The Bank of England re-instituted “quantitative easing” last week because British pension funds were threatened with insolvency, having hedged their bond portfolios with unstable derivatives. We have seen this movie before, in 2007-08. Dopey behavior by financial institutions, central banks and regulators causes a massive unnecessary financial crash that blights the lives of billions of innocent people. It’s about time they made these people pass an IQ test!
To be fair, the British pension funds’ errors were not entirely of their own making. EU regulators, from whom British pension funds should have been freed with Brexit, imposed an altogether too restrictive mandate upon them to match assets and liabilities. Since these employer-driven final-salary pension schemes were largely closed to new entrants, there was little new money coming in; consequently, under EU regulation they had to match their liabilities stretching up to 50 years or more against assets.
Particularly in the financial services sector, Brexit was supposed to liberate British financial institutions from this kind of thing, where continental regulators who have no clue about how a free market operates impose their Germanic rule-mania on the City of London. However, as in most things, the governments of Boris Johnson and his predecessors have been utterly feeble in resisting the socialist Euro-Blob.
The need to match their liabilities forced the pension funds into government bonds, which since the “funny money” mania of the 2010s have suffered from negative real yields, thus being entirely unsuitable for pension fund investment, whatever the regulators mandate. Indeed, the pension funds’ insistence on fulfilling impossible EU mandates had driven them to over-invest in inflation-linked government bonds, driving their yields to impossibly negative levels. (I have a bone to pick with them here; in an attempt to hedge part of my own modest UK pension portfolio against the twin risks of inflation and a share price collapse, I too had invested in a fund containing these bonds, which has now halved in nominal value in the past year, a worse performance than that of any of the share portions of my portfolio. Only the stupidities of EU regulation and the Bank of England could have caused a conservative investment in government bonds to go so spectacularly wrong!)
While the dozy pension funds were the immediate trigger of last week’s “crisis” the even dozier Bank of England was the fundamental cause of it. The “mini-Budget” of Messrs. Truss and Kwarteng was a relatively unimportant side issue, valuable though it was for the economy as a whole – back to that later. The Bank of England had undertaken £860 billion of “quantitative easing” (QE) bond purchases in the last decade, which it was now proposing to start reversing through “quantitative tightening (QT).” However, its room-temperature-IQ minions had not thought this through. QT is not a feasible policy, on any but the smallest scale.
If you are tightening policy and raising interest rates, then bond yields are rising and bond prices correspondingly declining. In such a market, the ”carry” trade between short-term and long-term instruments is disappearing, while bond investors, who have an exposure to interest rates through their holdings of long-term bonds, are running ever-increasing losses on their portfolio, which today’s accountants force them to “mark to market”. In such a market, there is very little demand for new long-term bonds, because investors are suffering continual losses on the bonds they already hold. In such an environment, dumping additional bonds on the market, beyond the government’s inevitably bloated borrowing needs, is bound to cause a market crisis.
You can only do QT in periods when interest rates are declining and you are reducing short-term rates, but in those periods, you don’t want to do QT by and large. QT is thus an unimplementable policy, and QE a dead-end that imposes catastrophic permanent distortions on the capital markets.
Ben Bernanke, the inventor of the utterly pernicious QE policy, obviously never thought of this, and neither did the Japanese, British and European central bankers who idiotically followed his lead. Through a decade of QE, central banks have bloated their balance sheets without any possibility of unwinding the policy. In doing so, they have subsidized government waste at the expense of productive private investment. It is thus little wonder that the performance of productivity growth has been utterly abysmal in all countries where QE has been implemented. Central banks have starved the goose that lays the golden eggs and stuffed the goose that eats them.
There is another problem, which becomes clear when you consider the incentives for commercial banks as interest rates rise in countries such as the United States where QE has been implemented and they have large interest-bearing deposits with the central bank. If the Fed were to raise rates to 10%, it would kill the private sector economy, but not because there are no projects that might yield more than 10% (particularly in an environment where inflation is itself running close to double digits). However, where would such projects get their financing?
The big banks all have large amounts of nearly free deposit money from their retail and small business customers who keep transaction balances with them. Entirely without risk, if the Fed deposit rate were 10%, they could lend that money to the Fed and report gigantic profits. Why would they ever do anything else? The marginal profit from making a business loan is so much lower than the profit from simply depositing the money at the Fed that it is not worth the trouble. The banks can fire their lending departments, reduce overhead and increase profits still further. This will not be a problem to the corporate behemoths, who can borrow in the bond markets, but it will make finance entirely unavailable to small business, which depends heavily on the banking system. Guess what that will do to innovation and productivity!
The financial plans of Liz Truss and Kwasi Kwarteng are entirely sensible, the first decent economic policy proposed in Britain since Margaret Thatcher left the prime ministership, or more precisely since Nigel Lawson quit as Chancellor of the Exchequer in 1989. (His successor John Major was truly a disaster, taking Britain into the Exchange Rate Mechanism at an overvalued parity and then two years later, when it crashed out in humiliating circumstances, blaming his successor Norman Lamont for the policy he had implemented – a loathsome as well as inept human being.)
Naturally, the Truss/Kwarteng policies have come under withering attack from all sides. Truss has already put blood into the water by abandoning the sensible reduction in the top rate of income tax – a reform cheap even nominally and paying for itself many times over through supply-side effects. Whether the remaining reforms, minus the foolish energy subsidy, are sufficient to galvanize the economy enough to win her the next election, we shall see.
The greatest supply side reform she could undertake would be to remove the control of Conservative Campaign Headquarters from parliamentary candidate selection, thus removing the worst socialist back-stabbers from the parliamentary party. Having been Vice Chairman of a Conservative party Constituency Association, I can tell you that they are not uniformly sensible; those in the fancier suburbs in particular have an unpleasant “woke” and environmentalist element. However, the majority of Associations can be relied upon to pick a local candidate who will not betray party policy, and that would be a huge improvement on the present collection of woke quisling “Conservative” MPs.
In today’s naughty world, giving more power to Conservative party Constituency Associations is the nearest we can get to returning the franchise to the “forty shilling freeholders” in whom it rested when Britain was properly run!
As I said in the introductory paragraph, we are in these markets largely innocent victims of the fools who have gone before us. The only grounds for optimism are that the results of their foolishness seem likely to be unpleasant enough to compel a return to good sense – maybe!
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)