The ugly truth about central banking

“All the banks are broke”, he complained. “It isn’t an act of God. It isn’t because of some sort of Tsunami. They’re broke because we have a system call fractional reserve banking…banks can lend money that they don’t actually have”.

The other Members of European Parliament sighed.

“It’s central banks who manipulate interest rates commissioner”, he complained. “Central banks repress the amount of interest rates so we don’t have the real cost of money”.

Godfrey Bloom wasn’t going to let this go:

“Underneath all of this we speak loosely, in a rather cavalier fashion…about deposit guarantees. So when banks go broke through their own incompetence and chicanery, the taxpayer picks up the tab”.

This prominent UKIP member (at the time) made no attempt to hide his fury.

“It’s theft from the taxpayer” he retorted. “And, until we start sending bankers, and I include central bankers, and politicians to prison for this outrage, it will continue”.

I’m not aligned with Godfrey. I voted to remain in the EU. I don’t share his views on immigration or his archaic ideas on women. But did he have a point?

There has been a decade-long saga where central bankers have been cast as the villains. They have been accused of outrageously flooding the world with stimulus using something called quantitative easing (QE).

When it was first unleashed, many foresaw a hyperinflation end game. It was seen as horrifically aggressive and untested. The death of the US dollar was considered almost certain and a huge bubble was predicted to form in government bonds.

But it didn’t quite happen like this.

The recession turned out to be more painful than anyone imagined. Economists rationally explained that there was an enormous output gap of unutilised economic potential. It had deepened to an unknown depth creating a gigantic economic sinkhole.

The successive glugs of quantitative easing were poured into this bottomless pit, which just disappeared into a void of uncertainty. Hyperinflation was suddenly at risk of deflating with the economic weakness.

Weirdly, QE’s newly created cash – made in exchange for government bonds held by the banks – did not lead to a gushing out of bank lending. It was instead, soaked up into the reserves of banks, now fearful of insolvency. 

Godfrey Bloom got his less fractional reserve system, but at what cost to our economy?

QE if it worked, would have led to the investment, spending and consumption that our developed economies needed. Instead it was accused of creating all manner of distortions in capital markets. Everything floated up – bond, equities and real estate – including the junk from the sewers.

Look, it’s not all bad!

The US dollar has actually appreciated and inflation never really reared its ugly head. However, one fear has persisted all the way until 2018 – the popping of an almighty ‘everything’ bubble.

Some portfolio managers have bet their careers on it bursting. 

Crispin Odey, a respected hedge fund manager, has consistently argued for the past decade that this wanton level of stimulus will end in a gigantic financial assets crash. He has bet heavily on this outcome, which has seen painful losses for his fund. He was down 20 per cent in 2017 and 50 per cent in 2016.

He’s not alone. John Hussman, an American portfolio manager, shares a similar view. His Strategic Growth fund lost 9.7 per cent over the last five years, while the S&P 500 has returned more than 85 per cent over this period.

Russell Clark, the manager of the Horseman Capital Fund, saw a loss of 24 per cent in 2016 for this view, and explain to his investors that “corporate bonds have performed much better than I expected…the signals are there, but everyone is making too much money to care”.

I don’t disagree with these very intelligent individuals. But as an investor I want more clarity on this subject before I make an investment decision like they have. So vilifying central bankers is not good enough to explain to me why my portfolio is at risk in 2018.

I’m just not satisfied with the views that the ‘experts’ regurgitate.

So let’s get down to the issue.

Bond prices should not fall when equities rise and yet they have for the last ten years. Now that interest rates are rising, bond prices remain stubbornly high alongside equities. 

It appears that central banks have lost their influence on long-term interest rates. Perhaps an all-asset bubble is now forming.

The state of the market is, however, far more complicated than this QE-policy narrative. Since the 1980s, real interest rates have been falling. If this is a crime, there are more suspects than the central bankers and their policies that we blame. 

We need to include ageing populations, deleveraging and my favourite of all, secular stagnation.

Let me explain.

Before the financial crisis, former Fed Governor Ben Bernanke identified a link to falling real interest rates. He noticed that the global supply of savings has also been increasing ever since the 1980s. This hasn’t been met by the same demand for these savings. Real interest rates as a consequence have struggled to fall low enough to clear this glut, which still continues to grow.

In terms of demographics, an ageing workforce is saving more than ever for retirement. The integration of China into our modern world economy has brought more than a billion people with a 40 per cent savings rate.

Deleveraging also continues thanks to the Financial Crisis. Meanwhile, younger workers are saving more than ever to clear student loans and get a step onto expensive housing markets. Millennials are actually saving more than any other segment of the population.

Then there is famed economist Larry Summers’ theory of secular stagnation. This suspects that the world is entering a sustained period of low economic growth. Here, there is a liquidity trap where low interest rates are insufficient to boost demand.

It’s an interesting theory that supports the points made on demographics and deleveraging, plus it explains the persistent disinflation that has been experienced over the past decade.

I think the real issue here, however, is much less grand. It is to do with our incorrect assumptions on low interest rates. Be believe that low interest rates will lead to great consumption. Yet for those looking to retire, lower interest rates mean they have to save even harder and longer. This what happens when you apply lower interest rates to discounted future cash-flows.

Perhaps what’s needed is a different tool, like expansionary fiscal policy. It might have more of an impact and it’s a lot nicer than austerity.

For now, I’m wary of making the call on a bubble suddenly popping this year. I don’t think this should drive how I should invest. So I won’t join the mob in vilifying central bankers. And I trust politicians even less than I did before. This is the ugly truth about central banking.