Earlier today, reader Charles asked me what I thought about an article on ZeroHedge entitled “Is The Fed Going To Attempt A Controlled Collapse?”
The question stems from lengthy (256 page PDF) from the BIS Annual Report (Bank for International Settlements) that stated among other things “The only source of lasting prosperity is a stronger supply side. It is essential to move away from debt as the main engine of growth.”
The BIS slammed the Fed in numerous places and in numerous ways, especially regarding the Fed’s reliance on QE.
The BIS slam, coupled with a recent stock market selloff, brought up debate on a “controlled collapse“.
I will address the absurdity of that notion momentary, but first please consider some snips from the BIS report that caught my attention.
32 BIS Snips
- The risk of normalising too late and too gradually should not be underestimated.
- Financial fluctuations (“financial cycles”) that can end in banking crises such as the recent one last much longer than business cycles. Irregular as they may be, they tend to play out over perhaps 15 to 20 years on average. After all, it takes a lot of tinder to light a big fire. Yet financial cycles can go largely undetected. They are simply too slow-moving for policymakers and observers whose attention is focused on shorter-term output fluctuations.
- Globally, the total debt of private non-financial sectors has risen by some 30% since the crisis, pushing up its ratio to GDP. Government debt-to-GDP ratios have risen further; in several cases, they appear to be on an unsustainable path.
- Monetary policy is testing its outer limits. Never before have central banks tried to push so hard. The normalisation of the policy stance has hardly started.
- In the countries that have been experiencing outsize financial booms, the risk is that these will turn to bust and possibly inflict financial distress. Based on leading indicators that have proved useful in the past, such as the behaviour of credit and property prices, the signs are worrying.
- Over the past few years, non-financial corporations in a number of EMEs have borrowed heavily through their foreign affiliates in the capital markets, with the debt denominated mainly in foreign currency. This has been labelled the “second phase of global liquidity”, to differentiate it from the pre-crisis phase, which was largely centred on banks expanding their cross-border operations. The corresponding debt may not show up in external debt statistics or, if the funds are repatriated, it may show up as foreign direct investment. It could represent a hidden vulnerability, especially if backed by domestic currency cash flows derived from overextended sectors, such as property, or used for carry trades or other forms of speculative position-taking.
- Low funding costs and volatility encouraged the search for yield. Through its impact on risk-taking behaviour, monetary accommodation had an impact on asset prices and quantities that went beyond its effects on major sovereign bond markets. Credit spreads tightened even in economies mired in recession and for borrowers with non-negligible default risk. Global investors absorbed exceptionally large volumes of newly issued corporate debt, especially that of lower-rated borrowers. And, as the search for yield expanded to equity markets, the link between fundamentals and prices weakened amid historically subdued volatility and low risk premia.
- Gross issuance in the high-yield bond market alone soared to $90 billion per quarter in 2013 from a pre-crisis quarterly average of $30 billion. Investors absorbed the newly issued corporate debt at progressively narrower spreads.
- Increased risk-taking also manifested itself in other credit market segments. In the syndicated loan market, for instance, credit granted to lower-rated leveraged borrowers (leveraged loans) exceeded 40% of new signings for much of 2013. This share was higher than during the pre-crisis period from 2005 to mid-2007. Fewer and fewer of the new loans featured creditor protection in the form of covenants. Investors’ attraction to riskier credit also spawned greater issuance in assets such as payment-in-kind notes and mortgage real estate investment trusts (mREITs).
- Restoring sustainable global growth poses significant challenges. In crisis-hit countries, it is unrealistic to expect the level of output to return to its pre-crisis trend. This would require the growth rate to exceed the pre-crisis average for several years. Historical evidence shows that this rarely happens following a balance sheet recession. Moreover, even the prospects for restoring trend growth are not bright. Productivity growth in advanced economies has been on a declining trend since well before the onset of the financial crisis, and the workforce is already shrinking in several countries as the population ages. Public debt is also at a record high and may act as an additional drag on growth. In many EMEs, the recent tightening of financial conditions and late-stage financial cycle risks are also clouding growth prospects.
