Inside investment: Did the drugs just work?

By:
Andrew Capon
Published on:

At first quantitative easing offered palliative care to the global economy – now the patient is finally reviving.


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During US president Richard Nixon’s visit to China in 1972, the premier of the People’s Republic, Zhou Enlai, was asked about his opinion of the impact of the French Revolution. The veteran Communist, who was already in his mid-30s when he organized military logistics alongside Mao during the Long March, is said to have replied: “Too early to say.” 

The curse of the columnist is to respond to the immediate stimuli of current events rather than the long-term historical narrative. The world economy seems remarkably buoyant. April’s Global Financial Stability report from the IMF paints a rosy picture. Growth is gaining momentum across developed and emerging markets, inflation remains in abeyance and gently rising interest rates are improving financial sector profitability and sharpening risk appetite.

If policymakers dream, this would surely keep them content in their slumbers. On waking they might then ask the two eternal questions: how and why? No one could accuse them of inaction. Bank of America Merrill Lynch trots out this tally every strategy report it publishes, but it is still worth retelling. Since the collapse of Lehman Brothers, interest rates have been cut 679 times and central bank balance sheets have expanded to $14.2 trillion. 

Quantitative easing, first trialled by the Bank of Japan in the mid-2000s, is the new monetary orthodoxy. The prescription is simple and well understood. Create money to buy financial assets and flood the banking system with excess reserves. This pump primes lending, boosts asset prices, revives animal spirits and averts a debt deflation spiral. The result is greater consumption, investment and growth.

Pesky counterfactuals

At almost any point from when the US Federal Reserve announced QE1 in November 2008 until now, that seemed no more than theory. Asset prices reached their lowest ebb in March 2009, but QE’s other promises looked hollow. The rich have done well. It is no wonder that inequality has become the defining political theme around the world. This may be QEs most enduring legacy. 

Lehman was a catastrophe. However, unlike every other credit boom and bust since the 1840s, no other important financial institution has failed. Bailing out bankers is not a vote winner. But banks are a necessary part of a functioning modern capitalist system. 

Growth and employment have ebbed and flowed, without ever reaching the extremes seen during the Great Depression. And all the time interest rates have remained low, keeping debt affordable for most. We cannot know what would have happened without QE; perhaps we should be thankful for this. 

Excessive credit creation is typically accompanied by rapid deleveraging. This has not been the case since 2007, with the exception of the financial sector. Total debt has increased globally by $49 trillion, according to McKinsey. In the case of China, debt has quadrupled. We have become used to the Chinese setting new economic superlatives, but this pace of credit expansion is completely unprecedented. 

Still a long march

New credit in China between 2009 and 2015 amounted to 139% of GDP. That is more than double the pace of credit creation in the US in the five years before the financial crisis. In China, as is the case all around the world, the productivity of debt is falling precipitously. For every dollar, euro or yuan of new debt created, less GDP is extracted.

In China, between 2000 and 2007, every new yuan of debt bought around 25 fen of GDP; today that has fallen to around eight. The law of diminishing marginal returns has been met by the ever-widening circle of debt. China matters. The current cyclical upturn has less to do with president Trump’s promises than Chinese action.

Faced with an unprecedented flood of money offshore in late 2015, the Chinese authorities intervened to support the value of the currency and kick-start reflation early last year. A devaluation would have seen China exporting deflation. Import volume growth in China over 2016 was 15%. It edged up in the US and was flat in the eurozone. The current benign economic picture owes much to Beijing. 

For lovers of cliché that have used Zhou’s enigmatic quote as proof of China’s long-term thinking, it is perhaps sad to report that contemporary observers say that he was referring not to 1789, but to the student uprisings in Paris of 1968, four years earlier. 

Those confident that monetary policy can cure anything should be similarly circumspect about distinguishing myth and reality. QE has helped the global economy dodge a fate akin to the French aristocrats travelling through the streets of Paris on a tumbrel. But this Goldilocks moment we are all enjoying is made in China.