For a world which continues to be on life support – in the form of unsustainably large fiscal stimulus and near zero interest rates – policy makers are fast running out of options. One of the options left is quantitative easing and rumours are rife that the Fed and the BoE are both contemplating another round. But how effective is QE? Evidence from Japan suggests that, as a central bank continues to expand its balance sheet, the law of diminishing returns kicks in. Japan has been at it for years to the point where total central bank assets are now ¼ the size of the overall economy (see chart 3), but the results have been less than impressive. There are several reasons for this, but the most important lesson learned from Japan is that you cannot stop de-leveraging with lower interest rates.
QE2 around the corner? Inside the vaults of the Federal Reserve Bank, this fact does not seem to have sunk in yet with Bernanke seemingly prepared to initiate another round of QE shortly. He has even stated publicly that equity and bond markets are far more sensitive to monetary policy than is the real economy; hence the most effective way to stimulate the economy is through boosting financial markets. One problem with such a policy, though, as pointed out by Edward Chancellor in the FT earlier this week, is that it requires for consumers to draw on their savings to be successful. America needs higher savings and investments, not a continuation of recent years’ reckless spending.
Another problem is that it distorts currencies, but the Fed clearly doesn’t care. Not that they have said so in so many words, but their actions speak their own very clear language. I also find it remarkable that the Fed suddenly seems to be applying inflation targets. In the past, the Fed has always stayed clear of such policy. Now they are stating publicly that QE is necessary as current inflation is too low. Maybe it is, but relative to what? Officially, the Fed does not have an inflation target. The only conclusion I can draw is that they want the dollar to go lower, and equity prices to go higher, in order to fix the economic mess they have created themselves in the first place.
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Related article: Capt Bernanke on course for icebergs – By Edward Chancellor
Our typical quarterly letter has three parts. We describe our current macro view of the world, discuss briefly a current investment theme, and conclude with an examination of micro-market dynamics. Our goal with this structure is to share with our investors what we are seeing from the front lines of the global capital market battleground. But rather than write one more description of the pros and cons of QE 2, rather than write one more post mortem of the SEC report on the Flash Crash or the pernicious impact of correlation on stock picking, we have decided to devote this entire letter to an in-depth review of an investable theme that we are currently researching and acting upon: the mortgage backed securitization (MBS) crisis of 2010. This theme also has secondary and tertiary macroeconomic implications, and therefore influences our portfolio-wide views on risk and exposures.
We call this an MBS crisis, as opposed to “foreclosure-gate” or “robo-signing”, because there are three distinct dimensions to the crisis, only one of which is directly related to the foreclosure process, but all of which are inextricably part of the mortgage securitization process. The dimensions are:
1) Securitization and Underwriting
2) Trust Formation
3) Servicing
We believe that there are substantial investment risks and opportunities stemming from each. Before we discuss these opportunities, however, a brief review of the mortgage securitization process is in order.
The global economy is in a "particularly dangerous" position that can only be corrected if the currencies of developing countries strengthen relative to those of developed countries, according to William White, one of the few policy makers to correctly predict the onset of the financial crisis.
In an interview with Dow Jones Newswires, While also said that a new round of quantitative easing in the U.S. would carry big risks as long as there is no accompanying plan to cut the budget deficit.
Until June 2008, White was economic adviser to the Bank of International Settlements, and prior to that spent 22 years at the Bank of Canada. In the years leading up to the crisis, he repeatedly warned of the dangers of allowing rapid credit growth driven by widening global trade imbalances, and criticized central bankers who argued they were powerless to address the problem.
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This "massive infusion of credit" is now manifesting itself in the sharp rise of asset prices in large developing economies, which could potentially become another bubble that will burst with disastrous consequences for the global economy.
"Equity prices are going through the roof, house prices are going through the roof, there's a lot of concern that the thing might just collapse," White said.
"In effect, if one characterizes the last 20 years as being a whole series of credit bubbles...the real fear would be that this is...another one, but it's not showing up in the countries that did the initial easing, it's showing up in the emerging markets and we have to wait and see how that whole thing will play out," White said. "We are at a particularly dangerous moment."
Related previous posts:
THE MAN NOBODY WANTED TO HEAR
William White, from the BIS, on failures in economic theory, politics and policy.
Link to: Greenlight Capital Q3 2010 Letter
Michelle Rhee and Adrian Fenty on what they learned while pushing to reform D.C.'s failing public schools.
Keynesian policies are inflicting untold damage on the U.S. and global economies today. Things did not have to be this way; Keynes did not have to be misread. His antidote for slow economic growth and high unemployment – massive doses of government spending – was appropriate in midst of the 2007-8 financial crisis, just as it was sensible during the 1930s global depression that Keynes was experiencing while he was writing The General Theory. In end of world scenarios, government spending is the last resort. But once the economy stabilizes – even at a diminished rate of growth - Keynesian medicine will cripple the patient if it is not withdrawn and replaced with a healthy fiscal regimen. Unfortunately, policymakers – in particular the current and past Chairmen of the Federal Reserve – have shown themselves to be either unwilling or incapable of making the transition from crisis management to post-crisis management of monetary policy. As a result, today’s Federal Reserve is missing the second great lesson of Keynes’ work, the “paradox of thrift.”
Part 1
Part 2
Part 3
Part 4
Part 5
Part 6
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Full Interview
Over the past decade, stock market investors have experienced enormous volatility, including two separate market declines in excess of 50%. Despite periodic advances, at the end of it all, as a reward for their patience, investors have achieved an average annual total return of approximately zero. If the past decade has been a lesson for investors, that lesson should have two components. The first is that valuations matter. Though valuations often have little impact on short-term returns over periods of less than a few years, they are undoubtedly the single best predictor of long-term market returns. Moreover, high valuations are ultimately followed by far deeper periodic losses than emerge from low valuations. Put simply, greater risk does not imply greater reward if the risks that investors take are overvalued and inefficient ones.
The second lesson is that the effects of wasteful misallocation of capital cannot be fixed by policies that encourage the wasteful misallocation of capital. Fortunately or unfortunately, policies can often help to prop up unsustainable patterns of activity in order to "kick the can down the road." This can postpone major economic adjustments, but often makes the ultimate adjustment even worse.
Put simply, policies and investment practices that are effective and friendly to the short-term can often be destructive and violent to the long-term, particularly when those policies and practices encourage the misallocation of capital. Presently, investors are resting their financial security on hopes about quantitative easing - a policy that is essentially intended to skew the allocation of capital and provoke risk-taking in an environment where risk premiums are already thin.