- It is unrealistic to expect investment, as a share of GDP, to return to its pre-crisis level in advanced economies. The drop in construction spending is a necessary correction of previous overinvestment and is unlikely to be entirely reversed. Moreover, the investment share had been on a downward trend long before the crisis, suggesting that, as output growth recovers, investment may settle below the pre-crisis average. Moreover, the investment weakness may be overstated. Over the past few decades, the relative prices of investment goods have been trending down: firms have been able to keep their capital stocks constant by spending less in nominal terms. In fact, in real terms, investment spending has fluctuated around a mildly increasing , not decreasing, trend in advanced economies. In addition, official statistics may underestimate intangible investment (spending on research and development, training, etc), which has been gaining importance in serviced-based economies.
- Financial cycles differ from business cycles. They encapsulate the self-reinforcing interactions between perceptions of value and risk, risk-taking and financing constraints which translate into financial booms and busts. They tend to be much longer than business cycles, and are best measured by a combination of credit aggregates and property prices. Output and financial variables can move in different directions for long periods of time, but the link tends to re-establish itself with a vengeance when financial booms turn into busts. Such episodes often coincide with banking crises, which in turn tend to go hand in hand with much deeper recessions – balance sheet recessions – than those that characterise the average business cycle.
- High private sector debt levels can undermine sustainable economic growth. In many economies currently experiencing financial booms, households and firms are in a vulnerable position, which poses the risk of serious financial distress and macroeconomic strains. And in the countries hardest hit by the crisis, private debt levels are still high relative to output, making households and firms sensitive to increases in interest rates. These countries could find themselves in a debt trap: seeking to stimulate the economy through low interest rates encourages the taking-on of even more debt, ultimately adding to the problem it is meant to solve.
- Accommodative monetary policy has had an ambiguous impact on the adjustment to lower debt ratios. It has supported adjustment to the extent that it has succeeded in stimulating output, raising income and hence providing economic agents with the resources to pay back debt and save. But record low interest rates have also allowed borrowers to service debt stocks that would be unsustainable in more normal interest rate conditions, and lenders to evergreen such debt. This tends to delay necessary debt adjustments and result in a high outstanding stock of debt, which in turn can slow growth.
- Indicators point to the risk of financial distress.
- Early warning indicators in a number of countries are sending worrying signals. In line with the financial cycle analysis developed in the previous section, several early warning indicators signal that vulnerabilities have been building up in the financial systems of several countries. Many years of strong credit and, often, property price growth have left borrowers exposed to increases in interest rates and/or sharp slowdowns in property prices and economic activity. Early warning indicators cannot predict the exact timing of financial distress, but they have proved fairly reliable in identifying unsustainable credit and property price developments in the past. It would be too easy to dismiss these indicator readings as inappropriate because “this time is different”.
- Financing problems of non-financial corporations in EMEs can also feed into the banking system. Corporate deposits in many EMEs stand at well above 20% of the banking system’s total assets in countries as diverse as Chile, China, Indonesia, Malaysia and Peru, and are on an upward trend in others. Firms losing access to external debt markets may be forced to withdraw these deposits, leaving banks with significant funding problems. Firms that have been engaging in a sort of carry trade – borrowing at low interest rates abroad and investing at higher rates at home – could be even more sensitive to market conditions.
- The sheer volume of assets managed by large asset management companies implies that their asset allocation decisions have significant and systemic implications for EME financial markets. For instance, a relatively small (5 percentage point) reallocation of the $70 trillion in assets managed by large asset management companies from advanced economies to EMEs would result in additional portfolio flows of $3.5 trillion. This is equivalent to 13% of the $27 trillion stock of EME bonds and equities.
- Regardless of the risk of serious financial distress, in the years ahead many economies will face headwinds as outstanding debt adjusts to more sustainable long-run levels. Determining the exact level of sustainable debt is difficult, but several indicators suggest that current levels of private sector indebtedness are still too high.
- Sustainable debt is aligned with wealth. Sharp drops in property and other asset prices in the wake of the financial crisis have pushed down wealth in many of the countries at the heart of the crisis, although it has been recovering in some. Wealth effects can be long-lasting. For example, real property prices in Japan have decreased by more than 3% on average per year since 1991, thus reducing the collateral available for new borrowing.
- Long-run demographic trends could aggravate this [the sustainable debt] problem by putting further pressure on asset prices. An ageing society implies weaker demand for assets, in particular housing. Research on the relationship between house prices and demographic variables suggests that demographic factors could dampen house prices by reducing property price growth considerably over the coming decades. If so, this would partially reverse the effect of demographic tailwinds that pushed up house prices in previous decades.
