Trade protectionism looms next as central banks exhaust QE
Officials at the US Federal Reserve may be more worried than they have let on about the treacherous task of extricating America from quantitative easing. This is an unsettling twist, with global implications.
A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution's capital base could be wiped out "several times" once borrowing costs start to rise in earnest.
By Ambrose Evans-Pritchard, International Business Editor
6:00PM GMT 24 Feb 2013
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A new paper for the US Monetary Policy Forum and published by the Fed warns that the institution's capital base could be wiped out "several times" once borrowing costs start to rise in earnest.
A mere whiff of inflation or more likely stagflation would cause a bond market rout, leaving the Fed nursing escalating losses on its $2.9 trillion holdings. This portfolio is rising by $85bn each month under QE3. The longer it goes on, the greater the risk. Exit will become much harder by 2014.
Such losses would lead to a political storm on Capitol Hill and risk a crisis of confidence. The paper -- "Crunch Time: Fiscal Crises and the Role of Monetary Policy" -- is co-written by former Fed governor Frederic Mishkin, Ben Bernanke's former right-hand man.
It argues the Fed is acutely vulnerable because it has stretched the average maturity of its bond holdings to 11 years, and the longer the date, the bigger the losses when yields rise. The Bank of Japan has kept below three years.
Trouble could start by mid-decade and then compound at an alarming pace, with yields spiking up to double-digit rates by the late 2020s. By then Fed will be forced to finance spending to avert the greater evil of default."Sovereign risk remains alive and well in the U.S, and could intensify. Feedback effects of higher rates can lead to a more dramatic deterioration in long-run debt sustainability in the US than is captured in official estimates," it said.
Europe has its own "QE" travails. The paper said the ECB's purchase of Club Med bond amounts to "monetisation" of public debt in countries shut out of global markets, whatever the claims of Mario Draghi.
"We see at least a risk that the eurozone is on a path to become more like Argentina (which of course is why German central bankers are most concerned). The provinces overspend and are always bailed out by the central government. The result is a permanent fiscal imbalance for the central government, which then results in monetization of the debt by the central bank and high inflation," it said.
In America, the Fed would face huge pressure to hold onto its bonds rather than crystalize losses as yields rise -- in other words, to recoil from unwinding QE at the proper moment. The authors argue that it would be tantamount to throwing in the towel on inflation, the start of debt monetisation, or "fiscal dominance". Markets would be merciless. Bond vigilantes would soon price in a very different world.
Investors have of course been fretting about this for some time. Scott Minerd from Guggenheim Partners thinks the Fed is already trapped and may have to talk up gold to $10,000 an ounce to ensure that its own bullion reserves cover mounting liabilities.
What is new is that these worries are surfacing openly in Fed circles. The Mishkin paper almost certainly reflects a strand of thinking at Constitution Avenue, so there may be more than meets the eye in last week's Fed minutes, which rattled bourses across the world with hints of early exit from QE.
Mr Bernanke is not going to snatch the punch bowl away just as the US embarks on fiscal tightening this year of 2pc of GDP, one of the most draconian budget squeezes in the last century. But he may have concluded that the Fed is sailing too close to the wind, and must take defensive action soon.
Monetarists say this is a specious debate -- arguing that the losses on the Fed balance sheet are an accounting irrelevancy -- but Bernanke is not a monetarist. What matters is what he thinks.
If this is where the Fed is heading, the world is at a critical juncture. The US economy has not yet reached "escape velocity", and in fact shrank in the 4th quarter of 2012. Brussels has slashed its eurozone forecast, expecting a second year of outright contraction in 2013.
The triple "puts" of the last eight months -- Bernanke's QE3, Mario Draghi's Club Med bond rescue, and Beijing's credit blitz -- have done wonders for asset markets but have not yet ignited a healthy cycle of world growth. Nor can they easily do do since the East-West trade imbalances that caused the 2008-2009 crisis remain in place.
We know from a body of scholarship that fiscal belt-tightening in countries with a debt above 80pc to 90pc of GDP is painful and typically self-defeating unless offset by loose money. The evidence is before our eyes in Greece, Portugal, and Spain. Tight money has led to self-feeding downward spirals. If bondyields are higher thannominal GDP growth, the compound effects are deadly.
America may soon get a first taste of this, carrying out the epic fiscal squeeze needed to bring its debt trajectory back under control with less and less Fed help. Gross public debt will hit 107pc of GDP by next year, and higher if the recovery falters as pessimists fear.
With the fiscal and monetary shock absorbers exhausted -- or deemed to be -- the only recourse left is to claw back stimulus from foreigners, and that may be the next chapter of the global crisis as the Long Slump drags on.
Professor Michael Pettis from Beijing University argues in a new book -- "The Great Rebalancing: Trade, Conflict, and the Perillous Road Ahead" - that the global trauma of the last five years is a trade conflict masquerading as a debt crisis.
There is too much industrial plant in the world, and too little demand to soak up supply, like the 1930s. China is distorting the global system by running investment near 50pc of GDP, and compressing consumption to 35pc. Nothing like this has been seen before in modern times.
This has nothing to do with the "Confucian" work ethic or a penchant for stashing away money. Fifty years ago the stereotype was the other way round. Confucians were seen as feckless. In fact, Chinese families never get the money in the first place. The exorbitant Chinese savings rate is due to a structure of taxes, covert subsidies, and banking rules.
Variants of this are occuring in many of the surplus trade states. Germany is doing it in a more subtle way within Euroland. The global savings rate is almost 25pc and climbing to fresh records each year. The overstretched deficit states in the Anglo-sphere and Club Med are retrenching but others are not picking up enough of the slack. Germany has tightened fiscal policy to achieve a budget surplus. This is untenable.
In the Noughties the $10 trillion reserve accumulation by Asian exporters and petro-powers flooded the global bond market. At the same time, the West offset the deflationary effects of the cheap imports by running negative real interest rates.
The twin policy regimes in East and West stoked the credit bubble, and this in turn disguised what has happening to trade flows. These flows were disguised yet further after 2008 by QE and fiscal buffers, but the hard reality beneath may soon be exposed as these are props are knocked away.
"In a world of deficient demand and excess savings, every country will try to acquire a greater share of global demand by exporting savings," he writes. The "winners" in this will be the deficit states. The "losers" will be the surplus states who cannot retaliate. The lesson of the 1930s is that the creditors are powerless. Prof Pettis argues that China and Germany risk a nasty surprise.
America's shale revolution and manufacturing revival may be enough to head off a US-China clash just in time. But Europe has no recovery strategy beyond demand compression. It is a formula for youth job wastage, a demented policy when youth a scarce resource. The region is doomed to decline until the boil of monetary union is lanced.
Some will take the Mishkin paper as an admission that QE was a misguided venture. That would be a false conclusion. The West faced a 1931 moment in late 2008. The first round of QE forestalled financial collapse. The second and third rounds of QE have had a diminishing potency, while the risks have risen. It is a shifting calculus.
The four years of QE have given us a contained depression and prevented the global strategic order from unravelling. That is not a bad outcome, but the time gained has largely been wasted because few wish to face the awful truth that globalisation itself -- in its current deformed structure -- is the root cause of the whole disaster.
It will be harder from now on if central banks conclude that their arsenal is spent. We can only pray that their help will not be needed.
