Every so often the free market fails to sort itself out and the economy grows more slowly than it should, according to the economists, bankers and investors. Measures need to be taken to spur economic growth so that it can run at its potential again. Having lowered interest rates to zero or close to zero with less than spectacular results on economic growth, central banks turned to unconventional monetary policy, also known as quantitative easing. Purists define QE as the expansion of the central bank’s balance sheet through the purchase of assets funded by, well, funded by the creation of money, a talent and right exclusive to central banks. Basically, governments borrow by issuing bonds, which to a point private investors become leery off due to the usually parlous state of the finances of governments wont to engage in such innovative practices. At this point the country’s central bank buys these bonds thus lending to its own government. The government. Fine distinctions have been made about whether central banks are lending to their own governments, which is seen rightly as debt monetization, and buying bonds in the secondary market from private investors thus injecting money into the economy which it is hoped will circulate and stimulate demand. The reality is that the private investors holding government bonds are hardly borrowing from the central bank by selling them their bonds, and experience has shown that the money thus injected gets saved or hoarded somewhere, usually back on the said central bank’s balance sheet. The velocity of money falls almost precisely to compensate for the liquidity injection and demand and output hardly budge. There is a physical analogy in all this.

Now that 8 years of QE have failed to produce the spectacular recoveries in economic growth expected, governments are beginning to toy with the idea of fiscal easing. The problem with fiscal easing is that it involves a government spending to boost the economy, in effect replacing private demand with government demand. Monetary easing it was hoped, would spur demand by placing money in the hands of businesses and households in the hope that it would spur demand but it’s easier to lead a horse to water than to make it drink. Fiscal easing is a bit like leading your horse to water and then leading by example and taking great swigs yourself. There is no guarantee that the horse will drink. A case in point is Japan which has engaged in QE and fiscal easing and seem its national debt surge to 2.5X annual output. At the current G7 meeting in Japan you can sense the government once again tilting towards fiscal easing. In April 2017 there is a scheduled sales tax hike. The options before the government are to scrap the tax hike or to go ahead with it and sterilize it with a big fiscal package. There is a physical analogy in all this.

Experience has shown that you cannot borrow yourself into solvency try though some countries might, given that some investors have been happy to buy bonds at negative yields. It might not be long before someone voluntarily buys a bond with a negative coupon. Perhaps a central bank somewhere might want to lead by example. At some point the world will realize that you cannot move a boat by blowing into your own sail.

There are solutions which can work but the weight of the establishment and politics stand against them. And the weight of the establishment can mobilize academia, investment pundits and popular opinion against such solutions. Putting aside arguments for equitable wealth distribution aside, it doesn’t take much to observe that a dollar taken from a billionaire does not change their consumption levels much if at all, whereas this dollar transferred to a poor household will be spent almost completely, raising the velocity of money, the one variable which has confounded QE. The efficiency of this transfer, however, will be drowned out by the indignant accusations of it being blatantly socialist policy.

Global economic growth has been slow and inflation has been stubbornly low despite efforts by central banks to raise them. The first round of unconventional policy involved central banks buying bonds and other assets and increasing their balance sheets. The strategy has only been moderately successful and is probably at the point of diminishing marginal returns. Therefore, an alternative unconventional policy had to be implemented: negative interest rates.

It is hoped that negative interest rates would encourage more credit creation to spur growth and inflation. What central banks would prefer markets to focus on less is the expected impact on currencies lest they are accused of waging currency trade war. Negative rates might also encourage investors further up the risk spectrum to taking more risk and reducing borrowing costs across a wider swathe of the economy.

There are a number of problems, however, with negative interest rates. First of all, it assumes that the problem stems from weak supply of credit. Low equilibrium interest rates are indicative of poor demand for credit, not deficient supply. Lowering the cost of credit is of limited impact in raising the demand for credit which depends more on the available unlevered returns in asset markets today, which looks quite meagre, as well as the prospects of paying down debt in the future. If economic prospects are poor, increasing the supply and lowering the cost of credit is unlikely to spur lending.

Negative rates are also confounded by banking regulation. Central banks and regulators have two conflicting missions for banks, make more loans and take less risk. Banking regulation highlights the fact that banks lend not out of liquidity but out of capital, and therefore the calculus for increasing the supply of credit is not entirely the cost of the bank’s credit but the cost of its capital as well. Cutting rates into negative territory helps with one part of the equation but is nullified by the other. Negative rates pay banks to borrow from central banks and to lend cheaply to borrowers. However, the type of borrowers central banks would like banks to lend to are small, medium enterprises, businesses too small to access bond markets. Unfortunately, loans to these types of borrowers consumer more capital under Basel III regulation. Banks have to apportion more capital against these loans which makes the cost of capital more relevant to the bank than cost of liquidity, which carries the negative interest rates. Cost of capital is a more comprehensive measure of how much it costs to make a loan and this is not directly addressed by simply cutting interest rates below zero.

