least to me) regulation that allows me to get some Social Security income for four years prior to turning 70 without affecting my post-70 benefits. There are scores of such obscure rules.
Larry says it is more often the case than not that he can sit down with somebody and make them more money than they thought they were going to get. As one reviewer says:
This book is necessary for three reasons: Social Security is not intuitive, and sometimes makes no sense at all. Two, Americans act against their best interests, leaving all kinds of money on the table. Three, there is usually a “however” with Social Security rules. Worse, Social Security is now up to three million requests every week, but Congress keeps cutting back budget, staff, hours and whole offices. Combine that with the complexity factor, and the authors conclude you cannot trust what Social Security advises. Great.
If you or your parents are on Social Security or you are approaching “that age,” you really should get this book. Did you know that if you are divorced you can get a check for half of your former spouse’s Social Security income without affecting their income at all? But you can’t know whether this is a good strategy unless you look at other options.
How many retirees or those nearing retirement know about such Social Security options as file and suspend (apply for benefits and then don’t take them)? Or start stop start (start benefits, stop them, then restart them)? Or– just as important – when and how to use these techniques?
Get What’s Yours covers the most frequent benefit scenarios faced by married retired couples, by divorced retirees, by widows and widowers, among others. It explains what to do if you’re a retired parent of dependent children, disabled, or an eligible beneficiary who continues to work, and how to plan wisely before retirement. It addresses the tax consequences of your choices, as well as the financial implications for other investments.
The book is written in Larry’s usual easy-to-read style, and you can jump to the sections that might be most relevant to you. The book is $11 on Kindle and under $15 at Amazon. This might be some of the better financial advice that you get from reading my letter: go get a copy of Get What’s Yours.
I can’t guarantee it will make you $40,000 in five minutes, but it can show you how to navigate the system. Larry also has a website with some inexpensive software to help you maximize your own Social Security. Seeing as how Social Security is the largest source of income for most US retirees, this is something everyone should pay attention to.
It is time to hit the send button. Quickly, we finalized the agenda for the 2015 Strategic Investment Conference. You can see it by clicking on the link. Then go ahead and register before the price goes up. This really is the best economic conference that I know of anywhere this year.
Your wondering how long they’ll pay me Social Security analyst,
John Mauldin, Editor
Outside the Box
Central Banks, Credit Expansion, and the Importance of Being
Impatient
This research note is based on the presentation
given by Christopher Whalen, Kroll Bond Rating Agency (KBRA) Senior Managing
Director and Head of Research, at the Banque de France on Monday, March 23,
2015, for an event organized by the Global Interdependence Center (GIC)
entitled “New Policies for the Post Crisis Era.” KBRA is pleased to be a sponsor of the
GIC.
Summary
Investors are keenly focused on the Federal Open
Market Committee (FOMC) to see whether the U.S. central bank is prepared to
raise interest rates later this year – or next. The attention of the markets
has been focused on a single word, “patience,” which has been a key indicator
of whether the Fed is going to shift policy after nearly 15 years of
maintaining extraordinarily low interest rates. This week, the Fed dropped the
word “patience” from its written policy guidance, but KBRA does not believe
that the rhetorical change will be meaningful to fixed income investors. We do
not expect that the Fed will attempt to raise interest rates for the balance of
2015.
This long anticipated shift in policy guidance
by the Fed comes even as interest rates in the EU are negative and the European
Central Bank has begun to buy securities in open market operations mimicking
those conducted by the FOMC over the past several years. Investors and markets
need to appreciate that, regardless of what the FOMC decides this month or
next, the global economy continues to suffer from the effects of the financial
excesses of the 2000s.
The decision by the ECB to finally begin U.S.
style “quantitative easing” (QE) almost eight years after the start of the
subprime financial crisis in 2007 speaks directly to the failure of policy to
address both the causes and the terrible effects of the financial crisis.
Consider several points:
- QE by the ECB must be seen in
the context of a decade long period of abnormally low interest rates. U.S.
interest rate policy has been essentially unchanged since 2001, when
interest rates were cut following the 9/11 attack. The addition of QE 1-3
was an effort at further monetary stimulus beyond zero interest rate
policy (ZIRP) meant to boost asset prices and thereby change investor
tolerance for risk.
- QE makes sense only from a
Keynesian/socialist perspective, however, and ignores the long-term cost
of low interest rate policies to individual investors and financial
institutions. Indeed, in the present interest rate environment, to
paraphrase John Dizard of the Financial
Times, it has become mathematically impossible for fiduciaries
to meet the beneficiaries’ future investment return target needs through
the prudent buying of securities. (See John Dizard, “Embrace the
contradictions of QE and sell all the good stuff,” Financial Times, March
14, 2015.)
