European Stocks, Anyone?

By now it has become trite to point out that the Chinese word for crisis is written by combining the characters for danger and opportunity.  That this is, in fact, not true doesn’t detract from its usefulness in the service of sophistry.  In that spirit, let’s take a peek at the ongoing crisis in Europe.

The global financial crisis that began in America in 2007 is currently on an extended tour of the European continent, with a focus on the warm, sunny nations along the Mediterranean.  So many pixels have been spilled on this subject that you’ll be forgiven if your eyes start glazing over.  We’ve all read ad nauseam how the profligate and aptly named PIGS (Portugal, Italy, Greece and Spain) brought this upon themselves through poor fiscal management and, in some cases, by outright cooking of the books.  Meanwhile, according to this story, the heroic Germans, after doing the right thing and keeping their own house in order all these years, are being blackmailed into bearing the cost of bailing out their lazy southern neighbors.  We’re told that the alternative is the end of the euro and, therefore, financial Armageddon.

This conventional narrative has it backwards.  In other words, the prospective break up of the euro is less of a danger and more of an opportunity.  Rather than viewing the European status quo ante as some sort of ideal economic equilibrium that was rudely disturbed by the US financial crisis, which spread like a malignant tumor to Europe and beyond, let’s recognize that the euro itself is the underlying cause of the disease.

Remember that the euro was always a political project.  That is to say, its creation was the culmination of decades of political integration with the objective of binding Germany to its neighbors and preventing another catastrophic war.  Although this integration has manifested itself in large part via the establishment of economic institutions such as the EEC (European Economic Community, later renamed simply the European Community, or EC), economic factors have always necessarily taken a back seat to this goal.  And the fact is that despite the inarguable progress made by Europe in terms of liberalizing trade and capital flows, the continent has never been an optimal currency area.  Unlike the United States, for example, the nation states of Europe don’t share a common fiscal policy and, in practice, workers enjoy relatively limited labor mobility from one country to another.  Thus two essential mechanisms for smoothing economic adjustment across the eurozone are absent, thereby forcing adjustment onto labor and markets for non-tradables to such an extent that political upheaval is the inevitable result.

The adoption of the euro led investors to change their behavior in ways that increased risk in the system, in the mistaken belief that currency risk had been eliminated.  The word convergence, as in the convergence of sovereign interest rates, was thrown around a lot in those heady days.  The most obvious example was the collapse in Greek sovereign borrowing costs following its entry into the eurozone, and the massive cross-border purchases of Greek sovereign debt.  Combined with the hyperleveraged nature of the European banking system, this created the recipe for an eventual crisis.

With this background in mind we can start to view the impending break up of the euro from a more optimistic perspective.  The euro imposes a rigidity on markets that forces an economically painful and politically impractical reduction of domestic wages and prices.  Removing this constraint would act as a safety valve, allowing movements in exchange rates to perform some of the required adjustment.  This occurs in two ways.  First, it permits an immediate improvement in the external balance, forcing foreigners to absorb some of the economic pain.  And second, it facilitates the reintroduction of a mix of fiscal and monetary policies that is appropriate for a country’s particular economic circumstances.  This is just a roundabout way of saying that it allows a government to use inflation to pay part of its bills.  This may sound cynical, and to some hard money advocates even unethical, but given current debt loads and ongoing fiscal deficits in a number of developed countries, there’s really no practical alternative to this.

Naturally there will be risks in the wake of such a shock.  Defenders of the euro argue that the dismantling of the common currency would unleash financial chaos and impose enormous costs on banking systems across Europe.  Contagion would be impossible to contain.  To these people I simply say, “Look around.”  We’ve already had chaos for at least two years.  Neither banks nor sovereigns are able to fund themselves via markets at acceptable terms in a number of countries.  There’s been a slow but steady ongoing run on bank deposits.  And as for the potential costs of writing down banks’ holdings of peripheral country debt, I would argue that these losses have already been born and we’re now just waiting to see whether they’re ultimately recognized in the form of default, devaluation or some combination of the two.  Banks all over Europe will need to be recapitalized regardless of whether Greece and/or other peripheral countries continue to use the euro.  You can’t squeeze blood from a stone, and debts that can’t be repaid won’t be, no matter what you call the unit of account.  The redenomination of contracts is likely to be a trivial problem when compared to the prospect of suffering many more years of grinding deflation.

