The Big Easing – QE and the big picture

The Big Easing – QE and the big picture

15 May 2013

The financial press always loves to offer sage rationalisation for asset price movements after the event. (Have you ever tried forecasting the future? It’s darned tricky). Today, we have enjoyed months of a rising stock market. Sub-investment grade financial analysis always thinks it is wrong (possibly morally wrong) for share prices not to reflect the perceived state of the economy. The UK economy has barely avoided a triple-dip recession but the FTSE 100 is +14% in the last six months. Problem for Johnny Journo. Someone or something must be blamed for this abuse of reason.

Consequently, the financial commentating community now “gets” quantitative easing (QE). There is the basic point that central banks buy “safe” long term assets (government bonds) for cash, thereby simultaneously supporting the price of those assets and putting cash in the hands of the sellers. The theoretical justification for this is that it curbs panic in a time of crisis and keeps the banks (which invariably own mountains of junk assets at the top of the market) solvent while someone works out whether they are worth saving.

The second rationalisation of QE is that eventually it will stimulate growth. With savings rates driven down, all those liquid assets will start to be spent.

The third rationalisation, favoured by fans of conspiracy, is that QE will boost inflation and reduce the real value of public and private debt at the expense of prudent savers.

As far as the rise of the stock market is concerned, the first rationalisation of QE looks good. Japan announced at the start of this year that it will significantly expand QE (so-called Abenomics) and its stock market is has jumped by 45%. Inevitably, there is much discussion trying to justify this economically – for some it is Yen devaluation, for others, domestic spending stimulation – but why go beyond the observation that there is extra cash chasing a diminishing supply of financial assets?

In the UK, the high prices and low yields of government bonds still make the value of equities relatively attractive. Obviously that attractiveness diminishes as share prices rise but there are still plenty of financially sound companies yielding >3%, which, with inflation at 2.8%, is the minimum level for a real yield. 10 year gilt yields are still <2%. Most savers will be aware that there is not a single bank or building society account that pays a real yield at present. One is obliged to conclude that they do not particularly want our money. This is not a bullish indicator for the economy.

So what of the idea that QE will stimulate growth? This is an attractive idea to those who still want to believe that the stock market rally is anticipating economic recovery. The trouble is that QE was fundamentally a huge response to a huge crisis. As long as the one persists (the response), it is rational to imagine that the other (the crisis) has not gone away. So, one could argue that, far from being a growth stimulator, QE sends the persistent message that we are not out of danger.

It is worth putting UK QE into numbers. In 2008, the Bank of England owned a negligible amount of gilts. At the end of 2009, it owned £190bn worth, or 24% of the total outstanding (£796bn). By the end of last year, it owned £398bn, or 29% of the total (£1354bn). Somewhat surprisingly, foreigners have also been net buyers over this period: indeed, they have actually increased their share of the total outstanding from 27% to nearly 31%. The share of gilts owned by either foreigners or the Bank of England has risen from 35% in 2008 to 60% now. That means that domestic institutions have effectively liquidated long-term assets equal to around 25% of the gilts in issue. To abandon numbers for a moment, they are drowning in cash. No wonder that savings accounts pay negative real rates.

What is the practical effect of this? It means that the economy is effectively on ice. The banks are holding extra cash reserves because the losses from the financial crisis have not played out. The housing market is being propped up by low interest rates and a highly controversial (to put it politely) government policy to subsidise the purchase of properties that buyers cannot afford. Note that this has the extra effect of again protecting the banks from having to realise potential losses from previous mortgage loans.

QE is ultimately a massive exercise in fixing asset prices for the purpose of saving capitalism (if you want to put it like that). Oh, the irony!

Yet we have no need to get shirty (or snippy) about this. There is no morally correct price for assets. Our nation’s policy is to save its banking industry at all costs. Moreover, this policy is vigorously pursued in Europe too. Much of the debt of the scary “peripheral” countries is owned by stupid banks in sensible countries like Germany and France. Although it is probably never explained to him in this way, the German taxpayer’s implicit underwriting of southern European debt is a hidden rescue of his own country’s banks. It is perhaps to the credit of the UK that its own banking rescue was quicker and more explicit (though not as quick and explicit as in the US).

Doing “whatever it takes” to prop up the banking system might be an insane policy that is never articulated in public, but once we understand it, we can act accordingly.

The conspiracy theory that the true policy is to erode the value of debts and savings through inflation is not quite plausible in my view. It is very hard to turn up inflation until the most important resource – labour – is in short supply. I see no sign of that, either in company profit and loss accounts, where labour costs invariably seem to drift down as a proportion of revenues, or in the bars and restaurants of London where native English speakers are as elusive as ever among the staff (though not among the customers).

Nevertheless, even today’s modest inflation rate of 2.8% is hurting risk-averse savers and potential pensioners, who are about to be offered pitiful annuity rates. The economy is flooded with cheap money but it has turned into ice. So what to do? The advice of this website continues to be that financially sound equities are relatively cheap. Tracker funds with low charges are available for those too lazy or nervous to pick stocks.

With interest accounts paying so little, it should be understood that you now have to pay – in real terms – to keep your money “safe”. If you store your savings in one of our country’s finest banks it might pay you 1%. After a year, each £1.00 will be worth £1.01 in nominal terms but just £0.9825 at today’s prices. After five years, with inflation continuing at 2.8%, your £1.00 will be worth £0.923 at today’s prices. Your savings will be melting faster than the economic ice.
I was taught that saving is a smart and moral thing to do. There is much merit in this attitude but it is not a rule. The big picture of investment includes the notion that at times it is rational to spend or even to give away money – your money, your choice.

It may be that the second rationalisation of QE – that it will stimulate growth – will prove to some extent correct, in the long run. In the long run we will be dead and, just prior to the end, we might regret not having invested more in living. Personally, I have the ambition to invest in a musical exploration of the cities along the Mississipi, ending up in New Orleans aka The Big Easy.

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