Meanwhile, negative interest rates have some less desirable side effects. For one, it encourages cash hoarding. While individuals might be expected to engage in cash hoarding it was instructive to see Munich Re, one of Europe’s largest reinsurance companies engaging in storing physical cash in vaults. Negative interest rates could, perversely, result in a shrinking of the money supply.

Negative interest rates are damaging to the savings industry, in particular insurance and pensions. Insurance companies have long term liabilities which have to be funded. With ultra low interest rates and low asset returns, assets maturing face a lower expected return. Most insurance liabilities, however, are not benchmarked to interest rates and many have a guaranteed floor on returns. Negative rates threaten the long term solvency of the insurance industry. The same calculus applies to pensions, especially defined benefit schemes which guarantee a certain level of payouts unrelated to the returns generated by their assets.

A more insidious way that negative interest rates undermines the economy is that interest rates represent a hurdle for investments as well as a tide for the economy to swim against. A certain level of interest rates is also useful in eroding excess capacity and euthanizing unviable businesses. Human enterprise thrives on hardship to innovate and evolve. Nothing destabilizes like a tide from the rear. It is the life support that keeps inefficient businesses alive, maintains excess capacity and ultimately weakens the economy as a whole.

Negative interest rates.

Hmmm. I’ve seen this kind of liquidity provision before…

Now I remember!

Policy:

In December, the ECB extended QE from September 2016 to March 2017. Markets did not think it was sufficient, spreads between peripheral bonds and bunds widened, the EUR strengthened and equity markets sold off.

In late January the BoJ cut rates into negative territory and was rewarded with a stronger JPY and weaker equity markets, and the equivalent of a coronary in its money markets. Fortunately, not all was lost and JGBs rallied.

Last week the ECB was given a second chance to demonstrate determination and did so by cutting rates, increasing QE by 33%, including non-financial corporate IG to the shopping basket, and another dose of TLROs. Markets were skeptical at first but seem to be warming to the measures. This is the 3^rd trading day after the announcement and markets are buoyant so only time will tell.

Tomorrow, the BoJ will announce its policy decisions. It is hard to see what it can do to boost markets. Evidently it can do nothing for the economy.

On Wednesday the Fed announces its decisions and publishes an update on the dot plot. The American economy is robust despite being in a shallow, temporary and controlled slowdown. On domestic data alone, a data dependent Fed would raise rates. The Fed is, however, unwilling to unnerve investors since their behavior impacts market interest rates and credit spreads and is therefore a Fed control variable. The Fed has not signaled strongly that it will act and therefore will likely delay the rate hike into the summer. Hopefully, the USD will be sufficiently weak, equities sufficiently buoyant and spreads sufficiently tight for the Fed to play catch up.

At some stage all these central banks are going to have to start thinking about what they can do for the real economy.

The ECB’s moves were largely expected except for the inclusion of corporate debt on the shopping list. This should at least put a floor under the Euro IG market. The details, however, have not been released so we don’t know what the total or country allocations might be.

The ECB’s best policy has always been its LTRO. Its first incarnation, a 3 year unconstrained program, turned the ECB effectively into a pawnshop. It achieved a number of things:

1. Banks bought government debt when the ECB could not. The ECB had co-opted the banks into its QE. Call it, proxy QE.

2. National banks bought their respective national debt thus unwinding current account deficits very rapidly.

3. Coupled with a rate cut, the ECB provided banks with a profitable business, good for 3 years, consuming no capital. The profits would recapitalize the banks to some degree.

4. Governments’ borrowing costs fell.

The subsequent TLTROs were less effective. Why?

1. Private enterprise is unwilling to borrow. That’s it. The TLTROs were extendable only if the banks were seen to be pivoting their loan books to SMEs and private obligors. These LTROs were not meant for government bond purchases.

2. As one hand of the ECB provided liquidity to fund private loan growth, the other hand increased capital requirements. This placed banks in an untenable position.

What about the latest TLTROs?

The details are still patch but basically, the repo rates are zero with a discount available for compliant banks, banks with a willingness to engage in more active private lending. At a fully discounted rate of -0.4%, the ECB is basically paying the banks to lend. In effect, it is co-opting the banks to grow their loan books. Will it work? Basel III and TLAC rules still hold which will continue to constrain the banks. Assets tendered in repo are not a true sale. And for all these technicalities, demand for credit is simply weak.