Water and Money Flow to the Lowest Energy State
As you might guess, add me to the list of hind-sighters looking back and calling Quantitative Easing a failed policy. The idea and intentions were good, but any objective observer can only conclude that this has been a perfect case study of enthalpy. In physics – and apparently in finance, all bodies seek the lowest energy state.
To wit: The Federal Reserve Bank has bought or is buying every last long-term bond and MBS (mortgage backed security) it can get its hands on – presently at a rate of $85 billion per month (or $1 Trillion per year). The intended (good) result from this was the downward pressure on long-term (specifically housing / mortgage) interest rates. This was expected to also have an additional economic benefit of driving down corporate borrowing costs (which it has).
The Lowest Energy State Monetary Policy of Lowering Yields
The ability of the Federal Reserve to gain hold of wide sections of the yield curve has been very successful. The Fed lowered rates (on the short end) to zero, and by being the ultimate force (and source) of demand on the long end, pushed 10Y and mortgage rates to record low levels. I am sure the Fed Board of Governors pat themselves on the back and congratulate out-going Chairman Bernanke for a job well done in that regard. The problem with all the congratulations is that the results of the effective policy manuevers have been a far cry different than what was intended. The Fed has created a tremendous supply of cheap money (a principal objective); the only problem is that those funds were used (almost entirely) in the least productive manner possible. Regardless of how people feel about who had access to the money (either directly via the Fed or via access to credit markets), almost the entire amount has ended up in a few excess reserve accounts rather than in the hands of the public. The entire Quantitative Easing program resulted in virtually no productive (capital investment) credit growth, and virtually no job growth.
Basically from a physics perspective the money started out at a very low energy state and then directly cascaded to the lowest energy state and stayed there – releasing the tiniest amount of economic boost possible then remained in a coma – with an occasional (low yield) heartbeat.
The Limitations of Monetary Policy
The above result describes the principal difficulty in using monetary policy to boost growth. When in a relatively normal economy, occasional rate changes up or down have the effect of juicing or starving the economic activity via credit creation (the non-productive segment of the economy). The problem arises when economic activity falls outside the “normal” range of growth / modest declines and the real productive part of the economy begins to shutdown. When a globally-connected economy enters this state (as it did during and since the financial crisis in 2008) – no amount of monetary policy change in the non-productive segment of the economy is going to restore growth to the productive part. Monetary policy produces low-energy state money which has extremely little impact outside the financial sector. It can add a few dollars to EPS of financial stocks but it will have no impact on economic or jobs growth – monetary policy just doesn’t ever reach the productive part of the economy. We have seen that in the world’s largest ever case study (running since 2008).
Where does the money go then? It’s fairly obvious who the biggest beneficiaries of loose monetary policy have been – the investment banks. No, this is not a post calling for a lynching of the finance sector – as far as I am concerned they have done exactly what anyone would have expected them to do: they took the money given to them and did what investment banks do with that kind of money: they invest it in existing securities and (to a vastly lesser extent) other assets. They did it so well in fact that on numerous occasions household names like JPMorgan and Goldman Sachs went entire quarters without a net trading-day loss.
What About the Impact of Lower Corporate Borrowing Costs?
Critics might argue that the lowering of interest rates on corporate debt would spur additional credit growth in the broader business sector and create an environment for business expansion. The problem is that business expansion requires a great deal more than free (or cheap) credit. Business expansion requires some level of confidence that there is a good opportunity *somewhere* to exploit. Business investment / expansion requires case studies of available opportunities that are expected to generate a positive (and significant) return. Ideally a business with significant amounts of available capital or credit will have a number of positive-return (positive NPV or net-present-value in corporate finance parlance) projects to select from and will then distribute that capital accordingly.
My question is: Where exactly are those positive NPV projects today? One of the biggest challenges to financial modeling is uncertainty of outcomes. The greater level of uncertainty of results, the higher the required return on investment (and hence lower chance of expected positive NPV). Businesses of all sizes today face tidal waves of uncertainty coming from every imaginable direction. To their credit, the Federal Reserve has done about as much as one can expect in reducing uncertainty in financial / credit markets – but who can reduce fear or failure everywhere else? What kind of fears do businesses face? Howabout uncertainty about the new healthcare law? What about data and systems security? Whatabout energy costs? Whatabout the impact of declining demand from demographic shifts? Whatabout the fear of global demand decline? What about the biggest one of all: Frozen Global Governments?
Some or all of these factors (and more) contribute to the decision-making process of capital allocators within corporations and businesses. Corporate finance executives are not dummies and to date have generally availed themselves of the massive amounts of low-cost credit available to them. The only problem is that despite all the available low-cost credit there just aren’t projects anyone can have confidence in. So finance executives do the only sensible thing they can with cheap debt: they buyback (higher cost credit) shares of company stock.
Fiscal Policy and Good Governance Is the Only Way Out
If we have learned anything from the last several years of cheap-credit from Quantitative Easing it is this: Monetary policy has no impact outside a certain range of economic conditions – and no matter how much cheap money you shove down Wall Street’s throat it isn’t going to create jobs on main street. In fact, it is more likely killing jobs and businesses – starved of new and future revenues because larger businesses have no expansion plans and have no choice but to cut costs (and heads) in order to maintain the illusions of EPS growth.
The only way out of this coming economic calamity is good Governance (no deadlock) and (productive) expansionary fiscal policy on a global scale. Without these two things on a global scale, we.are.done.