What are stock markets in the eurozone telling us?  Well, the euro has also taken its toll on equity prices.  With the notable exception of Germany, which has of course been the primary beneficiary of the common currency, most markets across the region are trading at levels seen 15 years ago and at PE ratios of 9x or below.  These valuations are comparable to those seen at the start of the great bull market that began in 1982.  Stock prices in Greece are down 90% from their highs and are at more than 20 year lows.  Spanish stocks are down nearly 60% from bull market highs.  Italy is down more than 70%.  Even France is off 55%.  Thanks in large part to the euro, European stocks have been mired in a severe bear market for a number of years.

According to the politically incorrect narrative to which I subscribe, the euro is a straight jacket, the removal of which provides hope of recovery within a reasonable time frame.  Countries on the periphery of Europe have the choice between devaluation followed by some short-term pain, then eventually by recovery; or a cycle of perpetual deflation, fiscal retrenchment and political crisis.  Stock markets across the region have priced in the danger of this latter outcome, and therein lies the opportunity.

Liquidity Preference and Why QE Doesn't Matter

Following up on the previous post, I wanted to talk a little bit about a concept called liquidity preference.  Traditional Keynesian economics posits an inverse relationship between the demand for money and the level of interest rates, at any given level of income.  Empirically there is quite a strong fit in the data, such that a graph of the monetary base per unit of nominal income against the level of interest rates looks more or less like a parabola:


source:  www.hussmanfunds.com

As far as it goes there isn't much to argue with here.  Clearly there is a strong inverse relationship between the demand for money and the level of interest rates---as rates fall the opportunity cost of holding money falls and the impetus to put one's money to work recedes.  Using this as a starting point, let's think through the implications of a potential rise in rates, now that the size of the Fed's balance sheet (i.e., the monetary base) has expanded so dramatically in the recent past.  Given that we're currently in the lower right corner of this graph, even a modest increase in rates implies a sharp rise in nominal GDP absent a significant reduction in the monetary base---in other words, we should expect a big rise in prices.

Now let's think back to the previous post and ask why this might not be the case today.  How is the level of reserves determined?  Well, the simple answer is that the Fed creates them in the process of buying Treasuries.  In fact, it can be shown that the level of reserves in the banking system as a whole is almost completely determined by the central bank's decision to sell or purchase assets (usually Treasuries but in recent years including various other assets).  Although it's possible for an individual bank to reduce its reserves, it's not possible for the banking system in aggregate.  There's a good explanation of this in a July, 2009 paper from the New York Fed.

But, as discussed last time, from the perspective of the banking system, in a world where reserves earn interest they are also a near substitute for Treasuries.  Banks decide on the optimal mix of risky and riskless assets.   In this framework the level of reserves, which we know is determined by central bank policy, is simply a component of the banking system's riskless assets.  Since today banks are continuing to increase their holdings of Treasuries, over and above the buildup of their reserves resulting from the Fed's policy actions, we can assume that the banking system wants to hold at least as many riskless assets as the Fed has created in reserves.  Thus, if the Fed hadn't bought all those Treasury securities, the banking system would have done it instead.

The above logic is why I feel confident in saying that, given the current circumstances, QE hasn't mattered---the Fed has just bought riskless assets that the banking system demanded anyway.  Of course, one could easily imagine a scenario wherein the Fed is growing its assets faster than the banking system would choose to, leading to an effort by banks to reduce the relative size of their reserves by expanding their balance sheets.  In fact, in looking at the state of the banking system today I wonder if we're not getting there.  Absent a reduction in the size of the public sector borrowing requirement or a rise in interest rates that is likely to be in our not-so-distant future.