- The downside of QE in the U.S.
and EU is that it does not address the core problems of hidden off-
balance sheet debt that caused the massive “run on liquidity” in 2008.
That is, banks and markets in the U.S. globally face tens of trillions of
dollars in "off-balance sheet" debt that has not been resolved.
The bad debt which is visible on the books of U.S. and EU banks is also a
burden in the sense that bank managers know that it must eventually be
resolved. Whether we talk of loans by German banks to Greece or home
equity loans in the U.S. for homes that are underwater on the first
mortgage, bad debt is a drag on economic growth.
- Despite the fact that many of
these debts are uncollectible, governments in the U.S. and EU refuse to
restructure because doing so implies capital losses for banks and further
expenses for cash- strapped governments. In effect, the Fed and ECB have
decided to address the issue of debt by slowly confiscating value from
investors via negative rates, this because the fiscal authorities in the
respective industrial nations cannot or will not address the problem
directly.
- ZIRP and QE as practiced by the
Fed and ECB are not boosting, but instead depressing, private sector
economic activity. By using bank reserves to acquire government and agency
securities, the FOMC has actually been retarding private economic growth,
even while pushing up the prices of financial assets around the world.
- ZIRP has reduced the cost of
funds for the $15 trillion asset U.S. banking system from roughly half a
trillion dollars annually to less than $50 billion in 2014. This decrease
in the interest expense for banks comes directly out of the pockets of
savers and financial institutions. While the Fed pays banks 25bp for their
reserve deposits, the remaining spread earned on the Fed’s massive
securities portfolio is transferred to the U.S. Treasury – a policy that
does nothing to support credit creation or growth. The income taken from
bond investors due to ZIRP and QE is far larger.
- No matter how low interest
rates go and how much debt central banks buy, the fact of financial
repression where savers are penalized to advantage debtors has an overall
deflationary impact on the global economy. Without a commensurate increase
in national income, the elevated asset prices resulting from ZIRP and QE
cannot be validated and sustained. Thus with the end of QE in the U.S. and
the possibility of higher interest rates, global investors face the
decline of valuations for both debt and equity securities.
- In opposition to the intended
goal of low interest rate and QE policies, we also have a regressive
framework of regulations and higher bank capital requirements via Basel
III and other policies that are actually limiting the leverage of the
global financial system. The fact that banks cannot or will not lend to
many parts of society because of harsh new financial regulations only
exacerbates the impact of financial repression. Thus we take income from
savers to advantage debtors, while limiting credit to society as a whole.
Only large private corporations and government sponsored enterprises with
access to equally large banks and global capital markets are able to
function and grow in this environment.
So what is to be done? KBRA believes that the
FOMC and policy makers in the U.S. and EU need to refocus their efforts on
first addressing the issue of excessive debt and secondly rebalancing fiscal
policies so as to boost private sector economic activity. Low or even negative
interest rate policies which punish savers in order to pretend that bad debts
are actually good are only making things worse and accelerate global deflation.
Around the globe, nations from China to Brazil and Greece are all feeling the
adverse effects of excessive debt and the related decline in commodity prices
and overall economic activity. This decline, in turn, is being felt via lower
prices for both commodities and traded goods – that is, deflation.
In the U.S., sectors such as housing and energy,
the effects of weak consumer activity and oversupply are combining into a perfect
storm of deflation. For example, The Atlanta Fed forecast for real GDP has been
falling steadily as the underlying Blue Chip economic forecasts have also
declined. The drop in capital expenditures related to oil and gas have resulted
in a sharp decline in related economic activity and employment. Falling prices
for oil and other key industrial commodities, weak private sector credit
creation, falling transaction volumes in the U.S. housing sector, and other
macroeconomic indicators all suggest that economic growth remains quite
fragile.
To deal with this dangerous situation, the FOMC
should move to gradually increase interest rates to restore cash flow to the
financial system, following the famous dictum of Adam Smith that the “Great
Wheel” of circulation is the means by which the flow of goods and services
moves through the economy:
“The great wheel of circulation is altogether
different from the goods which are circulated by means of it. The revenue of
the society consists altogether in those goods, and not in the wheel which
circulates them” (Smith 1811: 202).
Increased regulation and a decrease in the
effective leverage in many sectors of banking and commerce have contributed to
a slowing of credit creation and economic activity overall. And most
importantly, the issue of unresolved debt, on and off balance sheet, remains a
dead weight retarding economic growth. For this reason, KBRA believes that
investors ought to become impatient with policy makers and encourage new
approaches to boosting economic growth.
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