For all the talk about tapering (in both the US and Europe), the Federal Reserve has actually done remarkably little to reduce its balance sheet. And in an interview with Macrovoices Erik Townsend, former Wall Street executive Nomi Prins expands upon some of the same themes she covered in her latest book, "Collu$ion: How Central Bankers Rigged the World".
As Prins reminds us early on, the Fed and other central banks have expanded their balance sheets by more than $20 trillion, and despite all the chatter about withdrawing stimulus and letting its balance sheet roll off, the Fed's balance sheet has only shrunk from $4.5 trillion to $4.3 trillion.
Central bankers, Prins argues, like to pat themselves on the back for avoiding what many feared would be runaway inflation resulting from low interest rates and quantitative easing. But of course, they did create inflation, just not the kind that could be reflected by CPI:
But the reason the markets went up and didn’t see through that is not because they believed this wasn’t an act of desperation (I think), but because there was just free money being handed out. It’s sort of like if you’re a drug addict, and you know at some point you’ll be clearheaded if you just get off the drugs and get your act together and move forwards, that’s one way to do it.
Or if someone is supplying you with lots of drugs then it just works and everything else, well then you’ll take them. And this is what happened. The Fed was that sort of supplier of last resort and a lender of last resort of capital for the market.
And by, basically, blowing through interest rates, keeping them at 0% in the US and then globally as well, the cost of capital was so low, the ability of any actual government bond to return anything of any substance was also rendered low as a result.
While it's true that all of the money borrowed at rock bottom interest rates still needs to be repaid (unless you borrowed it from a European bank), the massive credit creation during the QE era could expose investors to additional credit risk as the global central bank stimulus is unwound.
And if we start to get problems, like credit risk that has been inflated since all the QE began would start to come to a head – defaults, delinquencies, emerging markets seeing their capital fly back out because there is just a little bit of a worry that this can’t go on forever – all of that starts to culminate into a major potential credit squeeze which, ultimately, can be the other leg of this crisis.
That consumers and corporations never took the opportunity to deleverage during the QE era means the underlying issues that caused the crisis haven't been remedied. This has left the global economy more vulnerable than it was before the crisis, and as central banks truly begin retracting their support (assuming they ever do), the fractures in the system will become apparent.
But I think, ultimately, the sort of coordinated effort of these central banks can keep the markets up for a number of years longer. But with more fractures coming into play, as the ones that we all envisioned would happen, which is that you can’t continue to allow the leverage to increase – forget the height of stock markets – but the leverage in the debt markets to increase indefinitely.
Because, at some point, even cheap debt has to be repaid. And so what we’re seeing right now, I think, is the beginning of that sort of reckoning coming in. With, for example, money flowing out of the emerging markets and emerging market ETFs as quickly as it has in the last few months. Because those are the markets that have, on a government basis, had more risk attached to them to begin with – and yet were able to attract massively oversubscribed bond issuances in the process of having to keep money available to them from a global basis, linking it to dollar-based debt (and so forth) from a corporate basis. And that just expanded the leverage in the world.
One of the most popular defenses of QE is that prices remained stable during the QE era, and the runaway inflation predicted by some detractors never came to pass.
But the notion that we haven't seen inflation is misguided. There has been inflation in asset prices - and of course in tuition and health-care. If we looked at inflation differently, perhaps people wouldn't give the Federal Reserve so much credit.
Again, it depends how we define inflation. There has been inflation as discussed in asset prices. There has been inflation in university costs, health care costs. There has been inflation in certain basic, let’s say, needs less than things like retail or areas that are actually deflating. And that sort of thing. There’s been inflation recently in oil prices, but not enough to really make the difference.
And there’s been cheap car loans so that people are still buying cars. So everything is kind of keeping itself in check. And inflation in general throughout the developed world where these main economic central banks operate is still really, really low.
And even in the US it’s kind of approaching the 1.9 or so percent on any given month. If you look back at the last 10 years, you know, yeah, it’s been at 2.3, it’s been at 1.5, it’s been at 2.2, it’s been at 1.0. You know, it’s still bobbling around very low levels.
And it’s even lower in Japan and in Europe and now moving that way in the UK and some of the major economies. So, yes, though, if you have that change, or if inflation was computed in such a way that it actually reflected people’s cost of living inflation and the financial markets inflation, then you probably would see stronger inflation.
Still, QE has taken us to a very strange place, Prins says. And that's not just in terms of the amount of quantitative easing, but in the nature and quality - the buying of riskier assets like ETFs in Japan and corporate bonds in Europe. And while central bankers like Mario Draghi, Janet Yellen and Ben Bernanke have more or less declared the post-crisis stimulus a victory, investors would do well to wait until balance sheets have been meaningfully reduced to judge.
Listen to the full interview below: