Thursday, September 19, 2013

Why we are not in recovery mode or having seen the end of QE

Deutsche Bank's Jim Reid, global head of fundamental credit strategy, explained why the global economy is not in recovery mode and why we have not seen the end of QE:  too much debt that will never be repaid still in the financial system.

“Nominal GDP growth is important because of the level of debt we still have in the system,” he told an audience on asset owners and their advisors. 
“At an aggregate level, we’re still on a huge pile of debt: if there’s little growth, there’s little chance of eroding that debt. And that makes us vulnerable to market shocks.”...
Please re-read Mr. Reid's observation that effectively we have not reduced the excess debt in the financial system since the financial crisis began.

This lack of debt reduction reflects the policy choices made and still being implemented to deal with a bank solvency led financial crisis.

Specifically the choice to adopt the Japanese Model and protect bank book capital levels and banker bonuses at all costs.

Just like Japan, the EU, UK and US has made little to no progress in restructuring the excess debt in their financial systems.  The burden of the excess debt has instead been placed on the real economy where it diverts capital needed for growth and reinvestment to debt service.

The result of adopting the Japanese Model has been the same economic malaise that has plagued Japan for the last 2+ decades.
Part of the situation has been caused by monetary policy interventions being directed at the wrong end of the market, Reid continued. 
Quantitative easing (QE) has resulted in an inflation in asset prices, but the money isn’t trickling down into the public’s pockets, making those wealthier people with assets better off, and the poorest people worse off, Reid said. 
This led to an effective propping up of the inefficient resources in our economies, instead of a radical redesign, he said. 
The financial system doesn't need a radical redesign.  It just needs to be used the way it was designed in the 1930s.

Specifically, policymakers need to adopt the Swedish Model which a modern banking system was designed to support and have the banks recognize upfront the losses on the excess debt.

This ends the excess debt burden on the real economy and allows capital to flow to where it is needed for growth, reinvestment and support of the social programs.  The Swedish Model also ends the need for all sorts of monetary policies like QE and ZIRP.

Banks are able to support the Swedish Model because of the combination of deposit guarantees and access to central bank funding.  With deposit guarantees, taxpayers are effectively the banks silent equity partners when the banks have low or negative book capital levels.
One partial consequence of QE and the greater access to refinancing methods is a decade of record-low default rates, making credit an attractive asset class for investors seeking greater returns in a low-yielding environment. 
Under normal circumstances, withdrawal of QE should lead to default rates increasing, as money is removed from the refinancing pool. 
But Reid argued central banks and governments won’t be able to accept a rising default rate as they want to keep markets calm. This will force central banks to put yet more unconventional monetary policies back on the table. 
Even worse, this will in turn hamper GDP growth by allowing bad companies to continue running, blocking more efficient, better performing new companies from breaking through. 
“The authorities are trapped,” he said. “I predict this low default rate environment will stay that way for a couple of years. But this isn’t a free market, it’s not capitalism. 
“A normal default cycle is good: if companies go bust it cleanses the system and allows entrepreneurial spirit to come through. I expect that default rates will be kept artificially low to keep the markets calm… it will get to the point where it chokes off economic activity.”
Please note, just like Japan, there is no endpoint for QE and a return to a "normal" capitalistic financial market where default rates are allowed to fluctuate freely.

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