“When the music stops,” Chuck Prince famously observed back in mid-2007, “things will get complicated”. The then Chief Executive of the US banking giant Citigroup was admitting that growing concerns about sub-prime loans could ultimately shatter what we now know was “irrational exuberance” on global financial markets.
“As long as the music is playing, though, you’ve got to get up and dance,” Prince continued. “And we’re still dancing”. There’s a “we’re still dancing” mood on global markets today, just as there was six years ago, in the run-up to what turned out to be the disastrous market melt-down of September 2008.
Rather than the securitization of recklessly extended commercial credit providing the music, the beat now comes from “quantitative easing”, courtesy of the world’s leading central banks.
The Dow Jones Industrial Average is up 15pc since last September, after the Federal Reserve launched QE3, its third round of money-printing. The Eurozone’s Stoxx 50 has soared also, gaining 30pc since July, when European Central Bank President Mario Draghi vowed to do “whatever it takes” to save the euro.
The Nikkei 225 has rocketed 44pc since late December, after the election of a new government committed to forcing the Bank of Japan to crank up its QE antics. The UK’s FTSE-100, too, has gained 20pc in 6 months, riding a wave of Bank of England largesse – and, crucially, the prospect of more to come.
The Western world is yet to stage a meaningful recovery from the sub-prime debacle. The fundamentals remain awful. The Eurozone economy, we learnt last week, contracted 0.9pc during the first quarter and has now been shrinking since late 2011 – Europe’s longest post-War recession. The UK is still enduring its slowest recovery since records began. Yet Western stock indices have been setting repeated all-time highs.
As financial markets dance, though, lost in the QE trance music, massive questions now loom. The ECB has expanded its balance sheet 150pc during the five years since the sub-prime collapse. The Fed has overseen a 220pc ballooning of base money.
“Extraordinary measures” on this scale may be unprecedented but both look moderate compared to the Bank of England, which has implemented balance sheet growth of 370pc since the credit crunch began in earnest, the vast majority of it, in a bizarre form of circular financing, being used to buy government bonds.
How will these vast balances be unwound? What will happen to sovereign bond prices once governments stop self-buying? That will truly determine, rather than any “forward guidance”, just how long our central banks can keep interest rates “ultra-low”. And what will the reaction of currently spaced-out Western equity markets be once the sugar rush fades, reality hits and the money-printing ends? What happens when the QE music stops?
Some of us have posed such uncomfortable questions for years now – and been derided for our trouble. In recent weeks, the now vast scale of QE, and its broader collateral damage, have forced such issues into mainstream discourse. Flickering signs of returning Western growth have also brought official recognition that such measures may soon be hard to justify and that, to paraphrase Chuck Prince, things could indeed “get complicated” when the lights come up and the QE party is over.
Last week, the International Monetary Fund acknowledged that, having strayed into “uncharted waters”, central banks will find the QE exit “difficult to control”. The world’s leading economic watchdog recognized, in an official paper, that long-term interest rates could spike as investors demand higher yields to fund cash-strapped governments, with commercial credit risks also rising as higher rates make it harder for borrowers to service loans.
Presenting his final quarterly Inflation Report before his July retirement, Bank of England Governor Mervyn King also warned that post-QE complications mean that rates “may rise faster than current market expectations” of no increase until late-2016.
The IMF also nodded to “diminishing returns” in continuing with QE. That states the case rather mildly. QE and the related slashing of interest rates to deeply negative real-terms levels has not only hammered pensioners and other savers but stored up a world of future inflationary pain.
With many large Western banks still moribund, and massive undeclared losses on their balance sheets, QE hasn’t resulted in more growth-generating working capital being extended to creditworthy firms and households. It’s gone instead into asset markets, bidding up not only shares but also oil and basic foodstuffs on global exchanges.
That’s pleased the City and Wall Street but done serious real world damage. Expensive energy has made Western recovery much tougher while soaring food costs have led to a wave of unrest across the developing world, arguably sparking the Arab Spring.
And, while we’re at it, QE has also deeply annoyed the governments of powerful Western creditors like China and Brazil. By inflating their currencies, our money-printing has harmed their exports. It’s also debased the dollar, pound and euro, so lowered the real value of what we owe. That’s a principle reason why the World Trade Organization is in turmoil, with the increasing strident emerging powers in open revolt and the world economy suffering the first failure of a multi-lateral trade negotiation since the 1930s. So, yes, you could say that QE now has “diminishing returns”.
Given the massive regulatory mistakes that had already been made, no-one is arguing that central banks shouldn’t have provided extra liquidity in the dark days of early 2009. Had they not, the Western financial system would have collapsed, causing economic and social chaos. Yet that extra liquidity should have been strictly limited, heavily conditional and used as a buffer, allowing us to flush out the rotten banks, implement root-and-branch reforms and move on.
Instead, QE has become an open-ended life-support mechanism for living-dead “zombie banks”, a mask to cover up financial wrong-doing. It’s also become a comfort blanket for politicians, allowing most of them to delay the really tough fiscal decisions. Money-printing on the scale we’ve seen has gone way, way beyond a necessary palliative and been transformed from legitimate temporary emergency measure into lifestyle choice – the economic equivalent of crack cocaine.
File the IMF’s calibrated hair-splitting nonsense in the historical dustbin and read instead a brave and important speech given last week by Jaime Caruana of the Bank for International Settlements, an umbrella group for the world’s central banks.
“Monetary policy can buy time to implement the necessary balance sheet repair and structural reforms,” thundered Caruana. “But it cannot substitute for them”. I couldn’t have put it better myself. “After five years of buying time, one has to ask if that time has been – or will be – used wisely”.
Asking aloud if “ever more monetary action” is “really justified”, Caruana observed rightly that on-going QE “gives borrowers, financial institutions and policymakers an incentive to keep kicking the can down the road”.
Tackling the myth that governments and firms really have been tightening their belts, the BIS boss reported that since the end of 2007, the total public and private debts of the world’s leading economies have risen by more than $30,000bn.
Challenge Western politicians finally to shake-out the banks, and impose supply-side reforms, Caruana concluded by asking: “What monetary policy can substitute for balance sheet repair by banks and borrowers … or remove impediments to a worker moving from an overbuilt sector to a more promising one?”
The speech was an onslaught of common sense, a tour de force. So sensible was it, in fact, that it’s destined to be ignored.