Focus on the real economy, not QE

The mainstream diagnosis was that the problem lay in excess credit and the need to control banks and shadow banks through more regulation and capital, bail-ins and a cap on overall leverage ratio. Since politicians were not willing to push fiscal policies to the limit, the central bankers opted for massive quantitative easing, or QE, to stimulate the economy, while simultaneously tightening regulation to restrain the “naughty” bankers. But who allowed the excess credit in the first place to create asset bubbles at excessively low interest rates before 2007?

Under crisis conditions you need to stimulate the economy and control the bankers – that’s understandable. But in controlling the bankers, why have they been fined $100 billion-plus so far, with another $150 billion to go (according to Financial Times estimates), after QE subsidised them to the tune of $300 billion (Bt9.7 trillion), according to IMF estimates?   

Furthermore, why are half the fines for breaking sanctions and not for making banks fail in the first place?       

These lofty central bankers and regulators have forgotten that finance is a derivative of the real sector. If the underlying asset (the real economy) is sick, fixing the derivative (finance), however sick, won’t cure the disease.  

Fixing finance is like strengthening the cart but ignoring the horse. If the horse is overleveraged, giving it more debt won’t make it run faster. Thus, it makes more sense to inject more capital to the real economy (the engine of growth), rather than the banking system.

Indeed, asking bankers to top up capital – particularly from overleveraged governments borrowing more to invest in banks facing lower returns from higher regulatory costs and lending constraints – does not make any sense. If the government has to increase debt, let it inject capital into small amd medium-size enterprises and infrastructure to push for real growth.

In other words, the world is short of equity, not more debt.  

There are several culprits for debt-before-equity. The first is ideology. One of the foundations of modern finance theory, the Modigliani-Miller theorem, suggests that the value of a firm is indifferent to its capital structure being debt or equity. This assumes no bankruptcy, perfect information and no tax differences. Theoretically, this is brilliant, but practically, it says that the market should be indifferent to whether a person lives as a drug addict or a pastor, as long as they don’t die.

The second culprit is tax biases against equity. Both interest on debt and provisions against non-performing debt are tax deductible, whereas dividends are taxable and capital losses are non-deductible. Indeed, US cash-rich companies prefer to keep their billions in cash abroad and borrow to pay dividends, purely for tax reasons. 

The third culprit is the inherent hierarchy of finance. Monetary policy is exercised through central banks at the apex providing liquidity (debt) when needed to a select core of “too-big-to-fail” banks, which will lend to the masses at the bottom depending on the right incentives. If central banks lend to banks at near-zero interest rates and banks can buy risk-free government securities which rise in price when they buy, is it any surprise they are not lending to the real sector?  

Furthermore, if bankers take risks and lend to those at the bottom of the pyramid with higher credit risks, they are likely to be admonished by regulators for allowing non-performing loans to rise and therefore should provide more regulatory capital.   

It is not surprising that credit to real businesses is still stagnant six years after the crisis. 

The hierarchy of finance means that “helicopter money” from central banks exacerbates social inequality. Central bank provision of low-interest-rate funds to a small circle of banks and fund managers who buy government securities from the central banks is de facto the 1 per cent subsidising the 1 per cent, not the 99 per cent.  

Notice that instead of buying government securities, the People’s Bank of China recently injected liquidity back to the real economy through lending 1 trillion yuan (Bt5.25 trillion) to the China Development Bank to finance housing reconstruction. This is exactly what the central banks in Europe should be doing to get growth back into the system – get money or housing to the people who need funds. 

It is amazing that after six years of painful stagnation, Europe is still debating the need for more austerity. The gold standard was abandoned in the 1930s because it exacerbated deflation. During the early stages of the Asian crisis in 1997, this was tried in the crisis economies with disastrous results. The only way that Greece and other crisis economies can get out of recession is to revive growth.

What worries me is that the cut in interest rates by the European Central Bank plus more QE becomes another way of getting depreciation of the euro relative to the dollar. Since August 1, the euro has depreciated from 1.34 to 1.29 to the dollar. Similarly, the yen has moved to a six-year low of 106 to the dollar.   

The central bankers are still pushing QE and lower interest rates because the politicians won’t act faster on structural reforms. With geopolitical tensions rising in Ukraine and the Middle East, it is amazing that market volatilities in equity and bond markets have become as low as the level just before Lehmans in 2007.   

Since we have not recovered to growth levels in advanced markets and emerging markets to pre-2007 levels, the only thing that seems to be supporting the buoyant financial markets is loose monetary policy. 

What is clear is that when the Fed starts calling for an end to QE and US interest rates rise, the markets are already preparing for some rather rude shocks. Watch for the smart money being taken off the table through the tech bubble.     

 

Andrew Sheng is former president of the Fung Global Institute.