Most recessions start when capital flees one asset class for another, in 1929 the Wall Street crash started as the savvier investors sold out of stocks and went to cash.
When the crash actually happens, confidence is eroded, people want to horde cash, but those who have incurred losses need to withdraw their long-term cash to cover losses. Spending is reduced, profits fall, and banks don’t want to lend, so businesses struggle to get the capital they need. Jobs aren’t created, exacerbating the crisis, and reducing confidence. The lower levels of economic activity then hit government revenues, this is likely to create a budget deficit and force the government to borrow.
In such a climate, those who have capital to deploy, tend to place it in safe haven assets, primarily cash and government bonds.
Recent decades have seen panoply of solutions prescribed to solve the problem. The remedy to emerge from the carnage of the 2007 financial crisis tried to square the various circles left rudderless by the credit crunch is a suite of policies known as ‘quantitative easing.’
The policy implies that two events are occurring in an economy mired in recession, the first is that banks are reluctant to lend to businesses and consumers, the second is that lots of cash will go into government bonds on the assumption that governments will always be able to make the payments, so the bonds are a ‘safe haven’, rather than the riskier, but probably more growth friendly asset classes.
Because an economy will always struggle to recover if there is a lack of availability of capital and credit, quantitative easing seeks to change this in two ways.
The first is that QE makes available at exceptionally cheap rates, credit lines to commercial banks. The theory is that those banks will take advantage of the cheap credit available to them, and increase their lending to the private sector, with the risk to the commercial banks lessened because they can finance the lending so cheaply.
The second impact, and perhaps the one more often remarked upon, is central banks creating money and using it to buy the bonds of their governments. The theory behind this is that by instigating such a large bond buying programme, the price of the bonds rises and the yields (interest rate) will fall because the demand is so high.
This reduces the attractiveness of the safe haven asset class that is government bonds, and, so the theory goes, pushes some investors into the asset classes that are more risky, but also more likely to support economic growth.
The first years of the last parliament were replete with querulous politicians lambasting the lack of lending by the commercial banks and muttering darkly about the rather rustic remedies that should be deployed to force the banks to lend more. In addition, those who may want to do the borrowing were faced with public spending cuts by their government, and worried about how this would impact on their business or household income. Such a climate is not usually the place where a desire to take on more, debt, however cheaply or available, that debt may be.
If there was a lack of lending, it was because of the somewhat singular nature of the last financial crisis. It was, to a huge extent, caused by the commercial banks lending too much and retaining insufficient capital to cope if the raucous capitalism of the late ‘90s were to come to a ruinous end.
The response of those who regulate the banking system was, perhaps rationally, to force the banks to retain more capital relative to the volume of deposits they hold.
So whilst the central banks were taking measures to increase the level of lending, the regulator was, essentially simultaneously, restricting the amount those same banks could lend out.
The second part of the equation, forcing bond yields down and cash into riskier assets has happened, though perhaps to a lesser extent than many had forecast for the simple reason that as long as the cost of the capital is low, then investors will accept a lower yield on their bond investment, this has helped to propel the bond market firmly into ‘bull market’ territory, but may have hindered the growth of the wider economy as the cheapness of the cash caused it to be deployed into assets that were not the most efficient for the economy, which is almost the definition of a bubble.
When investors, burned into a cautious mindset by the losses of crisis found that they could access liquidity quickly, they took the rational step, of moving to the next least risky assets after cash, bonds and property.
This is why yields on almost every part of the bond market have compressed so much, whilst property valuations raced ahead of economic and wage growth.
As QE rumbled even further on, the liquidity began to drip into the stock market, causing equity markets in the US and UK to accelerate rapidly, even as the earning of the underlying companies moved at a more pedestrian pace.
The much celebrated fund manager Neil Woodford summed up the impact of QE on equity valuations with the remark, ‘the stock market has gone up a lot, the economy has gone up by much less, the gap between the two, that is QE.’
But the deeper problem is that, whilst QE may have by now achieved some of its central aims, economic growth remains mordant around the globe.
GDP growth generally comes when policy makers achieve a multiplier effect in the economy. The multiplier is the factor that increases efficiency of the assets currently in the economy.
So economic growth should happen in a sustainable way when Old GDP number x Multiplier = New GDP number.
