Central Banks: Between Dei Ex Machinis and the Devil’s Advocates
Motivation
As the current economic situation has led to a lot of controversies I felt the need to understand the truth behind the veil (or at least to try to) and share my thoughts with the hope of helping others to get a clearer picture and also to connect my dots.
I have read tons of articles and posts lately and I couldn’t help but notice that most of the authors are absolutely convinced that they are right regarding their predictions, from economists to financial analysts or enthusiasts. The truth is that we, humans, are pretty bad at predicting things for plenty of reasons which I won’t discuss right now. Nassim Nicholas Taleb, one of my favorite risk analysts and writers, says that what makes a system fragile is not necessarily the inability to predict the future, but the conviction that certain events can’t or won’t happen.
Now, back to our story, there are a lot of debates and arguments on one side about the evolution of the economy and financial markets and on the other side about the governments and central banks’ interventions.
One of the most discussed topics is the money printing phenomenon and its implications. The most prominent factions are the anti-system and anti-government anarchists, the all-knowing white-collar bankers, analysts, etc. and the desperate traders with massive either long or short positions trying to convince the others and themselves of things that are strictly related to their profits. Within these groups, there are also decent and even brilliant people who might actually share characteristics with the above-mentioned ones, but with a strong and healthy mentality and reasoning. In order to train my thoughts filter and also avoid getting a biased view, I use to evenly read or listen to them.
The Context
It’s really difficult to fairly judge the actions of the Fed and other central banks of pumping money like there is no tomorrow. In a very very tiny nutshell, this is just a last resort measure to a) compensate for the demand shock caused by the pandemic by artificially increasing consumer spending and b) help companies continue to operate by providing enough liquidity (money) in times of reduced revenues and earnings. This has to be done because otherwise a) the demand shock would trigger a deflationary spiral when nobody is spending and, hence, nobody is producing anything anymore and b) the companies would have to shut down, destroying an enormous amount of value (the time and money spent to bring these companies to their current level) and potential future value (the products and services that won’t be created anymore), from the economic point of view, as well as making a lot of people lose their jobs, from the social perspective. Now, this sounds pretty legitimate, and flexible money supply is also one of the main reasons why we went off from the gold standard (even though it has occurred as a desperate measure), but how long can actually the printer go brrrr (pardon my unprofessional phrasing, I had to say it) and at what costs?
Diving just a little bit into The Quantity Theory of Money, the nominal spending (also called nominal GDP) is equal with the product between the money supply (how much money is available in the economy) and the money velocity (what is the rate at which money changes hands in the economy). Under the current circumstances caused by the pandemic, the money velocity has dramatically decreased (people still have money, but it is circulating in the economy at a slower pace) and, thus, the spending.
What the Fed and the other central banks are basically doing is trying to push up the spending by increasing the money supply.
The Mechanics of Money Injections
The money supply is increased (at first) by lowering the target interest rate at which banks lend to each other. The central banks start buying specific government securities (usually short- and medium-term bonds) from member banks (banks hold government bonds to earn “free-risk” interest on the money they didn’t get to lend to customers) through open market operations. By doing that, banks have therefore more money (reserves, to be more specific), meaning that they can lend to each other at lower and lower rates (as they are less “desperate” to meet their reserve requirements) until the target rate is met. As banks make profits by lending, they generally have a strong incentive to lend every single cent above the reserve requirement to either other banks or to the public, even with low-interest rates. If lowering the interest rates doesn’t stimulate enough economic growth, the central banks pull out the last resort measure: buying other assets like long-term government bonds, mortgage-backed securities, and even corporate bonds.
Now, to sum it up, they essentially replace debt securities (money that has to be received at some point in the future) from banks, with credit (money that can be used right away, i.e. the country’s currency). That credit is created ex-nihilo (out of nowhere), hence the “money printing” syntagma, however, banks don’t get it for free, they have to give the above-mentioned assets (which have theoretically the same value) in exchange. That’s why this process is called Quantitative Easing. The banks have now more real money (credit) on their assets side of the balance sheets and thus, more quantity to lend. The whole mechanism is way more complicated than that and there are many discussions about what money really means in this context, but for the moment it should be enough to get an overview. By (and only by) lending to people, the money supply also increases (theoretically), which, in the end, should drive the economic activity (and the spending) up.
Another justification for this measure could be that the money pumping would, in the end, put more money into the consumers’ wallets, restore the faith of the investors (seeing that the central banks are taking action) and force the savers to spend their money (constrained by low-interest rates and fear of inflation) which might also indirectly increase the money velocity eventually. However, as long as the people are locked in houses and the businesses are halted, not to mention the current uncertainty generated by the global turmoil, there are slim chances that the money velocity will come back to the pre-pandemic value. Moreover, there is the risk that the freshly injected money will distort the markets and cause asset bubbles.
That’s why Quantitative Easing is considered to be an unconventional monetary policy tool and it has been viewed with skepticism by economists since it was first used by Bank of Japan in 2000 to combat the Asian Financial Crisis and later, in 2008, by The Federal Reserve to prevent the last global financial crisis turning into a depression. And it actually did prevent it. In June 2009, the recession was officially over and in March 2011, only two years after the Dow Jones hit its lowest level of the crisis, the US stock market was roughly 75% above that point. In the case of Japan, however, the aggressive quantitative easing program didn’t help too much, as Japan has been struggling with a chronic deflation and a lethargic economic growth since 2000. As you can see, this kind of intervention seems pretty erratic. As an intuitive metaphor, it’s like trying to reach 100 km/h in the first gear by revving the motor to the red line. Nevertheless, most of the countries have now adopted this practice and it has started to become rather a conventional tool.
