Central banks are addicted to QE| Nick Hubble | 29 Jun 2021 |
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Dear Reader,
Central banks and governments have successfully papered over the economic and financial consequences of the pandemic surprisingly well.
That is as far as the aggregate economic statistics go, anyway.
But, what if we've become addicted to the various policies that prevented an economic and financial meltdown?
What if ending negative real interest rates, quantitative easing (QE), stimulus and welfare is just too much to bear?
Let me ask you, do you take drugs?
Why not?
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It's not because you'll end up in hospital from one pill, tab, snort or whatever it is. Many of us don't take drugs because we're afraid of getting addicted. A slippery slope, and all that.
You can tell I became a dad last year, can't you? This is very much the same speech I'll be giving to my daughter at some point in the hopefully distant future.
The thing is that investors need to hear the message too. Just applied to inflation instead of drugs.
QE in 2008 wasn't important because of the inflation which QE inherently creates. It didn't create much consumer price inflation, after all. But, just like a drug, it created a high. A high in the stock market, the property market and the bond market.
There were no bad consequences (consumer price inflation), but lots of good ones (asset price inflation).
Whoopee, so let's do it again!
You can see the problem, can't you?
Punters will know that a big win is very dangerous for those who have just discovered gambling. I experienced a traumatic loss at age five, which put me off gambling forever.
My mum gave me two pounds to spend at the arcade. I spent the next 45 minutes losing and regaining a pound's worth on the mechanised horse race gambling game.
Just as I lost my last 20p stake, some little shit several years older than me walked over, cluelessly put his money on the horse with the lowest odds… and turned 20p into eight pounds.
I was furious, began bawling and refused to spend my second pound on anything at the arcade.
My mum spent it on herself, on one of those motorbike racing games where you sit on the bike and lean to steer it…
So, I'm no good at gambling metaphors. That means I'll stick with our drugs and monetary policy metaphor instead.
The problem with QE and drugs is much the same. These days, every crisis gets a dose of QE. In fact, despite economies around the world being on the mend from the lockdowns, and inflation running hot, QE is set to continue indefinitely.
Just as drug addicts deal with every down by seeking an artificial high, only to go on to needing the drug all the time, we've become addicted to QE. In fact, we're reliant on it.
The creators of the European Central Bank (ECB) understood this risk of addiction. Well, the Germans did. That's why they banned financing of governments by central banks and placed other restrictions on the ECB. It wasn't about the inflation itself. After all, a little QE and deficit financing needn't trigger inflation. It can have good effects.
The German fear was about the longer-term implications of governments being able to finance themselves with the virtual printing press. And they knew that's what made the short-term temptations so dangerous, especially in a democracy.
Once politicians cotton on to the opportunity of forcing central banks to use QE to finance outrageous fiscal deficits, then anything goes. No cause is too big for the government budget. And that's how things really do descend into an inflationary nightmare.
Here's the reason the distinction between a little bit of recreational QE on the weekend and a constant dose matters: it's only once you're addicted to drugs that the bad effects really begin to emerge. In the same way, it's only when we're reliant on QE that inflation kicks in.
Why? Because it's going to be so hard to reverse the QE. It's not like we can just quit now. Governments would go bust and banks would go bust – the only question is who would go first.
Once markets discover this truth, that's when consumer price inflation takes hold. It is a situation where QE is set to continue indefinitely and a reversal would lead to something worse than inflation. In that scenario, central bankers will continue QE, even as inflation emerges… as they are right now.
In Weimar Republic Germany, inflation got out of hand because the government was trying to keep employment high, reparations paid and the left wing under wraps. The consequences of failing to monetise the government's deficit were considered worse than monetising it. Otherwise, they would've just stopped printing.
Today, we rely on central banks' QE to finance governments, keep interest rates under wraps, rescue banks and keep house prices rising. An end to QE would put all that at risk. And there's no question it'd be a catastrophe if it went into reverse.
This means that QE is a one-way bet. It'll reliably be rolled out at the faintest hint of trouble. And that's what hints at inflation so strongly; the inability to withdraw QE if inflation rises. The consequences would be too bad. We got a taste of them two weeks ago. And a few years ago, in what became known as the taper tantrum.
One way of describing this situation is that we won't be able to find a Paul Volcker or Hjalmar Schacht. The former chairman of the Federal Reserve was willing to rein in inflation at the price of undermining the economy in the early 1980s. The German currency commissioner in the 1923 was willing to do so as well, by launching an alternative currency. But things didn't go so well for the Germans as a result because the Great Depression hit just when they'd achieved currency stability…
The warnings about QE in 2008 should've been about where this leads in ten years' time, not about any immediate surge in inflation. Being able to turn to QE reshuffles the incentives of central bankers and politicians radically. It's only QE which made the pandemic fighting policies possible. Modern Monetary Theory was proven before it became popular.
It has often taken a decade for inflation to break out after loose monetary policy begins. In the meantime, times were very good. As they were in Weimar Germany and other nations which turned to the (real, rather than virtual, digital or metaphorical) printing press to solve their government deficit problem.
Where are we in this timeline? ECB president Christine Lagarde explained that in May:
| We are committed to preserving favourable financing conditions using the PEPP envelope, and to do so until at least March 2022. It's far too early and it's actually unnecessary to debate longer-term issues.
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Central bank financing of government will continue, because it is needed. But over the past few weeks, inflation data has begun to spike. In Germany, it's already above the ECB's mandate of 2%.
It won't matter, the addiction has taken hold. Good luck tightening, central bankers. It'll be worse than a taper tantrum if you do. That's the lesson we learned two weeks ago.
Nick Hubble
Editor, Fortune & Freedom
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