Approximately 9 years after various “tin-foil” wearing blogs first warned that the long-run negative consequences of QE will drown out and vastly outnumber any positive ones (which have mostly been confined to make the rich richer and create the illusion of economic stability built on the cracking foundations of trillions in newly created dollars), none other than JPMorgan today admits that QE may, indeed, have some devastating financial, economic and political consequences. And by some, we mean a lot.
What prompted this exciting moment of monetary introspection?
According to JPM’s Nick Panigirtzoglou, it was last week’s report that the BoJ has expressed concerns over negative side effects of its QE current policies (especially keeping the 10Y yield fixed around 0%), and which resulted in a sharp, if brief, global bond steepening which demonstrated once again just how dominant central bank monetization policies are in determining the long-end of the curve.
And, as the market demonstrated, a hawkish policy shift and a subsequent reduction in duration absorption by the BoJ would intensify the quantitative tightening already in place by the Fed and the ECB, and according to JPM represents “a significant tail risk that has generated intense debate among our clients.”
So what are these possible ‘devastating’ side-side effects from unorthodox BoJ – and other central bank – policies?
Here is a list of the key negative consequences arising from QE, from JPMorgan:
1. Results in Asset Bubbles and a Collapse in CapEx: Even as QE has likely exerted downward pressure on bond yields, the significant increase in central banks’ balance sheets makes an exit potentially more difficult, and raises the risk of a policy error or of an increase in perceptions about debt monetization. It potentially creates asset bubbles by lowering asset yields relative to historical norms, that an eventual return to normality could be accompanied by sharp price declines. Perceptions about asset bubbles can thus also increase long term uncertainty. In turn higher uncertainty might prevent economic agents such as businesses from spending, i.e. the collapse in CapEx observed over the past decade as company used cheap debt to purchase their own, making management teams richer.
2. Creates Zombie Companies and Crushes Productivity. Low credit spreads and corporate bond yields are an intended consequence of QE but not without distortions. By allowing unproductive and inefficient companies to survive, helped by low debt servicing costs, QE could potentially hinder the creative destruction taking place during a normal economic cycle. In principle, QE could thus make economies less efficient or productive over time. Which should answer the long-running debate over the chronic lack of economic productivity in the new normal. The debate about so called “zombie” companies has been particularly intense in Japan given the low business turnover rate. According to OECD, Japan’s business startup and closure rate is about 5%, roughly a third of that in other advanced economies with several commentators blaming the BoJ’s ultra-accommodative policies for this problem.
3. Low Rates crush savers, make the rich richer. One of the most visible impacts of QE has been the decline in discount rates, which in turn has created wealth effects via supporting asset prices. However, an argument could be made that these wealth effects are not evenly distributed, and that low discount rates mean savers suffer from an erosion of income.
4. Exacerbates currency wars. QE could exacerbate so called “currency wars”. The value of the Japanese yen collapsed after Abenomics started in November 2012 and has stayed at historical lows since then helped by BoJ’s ultra accommodative monetary policy. This is shown in Figure 5 by the real trade weighted index of the Japanese yen. Japan’s main competitors across EM and DM have been feeling the pressure from this depreciation, though it is not clear that the depreciation necessarily means the yen is undervalued.
5. NIRP hurts the economy, and chokes off credit supply. Beyond a certain threshold, negative interest rates can have unintended consequences such as lower bank profitability, higher bank lending rates, reduced credit creation to the real economy, impaired functioning of money markets and reduced liquidity in bond markets. And there is a good reason to believe that the threshold below which negative rates start having unintended consequences is higher in Japan than in Europe, not least because of the lower interest margins Japanese banks operate with… Deeply negative policy rates had taken their toll on Danish and Swiss banks’ net interest income (Figure 6). Net interest income as % of assets declined in 2015 for both Danish and Swiss banks following the introduction of very negative policy rates in these countries in January 2015.
6. Chokes Repo markets due to collateral shortages. It is not only commercial banks that are hurt as a result of QE. Reduced liquidity in money and repo markets is another side effect. UST collateral shortages have hampered US repo markets. The BoJ and the ECB inflicted similar damage to European and Japanese repo markets as government collateral was withdrawn at an even stronger pace. An argument could be made that the damage to trading turnover and liquidity is likely to have been even bigger with the BoJ’s and ECB’s QE relative to the Fed’s QE, because the BoJ and the ECB went even further than the Fed by lowering its policy rate to negative territory. Negative yields can hamper trading volumes and liquidity as money market participants are less willing to trade at negative yields.
7. Cripples pension funds by increasing funding deficits. Lower bond yields increase pension fund and insurance company deficits putting pressure on pension funds to match assets and liabilities. This pressure to move further away from equities and other high risk assets into fixed income is even stronger in countries like Japan where demographic pressures are more intense. For example, old age dependency ratios, i.e. the proportion of the population aged 65 years and over as a percentage of the population aged 15-64 years, have been rising steadily, with Japan aging more rapidly than the US or Europe (Figure 1). Generally, an aging population means that allocations are likely to shift towards relatively safer instruments as the ability to withstand larger drawdowns on capital diminishes as individuals age.
What is striking in Japan is that in contrast to GPIF, which shifted towards equities post Abenomics most likely under political pressure, private Japanese pension funds did the opposite shifting even more towards bonds (Figure 3).
8. QE Forces consumers to save even more. The yield-to-worst on the Bloomberg Global Agg Yen denominated bond index currently stands at close to 0.15%, around one-sixth of its average in the expansion preceding the financial crisis. In addition to the effect of deleveraging after the financial crisis and the Euro area sovereign crisis, QE has played a role in pushing down on long-term yields. Particularly the QE programs of the BoJ and ECB which have seen net issuance of government bonds outside of the public sector balance sheet turn negative, not just in their domestic economies but for the G4 on aggregate (Figure 4).
These low yields in turn depress the income that investors receive from bonds, inducing them to save even more, in the process making a mockery of the key “widely accepted” economist axiom behind QE.
9. The rise of populism and extreme political frictions. A longer-term tail risk created by QE is the potential for political frictions, which could escalate in the future especially once QE becomes a negative carry trade for
central banks, i.e. when the interest on excess reserves starts rising above the yield they receive on their bond
holdings.
JPMorgan’s punchline:
These political issues could become a big problem in Japan if in the future Abenomics, including BoJ’s ultra-accommodative policies, are perceived as a failed experiment that brought limited benefits to the Japanese economy and society.
Now if readers expand what JPM said about the failure of QE in Japan, they may be reminded of the piece “An Orgy of Blood” by the UK’s Clarmond Wealth, whose conclusion we repost below because with every passing day, the world it previews gets closer:
When historians look back and see the cavalier balance sheets of the central banks they would rightly assume there was a world war going on as every central bank balance sheet is now approaching or exceeding levels not seen since 1945. However, the worrying truth is that there are no external enemies to overcome; the central bankers are only maintaining the growth trajectory that we demand.
The age of sloganeers
The current social contract is mired in the quicksand of global finance. It is being kept alive by the corpulent balance sheets of central banks, who do their government’s bidding so that the politicians do not have to put unpleasant choices in front of their electorates. This cowardly behaviour gives rise to slogans and sloganeers, who provide familiar but false checklists of remedies. “Take bank control”…”America First”…”One Belt, One Road”…”Ein Volk, ein Reich, ein Fuhrer”…”One Man – One Kill”. Central banks are currently furnishing the excess credit that, in the past, has been followed by an orgy of blood.
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