So now what could happen when interest rates rise?  Should we be concerned about latent inflationary pressure, in the absence of a proactive reduction in the level of reserves?  In a world where reserves earn the same rate of interest as Treasuries the answer is no, since a rise in interest rates has no bearing on a bank's willingness to hold reserves (the rate it earns on those reserves goes up).  Of course, if the Fed ceased paying interest on reserves, or paid a rate much below the rate that banks could earn on other riskless assets, banks would attempt to reduce the relative size of their reserves, and the only way the system can do that in aggregate is by expanding its balance sheet.  The result would undoubtedly be inflationary.

All of this is a long-winded way of saying that as long as bank reserves earn interest comparable to Treasuries, a rise in interest rates is unlikely to trigger inflation, contrary to what is predicted by economic theory.  How's that for a mind twister?

Thoughts on QE, Inflation and Markets

Working in the hedge fund business and investing in the financial services sector, I spend a lot of my time trying to understand the interactions of monetary and fiscal policy with financial markets.  In the wake of the financial crisis, governments around the world have undertaken plenty of unorthodox policy measures, with varying degrees of success or perceived success.  Recently  I've been trying to better understand QE, the nickname commonly applied to quantitative easing by the US Federal Reserve or other central banks.

Lots of ink has been spilled on the subject, though it seems that the ultimate impact of the policy is still not well understood by pundits or market participants.  In general there seems to be a consensus that the current round of QE2, started last year, is evidence of ultra-loose monetary policy and that the inflationary pressures we're seeing around the world are the inevitable result.  Although I'm not denying that various measures of money have increased sharply since the crisis,  blaming this on QE or even on the Fed is an oversimplification or even a misrepresentation.  Since QE2 is slated to end in another two months and the implications for markets are considered to be significant, I thought it might be useful to go step by step through the mechanics of QE.  The conclusions may surprise you.

One unassailable fact is that the Federal Reserve has dramatically expanded the size of its balance sheet over the past several years.  Note that since before the crisis began in 2008 the Fed's assets have just about tripled.  As its assets have expanded so, mechanically, has the monetary base.  On the surface this sounds like an open and shut case:  The Fed has consciously expanded the money supply, and the price of oil and gold, etc. is soaring as a result.

But what exactly is the monetary base, how is it composed and how does its growth impact financial markets?  Well, in fact the monetary base is simply the liabilities of the Fed.  Historically these liabilities have overwhelmingly consisted of currency in circulation.  That's why they're called Federal Reserve Notes:  they're the debts owed to their holders by the Fed.  In the days of the gold standard you could take your dollar to the Federal Reserve and ask for the equivalent value of gold that backed it.  Now try that and you'll get...a dollar.  Anyway, the point is that until the crisis happened the monetary base, i.e., the liabilities of the Fed, consisted mostly of cash.

In October 2008, at the height of the financial crisis, the Federal Reserve announced that it would begin paying interest on reserve deposits by financial institutions.  These reserves are the second main component of the monetary base, which makes intuitive sense since deposits are an obligation to the depositor by the institution that holds them.  Notice what's happend to the level of bank reserves held at the Fed over the past several years:  They've gone from almost nothing to about $1.5tn.  Meanwhile, currency in circulation has grown by only about $200bn to around $1tn.

Let's step back now and think about what QE2 has meant in practical terms for the various participants in the market for government debt.  In the first place, the Treasury issues bonds to the Fed, which obligingly presses a button and creates a credit on the Treasury's account.  Now the Treasury takes its new money and buys guns, butter and builds bridges (to nowhere?).  The money it spends winds up in the hands of people and businesses that in turn deposit it in the banking system.  At this point the banks now have the money in their vaults and must decide what to do with it:  make risky loans or hold riskless assets?  In the past the only interest-paying riskless assets banks could hold were Treasury securities, but since 2008 they have the choice to put their excess reserves on deposit at the Fed and still earn interest on them.  In fact, the rate paid by the Fed on excess reserves, although low at only 0.25%, is still higher than the derisory few basis points earned on Treasury securities all the way out to one year on the yield curve.

