Monday, September 17, 2012

UK Treasury Committee calls for evidence on who QE hits hardest

In a potential fatal blow to Quantitative Easing, the UK Treasury Committee has called for evidence on who QE hits hardest.

Regular readers know that the answer is the real economy is hit hardest by QE.

There are many channels through which the real economy is damaged including, but not limited to a) crushing current demand and b) reducing investment in growth.

How does QE crush current demand?

It reduces current demand from savers.

Specifically, it reduces current demand from individuals who are saving for retirement.  With low interest rates, savers know they have to save more to a) offset the loss in earnings that their savings would generate in a normal interest rate environment and b) provide them with the income they were expecting in retirement in case the low interest rate environment still exists (note:  in Japan, the low interest rate environment has been going on for 2+ decades).

Specifically, it reduces current demand from individuals who have already retired.  These individuals have no way of replacing their retirement savings and want to be sure they have savings in case they are needed.

How does QE reduce investment in growth?

This decline in current demand from savers triggers a further negative feedback loop for the real economy.

Specifically, the decline in current demand acts as a drag on business investment and hiring.  If businesses don't see demand for goods and services increasing, they tend not to invest in expanding their business or hiring more employees.

Even if businesses saw demand for goods and services increasing, they do not necessarily have the cash flow they need to make the investments as QE traps them in the Pension Fund Death Spiral.

In the Pension Fund Death Spiral, companies have to take funds that in a normal interest rate environment would be available for investment and contribute them to their pension funds to make up for the lack of earnings caused by QE on the investments in the pension funds.

Japan has demonstrated for 2+ decades that QE does not work.  If it did, as David Rosenberg observed, the Japanese economy would be growing at an extraordinarily high rate.

As reported by the Telegraph,
MPs are to investigate the Bank of England’s claim that its money-printing operations have benefited pensioners, as the Treasury Committee launches a call for evidence.... 
The Treasury Committee called for written evidence in response to the Bank’s paper which said pensioners and older workers have gained the most from quantitative easing (QE), despite claims they have been hardest hit by the policy.... 
Andrew Tyrie, the Conservative MP who chairs the Committee, said: “Some people may be worse off as a result of quantitative easing. The impact - on the economy as a whole as well as on individuals - of QE requires careful scrutiny. 
“The Treasury Committee will make sure that as much transparency as possible is brought to bear on QE’s effectiveness, the winners and losers created by it and its cost to the taxpayer.”
Just a couple of quick thoughts in passing about the Bank's paper.

First, prior to the financial crisis hitting, a rule of thumb for asset allocation was for an individual to split their assets between stocks and bonds using the formula of 100 minus the individuals age.  So a 65 year old would have 35% of their portfolio in stocks and 65% in bonds.

Second, the 65% in bonds was not in 30 year gilts.  There simply were not enough 30 year gilts outstanding in 2007 for all of the savers, retirees and banks.  More likely, the savers and retirees held a bond portfolio with a maturity that represented the weighted average maturity of gilts outstanding.

This weighted average maturity bond portfolio was not as susceptible to a change in price movement as 30 year gilts and therefore did not increase enough in value to offset the decline in interest rates produced by QE.

Bottom line, the assumptions underlying the Bank's paper did not exist in the real world and savers/retirees have been crushed by QE.

Update II
From Morningstar,
Retirees face numerous risks in retirement, one of which is inflation. A March 2012 study conducted by the Society of Actuaries suggests that about 69% of retirees are concerned that the value of their savings and investments might not keep up with inflation.
Update III
In the 1870s, Walter Bagehot, the man who wrote the book on modern central banking, Lombard Street, observed that savers cannot take interest rates less than 2%.  If this happened, the real economy would have problems.

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