Now, the main issue with the whole process is that after the pandemic is over and we come back to normal (hopefully), the central banks will have to unload their balance sheets and “redeem” the money they have injected. It has to be done, otherwise, the excessive amount of money plus the low-interest rates will overheat the economy and make inflation skyrocket and that’s because (in my opinion) the post-pandemic economic output won’t match the huge money supply in the system. So, as central banks can “print” money, they can also “unprint” it. All they have to do is to progressively sell back the assets they priorly bought during the pandemic. And here is the crux of the problem. When the central banks start selling back those debt securities (especially the bonds), their price will decrease making yields to increase. That’s quite confusing at first, so let’s take an example.
You are a bank and you own a freshly issued 10-years T-Bond with a face (nominal) value of 110$ for which you paid 100$. As long as you hold the bond and the government doesn’t default you will get at the end of the period your 100$ back, plus 10$ as interest. That means that your bond has a 10% yield. Now, I am a central bank and I want to buy that bond from you. Because government bonds are considered to be ultra-safe and we are in an uncertain economic context you have no incentive to sell me that bond for the price that you initially paid for (the market price), so I’ll have to bid higher than that. Let’s say that we agree on 101$, so you get the money and I get the bond. After this transaction, the new market price of that bond is 101$, the face value is the same — 110$ — and the yield automatically got lower (110$/101$ = ~8.9%), because now the bondholder will receive the same amount of money for a higher premium (the “downpayment” for that bond), or other said, it will yield less profit. For each such transaction that I perform with either you or other banks, the price will slightly get higher and higher and the yield lower and lower, as per the law of supply and demand. The same principle applies when we do the reverse transaction. If I want to sell you that bond back, I’ll have to ask for a price a little bit lower than the market price, which will then increase the yield. This happens because the bond market is considered to be an efficient market.
And here comes the interesting part.
As soon as there will be signs that the quantitative easing programs are about to cease, the bondholders will start selling their bonds (knowing that the prices will go down) flooding the market. The massive sell-off will make bonds prices go down and implicitly the yields soar, which will then impede the Fed to actually sell back those assets without making the yields go even higher. That’s exactly what happened in 2013 when Ben Bernanke, then-Federal Reserve Chairman, announced that the Fed is going to taper the ongoing bonds purchasing at some point in the future.
High bond yields are undesired, because it means that the banks will increase the interbank (bank to bank) and prime (bank to customers) rates (in order to make lending more profitable than holding bonds) and it also means that the government will have to pay more interest on the future issued bonds. So basically, the Fed and other aggressive central banks are stuck with those securities on their balance sheets. To prevent a financial cataclysm, they will have to get rid of them over a long period or to just keep them until maturity.
Good or bad?
And now let’s think about what this actually means and try to understand if that’s bad or not. I’ll take the case of The United States, but this applies to other countries as well. So we have on one side the US Government which issues and sells (through the U.S. Treasury Department) bonds to the public in order to fund their spendings and on the other side the central bank of the United States (The Federal Reserve) which is an independent financial institution, supervised by the US Congress, which has the role of maintaining the financial stability by conducting the monetary policy and regulating banks.
What is now currently happening is that the Fed (and other central banks as well) is buying a good amount of government bonds and other debt securities with created money. The cost of money creation is (in very rough terms) the amount of money, as percent from the original money supply, that was thrown into the economy but hasn’t led to an increase in the economic output (i.e. the total value of all goods and services produced) — what we usually experience as inflation. The burden of inflation is beard indeed by the savers storing their wealth in bonds and bank deposits. In a context with low-interest rates and risk of inflation in the future, those are punished (even though they actively invested their money in real assets) and are basically enforced to migrate to inflation-protected assets, like stocks or commodities. It’s true that the United States has managed to keep the inflation under control during the last decades and it’s also true that many developed countries are actually struggling with deflation, but there is no guarantee that this will go forever.
By increasing its holdings of government and other debt securities (corporate, mortgage-backed, etc.), The Federal Reserve distorts the secondary bond market, impelling along also The Department of the Treasury to play the game (see the Supplementary Financing Program from 2008) and making the stock market lose its essence and become rather a bizarre echo of the monetary policies. Thereby, The Federal Reserve is directly increasing its leverage over the entire economy, completely diverging from the original role and also from the principles of capitalism and a free market, the pillars of the United States, a symbol of modern capitalism. Moreover, this behavior has been adopted by other OECD (Organisation for Economic Co-operation and Development) countries as well, either through their own central banks or through the ECB (European Central Bank), in the case of eurozone countries.
It’s quite surprising that almost none of those countries focused on fiscal measures instead of monetary policies in order to “save the economy” (an exception being Germany, who decided to cut the VAT, both standard and reduced ones, by 3, respectively 2 percent), even though the supply and demand (the crux of our current crisis) relies strongly on fiscal policies.
Final Thoughts
I’m not here to demonize neither the Fed, ECB, etc., nor the modern banking system in general, I’m in fact truly amazed by how this entire apparatus is working and that’s also the reason why I’m writing this. I’m here merely to encompass all this information about the current financial situation into an easy to comprehend picture. However, I can’t deny that it currently feels like our current financial system is about to enter into another realm or phase, where negative interest rates, central bank interventions, stock market bubbles and moral hazards are the norm.
I really believe that a broad understanding of such now-relevant subjects will help us properly judge the reality, make better decisions, and evolve as a society.
PS: This is my very first article on Medium and I’m perfectly aware that there is a lot space of improvement, so your feedback is well appreciated. I’m planning to continue to write about similar topics plus interesting Machine Learning, Neural Networks and Artificial Intelligence themes in the near future, so stay tuned!