From the point of view of a bank, what's the practical difference between buying Treasury debt and putting the money on deposit at the Fed?  I think the answer is pretty clear:  There is no difference.  Both have the same sovereign risk characteristics and the same liquidity.  If the Fed is offering 25bps and the Treasury 5bps, excess reserves at the Fed will increase, and that's exactly what we've seen.  And overall, riskless assets in the banking system have grown by about $2tn since 2008, mainly in the form of excess reserves.  The fact is that banks don't (yet) want to make new loans, since the value of real estate collateral has continued to be weak, as has demand for credit from creditworthy borrowers.

So although there's no practical difference from the bank's point of view whether it holds Treasuries or reserve deposits at the Fed, it does have vastly different implications for the measurement of the monetary base:  In the latter case the monetary base grows and in the former it doesn't.

At the moment we have the Treasury borrowing money from the Fed, which is in turn funded by the banks, who are ultimately funded by depositors, whose deposit growth is a result of debt-financed government spending.  The Fed is nothing but a conduit through which the banking system is lending to the government.  Banks have demonstrated that they don't want to make new loans to the private sector but instead want to increase their holdings of riskless assets.  Importantly, this would be the case whether or not the Fed embarked on its policy of QE.  Thus, if the Fed decided to unwind its QE the government debt that is currently sitting on the Fed's balance sheet is likely to end up on the balance sheet of the banking system, assuming that banks don't yet want to expand their loan books.  The counterintuitive conclusion of this analysis is that QE doesn't matter!

Then where does inflation come from in this system?  There are two channels.  First, notice that on bank balance sheets, although private sector loans are still shrinking, loans to the government, either directly in the form of Treasury securities, or indirectly as excess reserves held at the Fed (and then lent on to the Treasury by the Fed), have grown more than private sector loans have shrunk.  As a result, bank balance sheets in the aggregate have continued to grow throughout the post-crisis period.  All this has been funded by healthy deposit growth, including both checking and savings deposits, so broader measures of the money supply are also growing.  As noted above, this deposit growth is a direct result of increased spending by government.

Our fractional reserve banking system is replacing the private debt on its balance sheet with public debt.  If the government continues to borrow and the banking system is willing to lend to it, this cycle has the potential to be highly inflationary:  Since the capital requirements for holding Treasuries are effectively zero, the money multiplier on this additional borrowing is theoretically limited only by the desire of government to spend beyond its means and the willingness of banks to hold government debt.

The other channel by which inflation has percolated through the system is not directly related to the size of the Fed's or the banking system's balance sheets.  Instead, overnight interest rates of close to zero have driven required returns on alternative financial and hard assets towards zero.  I think we could argue about whether or not the Fed is artificially suppressing the level of interest rates---after all, banks seem more than happy to be rapidly expanding their loans to the government at interest rates of close to zero.  Nonetheless, the current level of rates is undoubtedly leading to increases in the prices of certain scarce assets as the opportunity cost of holding these assets has disappeared.  This perceived inflation is really a change in relative prices rather than a generalized inflation, though from the point of view of consumers of scarce commodities it probably feels about the same.  It's important to understand that this commodity hoarding has nothing to do with QE, per se, but follows logically from the current structure of interest rates, which is not directly impacted by QE2 except insofar as the Fed is willing to hold longer term government debt than would be preferred by the banking system directly.  Presumably an increase in the level of rates has the potential to deflate this bubble as rapidly as it inflated it.

The bottom line is that QE per se is not the source of inflation in this system.  Inflation is the result of debt financed spending by the government accomodated and multiplied by the fractional reserve banking system,  and by zero interest rates and resultant commodity hoarding.  The end of QE in a couple of months is thus not by itself going to lead to a reversal in the rise of commodity and other asset prices that has characterized the past couple of years.  Logically what we should be watching out for are signs of lower government borrowing and an explicit rise in interest rates.  Might we be closer to one or both of those than the markets currently expect?