- Debt service ratios also point to current debt levels being on the high side. High debt servicing costs (interest payments plus amortisations) compared with income effectively limit the amount of debt that borrowers can carry. This is clearly true for individuals. Lenders, for example, often refuse to provide new loans to households if future interest payments and amortisations exceed a certain threshold, often around 30–40% of their income. But the relationship also holds in the aggregate.
- In all but a handful of countries, bringing debt service ratios back to historical norms would require substantial reductions in credit-to-GDP ratios. Even at the current unusually low interest rates, credit-to-GDP ratios would have to be roughly 15 percentage points lower on average for debt service ratios to be at their historical norms. And if lending rates were to rise by 250 basis points, in line with the 2004 tightening episode, the necessary reductions in credit-to-GDP ratios would swell to over 25 percentage points on average. In China, credit-to-GDP ratios would have to fall by more than 60 percentage points. Even the United Kingdom and the United States would need to reduce credit-to-GDP ratios by around 20 percentage points, despite having debt service ratios in line with long-term averages at current interest rates.
- Inflation can also have an effect. But the extent to which it reduces the real debt burden depends on how much interest rates on outstanding and new debt adjust to higher price increases. More importantly, though, even if successful from this narrow perspective, it also has major side effects. Inflation redistributes wealth arbitrarily between borrowers and savers and risks unanchoring inflation expectations, with unwelcome long-run consequences.
- The alternative to growing out of debt is to reduce the outstanding stock of debt. This happens when the amortisation rate exceeds the take-up of new loans. This is a natural and important channel of adjustment, but may not be enough. In some cases, unsustainable debt burdens have to be tackled directly, through writedowns. Admittedly, this means that somebody has to bear the ensuing losses, but experience shows that such an approach may be less painful than the alternatives. For example, the Nordic countries addressed their high and unsustainable debt levels after the banking crises of the early 1990s by forcing banks to recognise losses and deal decisively with bad assets.
- The conclusion is simple: low interest rates do not solve the problem of high debt. They may keep service costs low for some time, but by encouraging rather than discouraging the accumulation of debt they amplify the effect of the eventual normalisation. Avoiding the debt trap requires policies that encourage the orderly running-down of debt through balance sheet repair and, above all, raise the long- run growth prospects of the economy.
- Central banks played a critical role in containing the fallout from the financial crisis. However, despite the past six years of monetary easing in the major advanced economies, the recovery has been unusually slow. This raises questions about the effectiveness of expansionary monetary policy in the wake of the crisis. For instance, term premia and credit risk spreads in many countries were already very low, they cannot fall much further. In addition, compressed and at times even negative term premia reduce the profits from maturity transformation and so may actually reduce banks’ incentives to grant credit. Moreover, the scope for negative nominal interest rates is very limited and their effectiveness uncertain. The impact on lending is doubtful, and the small room for reductions diminishes the effect on the exchange rate, which in turn depends also on the reaction of others. In general, at the zero lower bound, providing additional stimulus becomes increasingly hard.
- Unless it is recognised, limited effectiveness implies a fruitless effort to apply the same measures more persistently or forcefully. The consequence is not only inadequate progress but also amplification of unintended side effects, and the aftermath of the crisis has highlighted several such side effects. In particular, prolonged and aggressive easing reduces incentives to repair balance sheets and to implement necessary structural reforms, thereby hindering the needed reallocation of resources. It may also foster too much risk-taking in financial markets. And it may generate unwelcome spillovers in other economies at different points in their financial and business cycles. Put differently, under limited policy effectiveness, the balance between benefits and costs of prolonged monetary accommodation has deteriorated over time.
- Unless it is recognised, limited effectiveness implies a fruitless effort to apply the same measures more persistently or forcefully. The consequence is not only inadequate progress but also amplification of unintended side effects, and the aftermath of the crisis has highlighted several such side effects. 2 In particular, prolonged and aggressive easing reduces incentives to repair balance sheets and to implement necessary structural reforms, thereby hindering the needed reallocation of resources. It may also foster too much risk-taking in financial markets. And it may generate unwelcome spillovers in other economies at different points in their financial and business cycles Put differently, under limited policy effectiveness, the balance between benefits and costs of prolonged monetary accommodation has deteriorated over time.
- Very accommodative monetary policies in major advanced economies influence risk-taking and therefore the yields on assets denominated in different currencies. As a result, extraordinary accommodation can induce major adjustments in asset prices and financial flows elsewhere.
