Afternoon Must-Read: John Plender: Bewitched by Mandarins of Central Banking
The very sharp John Plender makes what is now the standard–but I believe incoherent–argument that central banks are doing bad things with quantitative easing and need to reverse it and raise interest rates. They need to do so, Plender thinks, even though doing so will reduce spending, raise unemployment, put downward pressure on wages and prices, and increase risk in a world that still appears to be grossly short of risk bearing capacity. So it is natural to ask: “Why?” What is the upside supposed to be? Is there an upside aside from believing that this will make it easier for investment managers to report black rather than red numbers to their clients while still holding safe Treasury bond-based portfolios?
That Plender’s argument is incoherent is, I think, demonstrated by the fact that markets do not respond as he thinks he should–he saw the end of large-scale US QE coming at the start of 2013, and confidently predicted a fall in US Treasury bond prices that simply has not happened.
The way I see it is this: The root problem is an inability of financial intermediaries to stand behind or to credibly assess risks, and so a reluctance on the part of investors to provide the factor of production of risk-bearing to the marketplace. Pushing safe interest rates way, way, way down and then pushing the supply of risk-free assets that the private sector can hold way, way, way down provides a form of Dutch courage to otherwise reluctant investors: even though they don’t trust financial intermediaries’ risk assessments, the low rates on and low volumes of safe assets give them no alternative. The long-run problems are twofold: First, safe interest rates expected to be very low for a long time artificially boost the value of long-duration assets–so capital is misallocated and we wind up with a capital structure that has in it too many long-duration relatively-safe projects that make at best very small contributions to societal well-being. Second, the demand for risky assets just generated is not a well-based demand for soundly-analyzed risks but rather for any priced risk at all–so the market becomes vulnerable to Ponzi and near-Ponzi finance.
From my point of view, however, the proposed cure of higher unemployment, lower demand, and greater fundamental risk from continued and deeper depression is worse than the disease. First best would be fixing the credit channel so that financial intermediaries would be able to stand behind risks they have credibly assessed. Second best is having the government take over and be a financial intermediary–have it borrow and spend, accepting that its spending will to a certain degree follow a political logic of greasing powerful and squeaky wheels more than amplifying wealth. Third best is continuing QE. Worst is attempting to revert to normal interest rates without financial policy to fix the credit channel or fiscal policy to maintain demand near normal-employment levels.
Bewitched by Mandarins of Central Banking:
“The continuing fall in government bond yields in the advanced economies…
…at the turn of the year was a salutary reminder of how hard it is to invest in markets that are heavily distorted by central banks. At the start of 2013 there was near-consensus among investors that US Treasury yields had nowhere to go but up…. The US Federal Reserve did indeed stop buying in the summer, but Treasury prices continued to rise and yields to fall. The most plausible explanation for this defiance of conventional wisdom was the persistence of global imbalances… excess savings in Asia and northern Europe had to find a home. The additional yield available in the US market, along with the potential for further dollar strength, made this a compelling trade…. Central banks, most notably the Fed, have put a cushion under asset prices when they go down while imposing no cap when they bubble up…. The great bond bull market that began in 1982 has yet to revert…. Market professionals who have hitherto contributed to the efficiency of market pricing through their analytical skills are reduced to hanging sheeplike on the words of central bankers about the likely direction of bond-buying programmes. And they remain bewitched by the mandarins of central banking despite the mixed quality of their forward guidance…. Whatever the benefits of QE, there are bound to be significant economic costs arising from the artificially cheap cost of capital. Capital will be misallocated. And it may go on being misallocated, for the central banks seem to be trapped in a process whereby measures to counteract the fallout from one bubble pave the way for another.