It is generally believed that the unconventional monetary policy of the Fed (and by extension the ECB and BOJ) is due to the so-called „wealth effect“. According to this theory, a rise in asset values will lead to higher average wealth, which in turn will boost confidence and spending. As for those households who have no assets to show for, don’t worry, the wealth is supposed to „trickle down“, from top to bottom. Step by step, all boats will be lifted by the tide.
Now, as an Austrian, I have always been sceptical of this theory. After all, the economic system is too complex to be planned in this way and unintended consequences are the rule, rather than the exception, as any real world decision maker will testify. Further, the typical Keynesian analysis of the root cause of the problem, namely that all ills are due to a lack of „confidence,“ strikes me as rather simplistic. What about incentives? The legal framework? Labour market flexibility? There is much, much more to a growing economy than confidence. And how do you define (or measure) confidence anyway?
But my view has changed. I do no longer believe the Fed believes in the wealth effect either. They are not that naive!
They must have noticed that buying financial assets merely increases inequality (and the systemic risks). A billionaire who gets another billion doesn’t spend much more than before. He usually also doesn’t start a new business. He still remembers how hard he had to work in the beginning to be successful: the sacrifice, the tension, the nagging doubts. Now he wants to enjoy the money – conspicuous consumption (check out Jim Chanos’s Sotheby’s short thesis here). Yes, he might give it to charity. But charitable spending, doesn’t lead to sustainable growth. Only risk taking and hard work can to that.
Likewise in Europe, Mario Draghi is not that stupid to believe that driving down the funding costs of his native Italy from 1.5 percent to negative will suddenly kick-start lending, or a healthy venture capital scene in that country. Obviously, the Mafia problem in the south is not a function of interest rates. He also must already have noticed that buying time for reforms doesn’t automatically lead to politicians delivering them. There simply is no empirical evidence whatsoever of governments reforming without a crisis. The much-cited Swedish banking crisis is a case in point: interest rates back than were not negative – they were in the triple digits…
But what, then, is this experiment about?
I think it has to do with the precarious state of the banking system. As I have hinted at on this blog (here) a few weeks back, I do not think the US banking system has been really fixed. In other words, I disagree with the common view that it is only Europe’s banks that are plagued by high NPLs. They might not appear as NPLs on the balance sheet, but surely a lot of debtors in the US are quite levered and would be in serious trouble with slightly higher rates.
Or, just ask yourself what would happen to the profitability of the banking system, if the Fed funds rate were 2 percent, i.e. if there were a cost to liquidity again. (2 percent is close to the 1.75 percent Stan Druckenmiller believes the fed funds rate should be if the Fed still followed the Taylor rule). Does anybody think they could reprice their assets accordingly? I can tell you what would happen: Banks would have an incentive to stop the extend and pretend game they like to play with debtors that are underwater. This would lead to accounting losses and falling asset values, as banks try to liquidate collateral.
David Einhorn’s latest quaterly letter contains an interesting observation which seems to confirm my thoughts. He points out that the sale of large chunks of GE capital, the banking arm of General Electric, led to a huge „after tax charge“ of USD 16 billion thereby casting doubt on GE’s reporting. Now, David thinks this is a GE specific problem, whereas I believe it is a bank-specific thing. I do not think GE could have cooked its books for such a long time if it were a mere industrial play.
I think central banks unorthodox policies are due to the fact that they recognize the banking system still suffers from legacy problems. Of course, it would be difficult to sell a back-door bailout of the banks to the public, hence the „wealth effect“. Now, there is no need to resort to conspiracy theories to get this result. It is a natural result of bureaucratic risk aversion and incentives. Neither does it imply that central bankers are omniscient. Whereas they are not that stupid to truly believe in the „wealth effect,“ they nevertheless can be considered naive to think that inflating asset prices can solve the bad debt problem, but more on that in another post.