Policy makers moving liquidity from up and down the risk curve of asset classes prevents the system seizing up, and stops, as the Bank of England noted in its own 2012 report into the impacts of QE that it ‘prevented a much deeper recession.’
But whilst it may have put a bottom on the impact of the credit crunch, Simon Edelsten, manager of the Artemis Global Select fund told What Investment that, ‘to get the sort of growth that comes from a multiplier effect you need there to be animal spirits, and animal spirits come when people feel confident enough about their own economic prospects.’
‘Animal Spirits’ is a term that was first coined by the prominent British economist JM Keynes to denote the time period in an economy when the general population start to feel that there circumstances are improving.
Edelsten believes that, despite economic growth showing through, a wide range of factors have delayed the arrival of animal spirits in this recovery.
The factor amongst those factors that is the consequence of QE is the rise in house prices, even if your income is rising, if your rent is rising, or you can’t get on the housing ladder, then the animal spirits are unlikely to arrive. QE is one of the drivers that pushes house prices up.
Edelsten also noted that many retirees and others who live off their savings will have been feeling poorer, and not have animal spirits.
But the debate on the efficacy of QE will continue to rage as long as interest rates, in general, continue at their current very low level.
This is because with the cash to buy being cheap, and the cash being plentiful meaning there is always a buyer, whatever the asset class, market participants have been gulled into believing that the current market is somewhere near normal.
Stephanie Flanders, the former BBC economics editor who is now chief market strategist at JP Morgan, commented that, ‘investors have enjoyed record levels of return with record low volatility, that cannot continue.’
Yet as this decade rumbled on, it must have seemed as though the party couldn’t end, with the day of reckoning receding further and further into the future.
But the problem with an economic recovery based on cheap and plentiful supplies of cash and liquidity, is that in time, the supply of those drivers to the economy must be constrained.
The first step to constraining the liquidity in the system is to simply stop creating new money, this has already happened, with the UK and US QE programmes having finished some time ago. The announcement by the US Federal Reserve last year that it would ‘taper’ its programme of creating money to buy bonds echoed through the chambers of the world’s finance and political institution as many assets sold off and some investors nursed losses.
The second phase of the unwinding of quantitative easing is a rise in interest rates.
This reduces the liquidity and levels of credit in the economy, if the timing of an interest rate rise is correct, then the economy will be able to withstand this, because consumer and business confidence will be high enough that they will have enough confidence in their prospects that they have no desire to horde cash, so will continue to spend. This ready stream of credit, cash and liquidity from the private individuals and companies replaces the liquidity taken out of the system by the banks, and stability ensues.
The reason rates have to rise at some point, is that if the liquidity from both the banking and the non-banking sectors is increasing, there is a danger that the volume of cash in the system grows at a faster rate than the increase of supply of the goods and services in the economy, creating inflation, which destabilises the economy.
Thoughts in the US and UK have long turned towards the rise in interest rates, the dilemma faced by policy makers is when to act.
The first challenge they face is to ascertain the real level of confidence in the economy, rather than the faux confidence of QE.
The second challenge is to understand what the reaction of those who are in the market now because of low interest rates will be when rates rise.
A rise in interest rates means that the rates one can get by leaving their cash in the bank will rise, tempting investors to horde once again.
Because banks will have to pay more for the cash they get, both from depositors and central banks, they will have to charge more for the loans they make to businesses and consumers. If the economy cannot handle this increased cost of borrowing, it is likely to lead to turbulence.
And Quantitative Easing also has an impact in the modern world on the actual growth rate that can be achieved by the countries that stop doing it. This is because much of the economic model upon which the developed world sits at present is geared around selling more to the fast growing emerging economies of the world.
But many of the companies, and countries, in the emerging markets have also been able to access cheap credit as the cash from QE spread far and wide. In some cases, this has tempered the appetite of those countries and companies to deliver the reforms they need to achieve the economic potential that so much of the developed world is banking on. But even without that, the fact that capital will exit emerging markets as raise rise is a certainty, the fact that the borrowing costs of many emerging market countries and consumers will rise is a probability, and both of those factors will hinder the growth potential of those markets. Any pronounced slowdown is likely to mean that developed economies, which have growth rates already hampered by high levels of debt and ageing populations, will have to look inwards for whatever growth is available, just as interest rates rise and make that easiest part of that growth harder to come by. The potential to generate growth at home is impacted in the current climate by the fact that developed market governments continue to cut spending.