- Policy responses matter too. Central banks find it difficult to operate with policy rates that are considerably different from those prevailing in the key currencies, especially the US dollar. Concerns with exchange rate overshooting and capital inflows make them reluctant to accept large and possibly volatile interest rate differentials, which contributes to highly correlated short-term interest rate movements. Indeed, the evidence is growing that US policy rates significantly influence policy rates elsewhere. Very low interest rates in the major advanced economies thus pose a dilemma for other central banks. On the one hand, tying domestic policy rates to the very low rates abroad helps mitigate currency appreciation and capital inflows. On the other hand, it may also fuel domestic financial booms and hence encourage the build-up of vulnerabilities. Indeed, there is evidence that those countries in which policy rates have been lower relative to traditional benchmarks, which take account of output and inflation developments, have also seen the strongest credit booms.
- Disruptive monetary policy spillovers have highlighted shortcomings in the international monetary system. Ostensibly, it has proved hard for major advanced economies to fully take these spillovers into account. Should financial booms turn to bust, the costs for the global economy could prove to be quite large, not least since the economic weight of the countries affected has increased substantially. Capturing these spillovers remains a major challenge: it calls for analytical frameworks in which financial factors have a much greater role than they are accorded in policy institutions nowadays and for a better understanding of global linkages.
Please read that list again. It’s quite a bit of snips, but it’s from a massive number of pages, and the ideas are very important.
My short take is that numerous points above politely (too politely) accuse the Fed of incompetence. Unfortunately, many other central banks followed.
The BIS is particularly concerned about risk taking, something hardly on the radar at the Fed at all.
Let’s now return to the question of today (yesterday to be more precise).
From ZeroHedge …
So what’s going on?
We could take all of this at face value if we chose: The BIS playing hawk, and the Fed playing dove. And that might well be the case — as to some extent Yellen is still something of an unknown entity.
But there is one more twist to the puzzle: Yellen has openly stated that she would not be offering clear guidance to the market as her predecessor had advocated. The age of Fed-glastnost is apparently coming to an end.
So indulge us for a moment as we present another possibility:
Yellen is going to orchestrate a controlled collapse. Or, at least one which we hope is controlled.
So just maybe the Fed fully intends on heeding the advice of the BIS, and is strategically positioning itself as a stalwart dove to shield itself from the public fallout of it’s orchestrated financial calamity.
To be completely fair, ZeroHedge did not write that. The original article was posted at NotQuant.
That said, ZH does get to choose what guest-posts he syndicates.
And unless ZH has lost his mind, there is no way he remotely agrees with the silliness of that post.
My first three thoughts when asked by reader Charles what I thought were as follows:
- Does the Fed know the difference between an asset bubble and my mom’s tuna casserole?
- Does the Fed know the difference between an asset bubble and a moon of Jupiter?
- Does the Fed care about asset bubbles even if it could detect them?
The idea the Fed understands there is an asset bubble is ridiculous. How many times did Bernanke deny the existence of a housing bubble until it exploded in his face?
Is Yellen any different?
Fortunately I had to spend zero time researching the preceding question.
As I was writing this article, Pater Tenebrarum at Acting Man pinged me with Janet Yellen Chimes in on the Bubble Question.
Risk? What Risk?
Fed chair Janet Yellen recently uttered what sounded to us like a stunningly clueless assessment of the potential danger the echo bubble represents. She indicated on the occasion that she was certainly in no hurry to raise the administered interest rate from its current near-zero level.
“I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns,” said Ms Yellen.
“That said, I do see pockets of increased risk-taking across the financial system, and an acceleration or broadening of these concerns could necessitate a more robust macro-prudential approach.”
“Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” said Ms Yellen.
Of course no Fed chair of recent memory has displayed even the slightest ability to recognize bubbles or to realize that they might pose a danger.
As to the remark about the “resilient financial system”, this is surely a joke. Does anyone remember how Fed officials and politicians (such as then treasury secretary Hank Paulson) were going on and on about the supposed ruddy health of the US banking system in 2007? Never had they seen the system in better shape than in 2007! By late 2008 it was close to complete collapse, but as they say, errare humanum est.
Credit Where Credit is Due
Does ZH really give Janet Yellen enough credit to recognize an asset bubble, then do something sensible about it?
I am 99.99% positive he doesn’t, yet that is precisely what the article suggests.
I propose Yellen is clueless. If she had any sense, she would have acted in advance to prevent an asset bubble or at least stall the one Bernanke had started.
The Fed is not going to attempt a controlled collapse. Yet, a collapse is coming. It will be anything but controlled.